Use spreadbets to protect you when markets are stormy
Don’t worry about turbulent times: there is a simple and inexpensive way to shield your portfolio, finds Katie Hope
Cash is king once again. Last week, research by Merrill Lynch found that fund managers were retreating to the safety of cash on fears that equities had further to fall. The worldwide poll of 191 fund managers found that 53 per cent were overweight cash, with 40 per cent underweight equities.
With the stock market in free-fall – the FTSE 100 has lost around 16 per cent since the start of the year, for instance – the temptation for the retail investor is to follow the big boys and swap his equity portfolio for cash.
Theoretically, someone with a sizable portfolio who was concerned that the market might crash could sell his shares, wait for the market to fall and then reinvest.
But brokerage charges, stamp duty as well as possible capital gains tax liabilities make this a pretty pricey option. Clem Chambers, chief executive of financial information website ADVFN, estimates that on a £1m portfolio such costs could amount to £35,000.
“Getting out of the market to re-enter later is therefore an expensive manoeuvre. It would of course be an expensive pain if the market continued to go higher,” he says.
Tin Hats
But before donning tin hats and running for cover, there is another way that could allow you to compensate for further falls in your physical portfolio without having to sell any shares.
Spreadbetting, often wrongly seen as simply a short-term investment tool, can also be used to hedge a physical share portfolio against short term falls in the market. It is much cheaper to do this than to sell the entire portfolio and buy it back at a later stage.
In its simplest form, you go short, by placing a sell bet on the major stocks in your portfolio so that if the market does drop, lowering the value of your share portfolio, then you will immediately make a compensating profit on your spread bet.
Alternatively, instead of placing a bet on the movements of individual share prices, you place a bet on the movement of the index which has the closest match to your portfolio.
If your portfolio is made up of large blue-chip companies, a spread on the FTSE 100 would be an appropriate hedge. Once you believe the market has bottomed, you can then close the spreadbet and leave the portfolio untouched.
“By taking out a bet in the opposite direction using a spreadbet investors can quickly and easily reduce the risk in their wider investment portfolio. “Spreadbetting is therefore a way in which risks can be reduced and overall returns enhanced,” says Paul Chesterton, senior sales trader at spreadbet provider CMC Markets.
Perfect Vehicle
In the current volatility, a lot of experts believe this kind of hedging makes sense and spreadbets seem to be the perfect vehicle.
“Hedging is possible on any product that you can sell short. You would use spreadbets to hedge your portfolio because it’s a low cost, tax efficient way to hedge. “You only need to put down a small amount of margin for a hedge, and gains are tax free,” says Manoj Ladwa, derivatives broker at TradIndex.
But timing can be tricky. “The problem with selling after big falls is that you may hedge at the low,” points out Tim Hughes, head of sales at spreadbet provider IG Index. Hedging will lock in values now.”
Also, just because conditions are volatile, that does not necessarily mean it’s a good time to hedge. “There’s no point doing it just for the sake of it, okay you might limit your losses, but in the long run you’d never make any money,” says Dave Evans, market analyst at fixed odds provider Betonmarkets.com.
“Hedging your portfolio is akin to taking your shares off the market temporarily, which may not always be the best option.”
Another disadvantage is that it may be difficult to create an exact hedge. If you own an ISA tracking the FTSE 100, then it’s pretty easy to hedge. But if your ISA tracks a broader basket then it may not be possible to create a precisely matching hedge. Even so, in the right circumstances hedging can be a good strategy.
With fixed odds betting, for example, assuming your share portfolio is largely made up of FTSE 100 stocks, you can hedge against a large one-month drop using something called a “one touch” trade.
For example, you predict that the FTSE 100 will touch a level 1,000 points below its current position in the next 35 days. Such a bet could return 2,693 per cent – or £965 profit – for every £35 risked, according to Evans who says this trade would cost £7.
A 1,000 point fall in the FTSE would represent roughly a 20 per cent decline in your portfolio, or £200 based on a £1,000 portfolio.
“The good thing about a one touch trade is the fact that the market only has to touch the predicted level once for you to win. It could rebound from that point and you will have still made money,” he says.
So, to hedge or not to hedge? In the end it comes down to whether your strategy is based on long term gains, or making money in the short term.
Whatever your ultimate aims, hedging using spreadbets is a useful tool to add to your trading tactics armoury, but undoubtedly one to be deployed with care.
What its hedging?
Hedging is a popular strategy used to reduce the risk of holding a long term position in another instrument. To hedge, you should take a short and equal position, via a CFD or spreadbet, in an instrument whose price moves in the same way as your long term holding.
You may hedge if you believe that the value of a holding will fall in the short to medium term, but you don’t want to sell your holding due to transaction costs or tax consequences. Instead you can temporarily reduce your exposure with a down bet on an equivalent product.
If the value subsequently falls as you fear, your physical holding is worth less, but you have a trading profit to compensate for that. You can also hedge part, rather than all, of your holding, thereby retaining some long exposure should your decision to hedge be wrong.