Calculate Return on Futures Hedged Position

What is Return on Futures Hedged Position?

The return on a futures hedged position refers to the net profit or loss generated from a trading strategy that uses futures contracts to hedge against price movements in an underlying asset. This metric combines the potential profit from the futures contract with the cost of establishing and maintaining the hedge.

Hedging with futures contracts is a common practice in commodity trading, financial markets, and risk management. By taking a position in a futures contract that offsets potential losses in the underlying asset, traders can protect their portfolios from adverse price movements.

How to Calculate Return on Futures Hedged Position

The return on a futures hedged position can be calculated using the following formula:

Where:

• Profit from Futures Contract is the difference between the futures contract's settlement price and the initial price.
• Cost of Hedge is the total cost of establishing and maintaining the futures contract.

This formula provides a percentage return that reflects the effectiveness of the hedging strategy. A positive return indicates that the hedge was profitable, while a negative return indicates a loss.

Example Calculation

Let's walk through a detailed example to illustrate how to calculate the return on a futures hedged position.

Step 1: Determine the Profit from the Futures Contract

Suppose you enter a futures contract to hedge against a decline in the price of gold. The initial price of the futures contract is $1,500 per ounce, and the settlement price is $1,600 per ounce.

Profit from Futures Contract = Settlement Price - Initial Price = $1,600 - $1,500 = $100

Step 2: Calculate the Cost of the Hedge

The cost of the hedge includes the initial margin deposit and any additional fees. In this example, the initial margin deposit is $1,000, and there are no additional fees.

Cost of Hedge = Initial Margin Deposit = $1,000

Step 3: Compute the Return on the Futures Hedged Position

Using the formula, the return on the futures hedged position is calculated as follows:

Return on Futures Hedged Position = (Profit from Futures Contract - Cost of Hedge) / Cost of Hedge

Return on Futures Hedged Position = ($100 - $1,000) / $1,000 = -0.9 or -90%

This result indicates that the hedge resulted in a 90% loss, suggesting that the hedging strategy was not effective in protecting against the price decline.

Interpreting Results

Interpreting the return on a futures hedged position involves understanding the implications of the calculated result. A positive return indicates that the hedge was profitable, while a negative return indicates a loss.

Here are some key points to consider when interpreting the results:

• Positive Return: The hedge was profitable, and the trading strategy was effective in protecting against price fluctuations.
• Negative Return: The hedge resulted in a loss, indicating that the hedging strategy was not effective in protecting against price movements.
• Zero Return: The hedge broke even, meaning that the profit from the futures contract was equal to the cost of the hedge.

It's important to analyze the results in the context of the overall trading strategy and market conditions. Factors such as market volatility, interest rates, and transaction costs can significantly impact the effectiveness of the hedge.