Scenario: You have been positioned in the market for quite some time and reviewed both fundamental and technical analysis in formulating your investment decisions. Your present portfolio is comprised of $334,000 of large capitalization stocks similar to the DJIA and $66,000 invested in a money market fund.

In August, the value of the DJIA is 7800 and the stock market continues to rise. A variety of technical and fundamental factors that you have been charting, however, suggest a possible short-term downturn as early as September. Consequently, you believe you should change the mix of your investments to $100,000 in stocks and $300,000 in money markets, or 25%/75%. With this reallocation, you still keep some exposure to equities in case the market does not decline.

Strategy: Because you feel any market decline will be short-lived, you would like to keep your cash portfolio intact. The CBOT DJIA futures market provides a proxy for the reallocation of assets in your position. To decrease your equity exposure by $234,000 (to achieve the 75% allocation), you sell CBOT DJIA September futures contracts. The futures price is 7839. (Therefore, the cost-of-carry rate = .5% or 7839/7800 - 1.)

Inputs: The DJIA is 7800. The appropriate number of contracts to sell is :
$234,000 / ($10 x 7800) = 3 futures contracts

Results: Your market expectations were correct. At expiration of the September futures contract, the DJIA is 7644, giving you a return of -2% on your portfolio (exclusive of dividends). The money market portion of your investment has earned a rate of return of .5%. (This is the same as the cost-of-carry rate, because the futures price is assumed to be at its fair value.)

Value of Portfolio with No Market Action Taken
STOCKS $334,000 x .98 = $327,320
MONEY MARKET + $ 66,000 x 1.005 = $66,330
$393,650

Value of Portfolio with Futures Position
SHORT CBOT DJIA FUTURES 3 x $10 x (7839-7644) = $5,850
$399,500

Value of Portfolio with Reallocation of Assets in Cash Market
STOCKS $100,000 x .98 = $98,000
MONEY MARKET + $300,000 x 1.005 = $301,500
TOTAL $399,500

Comments: By using the futures market to achieve your objectives, you now hold the equivalent of a $100,000 investment in DJIA stocks and a $300,000 investment in the money market instrument. The stock market decline now only impacts $100,000 of your stock portfolio rather than $334,000; in addition, you earn a money market rate of return of .5% on the $234,000 difference.

Without futures, your portfolio is worth only $393,650. The $5,850 profit on the short futures position offsets the loss on the $234,000 of your portfolio that was moved out of equities by the short futures position. In short, by selling futures, you are able to shield $234,000 of your initial wealth from a stock price decline, achieving nearly breakeven given these market conditions. Of course, had you been more confident of the market decline, you might have completely neutralized the equity risk on the portfolio by selling more futures contracts. This would have converted the entire stock position to a $334,000 investment in the money market. The amount of protection you should obtain depends on your assessment of the market and your tolerance for risk.