Creating a Diversified Portfolio With Futures

Creating a diversified portfolio using futures contracts involves having a working understanding of how to diversify assets and how various assets are correlated with one another. 

Futures contracts typically have a different trading dynamic than their underlying assets. Futures also offer portfolio managers the advantage of leverage, which lets them control a relatively large diversified portfolio with a given amount of funds. 

In this article, Benzinga explains in practical terms how to create and manage a diversified portfolio using the variety of futures contracts currently available. The benefits of including futures in your portfolio entails are also discussed in detail.     

How to Create a Diversified Portfolio With Futures

• Describe Your Outlook and Plan of Action
• Choose the Sectors You Wish to Follow
• Determine Leverage Ratios and Contract Values
• Evaluate Maximum Risk Per Futures Position
• Establish Positions in the Portfolio

If you’re already an experienced investor, then you’re probably aware that fostering diversification in your portfolio creates a certain level of safety. By investing in multiple financial instruments and asset classes, your funds are protected to a certain extent against market fluctuations since non-correlating assets generally trade independently of each other. 

When using diversification to create a safer portfolio, you’ll need to take certain steps before you can start to diversify with futures. Keep in mind that futures trading can be riskier than taking an equivalent position in the underlying asset because of the amount of leverage available, so you’ll want to watch your futures portfolio closely and use prudent risk and money management techniques as appropriate to protect your investments. 

The steps below lay out what you’ll ideally need to do to set up a diversified portfolio, as well as what futures contracts you can select to include in your portfolio. 

Describe Your Outlook and Plan of Action

To create a diversified futures portfolio, you should have developed a medium-term outlook on the general economy. This outlook should include how you think global economic conditions will evolve over your chosen investment time horizon and how this projected scenario will likely affect the asset markets you plan on investing in. 

For example, if your outlook is for the U.S. dollar to remain strong over the medium term, think about how this might impact the price of gold. Also, if you have a bullish view of energy prices, consider how that might affect the stock and bond markets over the coming year. 

Once you’ve formed a knowledgeable opinion on the overall outlook for economies of interest, you can then more easily select appropriate asset types and begin monitoring their markets to find a good time to take futures positions in them. 

Choose the Sectors You Wish to Follow

To build a diversified portfolio, you will need to select what assets you plan on investing in. If your diversification plan involves futures contracts, then you’ll need to choose among the various assets, indices and commodities that have futures contracts traded on them. 

The CME Group is a futures exchange that offers trading in futures contracts on a wide variety of assets that can help diversify your portfolio.

A partial list of these futures products includes:

• Agriculture: Corn, Soybeans, Soybean Oil, Soybean Meal, Wheat, Lean Hogs and Live Cattle
• Energy: Crude Oil, Henry Hub Natural Gas, Brent Last Day Financial Futures, Reformulated Blendstock for Oxygenate Blending (RBOB) Gasoline, NY Harbor Ultra-Low Sulfur Diesel (ULSD) fuel and E-Mini Crude Oil
• Equities: E-mini S&P 500, E-Mini Nasdaq-100, E-Mini Dow Futures, Nikkei/yen, E-Mini Russell 2000 Index and E-Mini S&P MidCap 400
• Currencies: Australian dollar, Canadian dollar, Swiss franc, EU Euro, British pound, Japanese yen and Mexican peso versus the U.S. dollar, plus the EUR/GBP cross and Bitcoin. Currency futures contracts are generally traded in foreign currency amounts and priced in U.S. dollar terms
• Interest rates: Eurodollar, U.S. 2-year Treasury Notes, U.S. 5-year Treasury Notes, U.S. 10-year Treasury Notes, U.S. Treasury Bonds, 20-year U.S. Treasury Bonds and the Three-Month Bloomberg Short-Term Bank Yield Index
• Metals: Gold, Silver, Platinum, Palladium and Copper 

CME Group futures contracts typically have quarterly delivery dates in March, June, September and December. Some futures contracts also have regular monthly delivery dates, while others have an irregular schedule, so you’ll need to check to ensure your desired delivery date is offered. 

In addition to the standard full-sized futures contracts, you can also trade E-mini futures contracts on some assets that are 1/5th the size of standard futures contracts, as well as micro futures contracts that are 1/5th or 1/10th the size of the E-mini contracts. 

Micro E-mini futures can currently be traded on the S&P 500, the Russell 2000, the Nasdaq-100 and the Dow Jones Industrial Average, in addition to eight different currency pairs, gold, silver, copper, Bitcoin, RBOB Gasoline, NY Harbor ULSD and WTI Crude Oil. 

Determine Leverage Ratios and Contract Values

In most cases, you will want to place only a small percentage of your total investment funds into each futures position when using futures contracts for diversification purposes. This practice avoids overweighting your portfolio’s exposure to a particular asset. 

The cost of a futures contract and the amount of leverage you can use with that contract should also be taken into account before allocating funds to each futures position. You will also need to know what futures expiration dates are available for the asset you have selected. 

For example, silver futures (SI) have a contract unit size of 5,000 troy ounces and trade on a fairly irregular expiration calendar. At a price of $24 per troy ounce, one silver futures contract would be worth $120,000. 

To control just one standard silver contract, you would need to put up an initial margin amount of $4,675, as well as an intraday maintenance margin requirement of $4,250, an overnight requirement of $9,350 and a maintenance margin of $8,500, for a total of $26,775 or 22.3% of the contract’s current value. This implies a leverage ratio of 22.3/100 or around 1:4.5. 

In contrast, the E-micro silver futures contract only has a size of 1,000 ounces of silver per contract, which would be worth $24,000 at a price of $24 per troy ounce. This contract size has a proportionally smaller initial margin of $935, an intraday maintenance margin requirement of $850, an overnight requirement of $1,870 and a maintenance margin of just $1,750, for a total of $5,405 or 22.5% of the contract’s present value. 

Depending on the amount of money you plan on investing, you can generally size each of your futures positions appropriately using full-size contracts, E-mini or E-micro contracts. With the impressive leverage available in the futures markets, you’ll be able to control a substantially larger position than if you took a position in the underlying asset markets.   

Evaluate Maximum Risk per Futures Position

After selecting the futures contracts you’ll be using to diversify your portfolio, an evaluation of the maximum risk you wish to take on each futures position would be prudent as the next order of business. Keep in mind that using leverage means that both your profits and losses get magnified.

You can then enter orders to manage your futures positions when your risk tolerance is exceeded. To do this, you would first determine your maximum risk per position. You can place protective stop-loss orders on all of your futures positions that will be executed when the market reaches your maximum risk levels. 

If you have an existing asset portfolio, you might be able to use futures to either hedge existing positions or add to them. You might be able to adjust your risk profile using options on futures contracts to take advantage of a specific market view. 

Establish Positions in the Portfolio 

Ideally, you’ll have some experience researching the markets you plan to trade, which will benefit you once you begin trading into your positions. For in-depth market analysis in virtually every financial market, Benzinga Pro provides some of the best futures news and information on the Internet. 

Once you have selected the futures contracts that you’ll be trading in your portfolio, you can begin establishing futures positions in your portfolio account. 

Remember that using prudent money management techniques to size your futures positions can help manage your risk considerably, but most investors will still want to protect their futures positions with stop-loss orders since the unexpected can happen often enough to warrant having that sort of insurance in place. 

The Benefits of a Diversified Portfolio

Having a diversified portfolio helps prevents you from taking investment losses by not metaphorically “putting all of your eggs into one basket.” If the bottom of that basket fails unexpectedly, then you get stuck with a bunch of worthless broken eggs. 

Similarly, your net worth will suffer the losing consequences if the bottom drops out of the market for your main investment if you have not diversified into other more resilient assets.

The benefits of a diversified portfolio versus a standard concentrated portfolio are many. One of the more obvious benefits is the reduced exposure your portfolio experiences to the volatility of any one market. This plan can both protect your principal and help you grow your portfolio steadily over time. 

Below you’ll find three benefits offered by a diversified portfolio that you will not necessarily enjoy with a standard portfolio:

• Less risk: By spreading your investment principal among futures contracts on a wide range of underlying assets, your overall risk decreases if the underlying assets are negatively correlated. Having less risk also means you experience less stress, especially if you have a low degree of risk tolerance.
• Added profit potential: When positioning among various assets, your profits could potentially increase if one or more positions notably outperform the rest of the portfolio. The reverse could also occur depending on what futures contracts you have in your investment account.  
• Better overall long-term performance: When you allocate your funds among non-correlating markets, your portfolio can better weather economic downturns, inflation, interest rate shifts and other potentially adverse economic events. Diversification also helps improve your portfolio’s overall long-term outlook and performance, although that will also depend on which assets you choose to invest in. 

Considerations When Diversifying Your Portfolio

Actively managing a diversified portfolio takes time and effort, so it is not suitable for every investor. This factor explains why you can find so many diversified portfolio mutual funds to invest in since they can considerably simplify matters for those who wish to avoid the hassle of selecting their own varied investments and allocating funds among them. 

The sections below include three major considerations you should take into account regarding diversifying your portfolio with futures contracts.  

• Selection of underlying assets: The most important element in creating a diversified futures portfolio is selecting the right underlying assets and futures position amounts to add to your portfolio account. Having a solid background in technical and fundamental market analysis can give an investor a good foundation for selecting assets. Also, using prudent money management techniques can assist with sizing positions appropriately.
• Keeping track of several markets:  Desiring diversity in your investment portfolio suggests that you might operate in several different futures contracts and preferably in contracts without correlated prices. While may sound relatively easy, keeping track of several asset markets at one time may prove overwhelming to some investors regardless of their level of experience. 
• Capital intensive: While the margin amounts required to hold micro-sized futures contracts are fairly low, trading futures as a portfolio diversification strategy can be quite capital intensive, especially when you’re holding futures positions in more than one market. Futures markets also have periodical expirations where you have to either close out your positions or roll them into the next futures expiration date. Basically, you’ll need a well-funded futures trading account with sufficient money to hold positions over your intended investment horizon to use futures to implement a portfolio diversification plan. 

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