In a volatile market, investors should look at ways to protect themselves against the uncertainty of the share market and adverse price impact on the value of their assets.

To do that, one could bank on Extended Settlement (ES) contracts, which are forward contracts with a 35-day settlement period.

ES contracts let investors lock in prices in advance and allow hedgers to reduce their price risk by buying ES contracts to create a long hedge or sell them to create a short hedge.

Compared to other derivatives such as options, ES contracts are a better tool for hedgers, as seen in the table below.

While investors can use a short ES contract to lock in a higher price in anticipation of short-term slides in share prices, they can also use long ES contracts to hedge on an anticipated rise in the price of shares they are eyeing.

Through a long hedge, investors can protect themselves against a rise in the price of shares and lock in the “purchase” price of the underlying shares before paying for it.

For example, ABC shares are trading at $3 on Sept 1, 2010, and the Sept contract of ABC ES is trading at $3.01.

An investor, who has been planning to add 10,000 ABC shares to his portfolio, may feel ABC shares is slightly undervalued and is a good investment at this level. However, his funds may not be available immediately and he wants to lock in the price before it increases.

Buying and ES contract (with less cash) will let him take delivery of the share when the contract expires, as his funds become available. He can then buy 10,000 ABC

ES contracts at $3.01, at the margin of $1,505.

Assuming his funds become available in two weeks, both ABC and ABC ES contracts rise to $3.50.

The gain in his ABC ES position would be ($3.50 - $3.01) x 1000 x 10 lots = $4,900.

The gain — from his long ES position — is his savings from purchasing the ABC shares early.

Hence, ES contracts allow investors to hedge both long, and short, and make the most of fluctuations in share price movements at the same time.