Hedging with Spread Betting

Another trading strategy is using spread betting as a hedging mechanism; indeed the recent volatility has made hedging more popular amongst investors and necessary. Financial spread betting involves betting on the direction of a financial market without buying or selling the underlying instrument. Hedging at its core is different from speculative trading in that traders actually have an asset to protect – they are not just taking a bet on prices and hoping to make a profit. Because of the relatively high level of gearing and the favourable tax treatment of profits, it can be a useful and effective method of hedging a portfolio or a currency exposure for the short to medium term.

Spreadbets are a useful instrument for hedging purposes. You can hedge because financial spread betting allows you the ability to bet on whether a financial instrument will move up or down in value; the fact that spread bets are leveraged means that investors can protect their shares portfolio with a financial outlay that is just a fraction of the value of their shareholding. But short selling isn’t only useful for speculation, though. Since spread betting allows the option to profit from falling market prices, it offers a perfect protection for anticipated losses portfolio values. Hedging essentially means protecting or trying to minimise any risk that may affect your existing investment portfolio. Hedging in this respect involves using spread betting as part of a short-term strategy as a means to protect your shares portfolio when faced with market turmoil.

Some speculators tend to hedge when important economic news is due like a company issuing a trading update or big economic news. In this respect, financial spread betting allows you to setup a quick and effective hedge to protect your investment portfolio without having to sell and exit your long term positions. Having said that using spread bets as a hedging mechanism is not ideal due to the tax regime. This is because profits from spread betting are a wager for tax purposes which effectively means that while gains are not taxable, losses are likewise not allowable and thus cannot be offset against profits elsewhere.

Hedging a Shares Portfolio through Spread Betting

Spread betting provides traders and investors alike with an excellent trading tool capable of protecting investments against unfavorable movements in share prices. While some market participants are day traders in spread bets, others are investors who use them in conjunction with other investments as a way to mitigate risk or limit any possible harsh consequences of stock market volatility. Spread bets allows traders and investors to lock stock value at the present price by placing a down bet in the same stocks in their portfolios, which is especially useful if a market or share is about to fall in value. For example, such investors will go short in the market to benefit from falling markets to hedge against their existing shareholdings. Additionally, spreadbets being margined transactions means that you are able to leverage short positions. So for a fraction of the underlying market exposure, you can undertake a hedging strategy.

Placing a bet of £1 per point is the equivalent of holding 100 shares, so with a holding of 10,000 shares, placing a down bet of £100 will lock the value of the holding until the hedge bet is closed. For instance, if you were worried that your existing shareholding worth £10,000 of Vodafone shares might be in for a rough ride in the short-term but you still believed your investment to be sound for the longer haul, you could short sell the equivalent of £10,000 Vodafone shares using a spreadbet. Because spreadbets are traded on margin, you only need a fraction of the total notional value of the trade in your trading account to open the trade. Should Vodafone’s stock price then fall by 10%, the loss in value of your shareholding would be offset by a gain in your short sell spread betting trade.

Equally, if you were of the opinion that the markets will keep recovering but you aren’t so confident to buy heavily in the real market, a spreadbet could be used to hedge against underlying shares that you own. Let’s say you owned 5,000 shares in Barclays and was worried about them in the short-term due to the ongoing Eurozone problems but still wanted to retain them as part of your longer term investment strategy. These Barclays shares could be part of your ISA or SIPP for instance. In this case you could take out a short position (this is selling a share with the expectation that its value will decline) if you are uncertain of how a stock will do in the future, but you want to keep hold of the underlying stock.

Let’s take an actual example. You bought 100,000 of ordinary stock in Company XYZ at £1 per share. Over a 6 month period they increase to £120p and are now worth £120,000. You think that they might fall back to about 110p per share but wish to avoid selling them now to avoid creating a capital gains tax liability so you decide to take out a spreadbet. This way, if your fears prove right, although you’ll still lose money on the shares, you’ll make money on your short spread betting position.

So you take out a short position at 120p with a spreadbet at £1,000 per point. This is the same as a stock exposure of £120,000 and with a 10% deposit margin, you would only need to put down £12,000 to open the position. As you feared, the stock price falls to 110p and now you close the spreadbet, buying at 110p and giving you a gain of £10,000. So in essence you have lost £10,000 on your shares holdings, but the loss has been offset by a tax-free £10,000 profit on your spread bet.

For instance, back in 2007-2008 when the credit crunch was heavy underway, anyone who owned shares in a bank institution or home building company could have sold the spread-betting quote. And while their underlying share value was going down, their spread betting would have offset the losses incurred on their shares positions.

Several times recently I’ve seen my holdings in ARM stock jump on some rumour and then fall back as the market overreaction settles back. The temptation is to sell after such a jump and then buy back, but one could use a an opposing spread bet to lock in the financial gain more cost-effectively. Though here you have to take into account the opportunity cost of the margin funds as you have to keep this at the spread betting company rather than investing it. This type of hedge is particularly effective if you have a shares portfolio which is overweight on a particular sector as shorting a key stock in that sector will help reduce the downside risk. Please note, however, that if you take a short equity position you will be liable for the disbursement of any dividends (when/if this comes due) so its a good idea to keep a calendar and make sure that a share is not about to go ex-dividend if you want to avoid this charge.

Spreadbets can also be used to hedge against rising household costs, such as fuel bills, food prices and rising mortgage repayments. Say, if you are worried about rising interest rates and do not have a fixed-rate mortgage, you can take out a ‘sell’ bet on short-dated UK treasury bonds (short sterling). That way, if interest rates rise more than expected, you will make money that you can use to offset higher mortgage repayments. Likewise, if you were thinking about buying a property in Spain later this year but were concerned the sterling/euro exchange rate might adversely affect your purchasing power – you could hedge your exposure with a spreadbet. If the exchange rate is, at say, 1.17, and you believe it might reach parity you stand to lose 17% of the value of your sterling. You can take a short trade for the equivalent value of your future property purchase to protect yourself against such a scenario.

Other forms of hedging could make use of options and warrants, but they don’t offer stop-loss orders to limit orders, In addition, spread bets generally can be rolled over overnight so have not strict time limits.  The other day someone suggested to me that if you had high-yielding corporate bonds but were concerned about the company’s ability to continue paying, you could hedge part of the risk by taking a short position on the company’s stock using spread bets (but then maybe it might make better sense selling the bonds immediately?)

Note that hedging is designed to eliminate market exposure and is not a means to making an overall gain – it will simply ensure that you will always roughly breakeven. Hence, hedging your portfolio does somewhat reduce the prospect for making additional gains but in certain circumstances it makes practical sense to cover your positions. Sometimes the best hedge is to let go of a losing position. A hedge will neutralise any profits/losses so wherever the market goes your Profits & Losses will remain largely unchanged. That’s basically the same as not having a position at all and when you think about it you could always get back into the trade. It is worth noting that hedging costs commissions in terms of the bid-offer spread and increasing costs in trading only makes it harder to come ahead.

Remember, the key at the end of the day is to ensure that your winning profitable trades outnumber your losing ones, so keeping your spread betting losses to a minimum in this way can make all the difference to your bottom line.

Hedging using Index Spreadbets

If your stock portfolio consists of a number of ‘bell weather’ stocks such as banking stocks and large established industrials, you may choose to sell one of the future indices such as the Dow Jones, the Nasdaq or the S&P depending on which is the most appropriate.

This would offer a degree of protection against a downswing in the stock market in so far as you would gain on this spread trade offsetting the lower stock prices of your shares portfolio. Thus, long term share investors who are concerned that the wider market is about to experience a steep fall, with consequent downside pressure on their shareholdings, could sell short an index spread bet to offset some of the risk. This is a very simple and effective way to protect the value of a diversified shares portfolio without having to liquidate the individual shareholdings.

Let’s take the scenario where you have £20,000 tied in an exchange traded fund that follows the FTSE 100 index. You are concerned that with the sovereign crisis engulfing Europe, your ETF portfolio might suffer a steep fall in the next few months but you prefer not to sell today for tax reasons. So instead you decide to place a sell trade via a spreadbet with a total value of £20,000. As you feared, the FTSE 100 falls 6% in the next few months reducing your tracker’s portfolio value to £18,800. However, your short spread bet is in profit and effectively cancels the loss on your tracker fund.

Here you would in effect be betting a certain amount per point that the index will go lower. Of course if an investor has a shares portfolio that is more diversified than normal, then it may be feasible to make use of a beta-adjusted hedge. A prudent investor would normally have an exposure that is less volatile so a 1% fall in the FTSE 100 might translate to only a 0.5% drop of the investor’s portfolio. In this case it might be workable to go for a 50% hedge using an index spreadbet. Beware that the FTSE 100 is dominated by mining and oil companies so if your shares portfolio is heavily invested in other shares, the effectiveness of such a hedge will be limited.

On the divergence, this is something I’ve given a lot of thought to recently, since I’ve been playing the better vs worse economies/markets idea to balance out the accounts. At the time of writing (June 2012) I think that one of the best hedges against long positions at the moment is the French CAC 40. Nice tight 2 pip spread on IG with a min £2pp for an end of day position. To my mind its a better short than Dow or FTSE given the the French seem intent on burying their heads in the sand and following in the path of Greece. I still retain some select company holdings and then a side-order of European shorts, with a little US indices to balance the risk to an area that is supposedly close to market neutral (a lot of difficult estimates in there). I don’t use the FTSE because there are worse EU economies to pick from, and the FTSE can be quite sluggish at the best of times. The idea being to avoid having to sell good companies rather than explicitly to make a profit, like a buffer.

Let’s take another instance where an investor has £6,500 worth of blue chip shares. If the FTSE 100 were trading at 6500, a £1 down bet on the FTSE would neutralise the exposure. For an investor with £13,000 worth of FTSE 100 investments the £1 down bet would hedge 50% of this exposure. Thus, for a 20% fall in the market, the investor could expect to lose half this (10%) as gains on the spread bet would partially compensate for losses in the shares portfolio.

Do keep in mind though that while such a hedge will remove some of the downside risk, it will also effectively reduce (if not eliminate) any gains on your shares portfolio, so this is more of a short-term strategy and should not be utilised for long periods of time. The hedge removes the need to have individual stop losses on your individual share positions as the premise is to ride the market turmoil keeping in mind that any losses incurred on your hedging position would be offset by gains on your shares portfolio. Of curse this also means that you need to maintain sufficient cash reserves to maintain the hedge for as long as you believe it to be necessary.

Other things to keep in mind that an index short trade might not be a good-enough hedge against the performance of the constituents making up the index and you also have to consider such things as weightings on indices, margins and cost of financing for a long term hold.

Hedging against Adverse Currency Movements

You can also use spread betting to protect yourself against adverse foreign currency exchange movements. While nobody knows exactly what is going to happen next, we can use spread betting to help minimise our exposure. If you are holding a large amount of savings or other investments in British Pounds, you can quite straightforwardly put a ‘sell’ trade on the GBP/EUR currency pair to help mitigate any losses from a further decline in the value of the pound.

Of course if the pound recovers and you start to make a loss on this position, you can quickly close it safe in the knowledge that your pound investment would have strengthened in value.

Example: Let’s suppose you reside in the United Kingdom and have a €200,000 mortgage on a Spanish holiday home, with monthly repayments of €1000. Let’s say the euro/sterling exchange rate moves strongly against you, from €1/80p to €1/£1. While your monthly repayment in Euros is still €1000, it now costs you £1000 to buy those Euros rather than the £800 you were paying previously.

To protect against adverse currency movements like this, you could take a short position on the pound and buy Euros via a spreadbet. The objective here would be to offset any any increase in the cost of buying Euros every month with profits on your trade. So, say, you might take out a Euro/Sterling long position equivalent to two years’ worth of payments, or €24,000. This would entail only deposit a percentage of this amount with your spread betting provider, but would be sufficient to cover any adverse movements against you. In this case since you likely want to maintain the position for a considerable period of time, you would open a futures bet. Assuming that on expiry you wanted to retain your hedge, you’d simply roll your contract over at each expiry date.

Some companies such as CRH depend for much of their earnings on the value of the USA dollar, so the euro’s recent relative strength had a negative impact on their profits and consequently the stock price suffered. In a case like that it may make sense to buy EUR/USD for the current or the next quarter, although this is naturally a less exact method of hedging unless you are actually holding USA dollars. For corporate customers, adverse swings in currencies can be hedged in the same way, thus removing the exposure on earnings.

Hedging against Inflation

To hedge against inflation you could look at taking a position on soft commodities such as rice, wheat and corn. Commercial property prices traditionally are also closely linked to inflation in which case it might be worth following stocks like British Land and Segro. But the classic hedge has always been Gold although this has already gone up substantially in price so it’s not without any downside risk.

Note: Having said all this, while spread trading may possibly lead to risk reduction, most traders and investors rarely use it for this purpose. Most short-sell to speculate – taking a view that the price of a financial instrument will fall however trading can be a dangerous activity, since you are usually buying stocks on margin and leveraging yourself in the market. When shorting a market the risk is even greater when going short than going long as in the unlikely scenario of a stock price going down to zero, that would be the lowest it can go for a short trade (capping profits) while the downside is potentially unlimited as there is theoretically no limit to how much a share price could climb. Thus, the risk of amplified and potentially limitless losses has to be factored in.

And similarly, some likely movements will not turn out as expected. It’s therefore crucial to deploy accurate stop-loss orders to prevent a potential hedge against loss from becoming a source of loss in itself. Then again, due diligence should be part of any trading strategy. CFD hedges are not to be used as a way to avoid selling stock that has little future prospects. If you have been running hedges alongside your equity shareholdings for months on end, you could perhaps do with a hard look at what you are doing.

Hedging SIPPs and ISAs

If you have a self-invested personal pension (Sipp), you’ll probably know that dealing frequently can quickly add up costs. Spread betting on the other hand permit you to make from even from short-term falls, without having to sell any stock you own.

Let’s suppose that you have a FTSE 100 tracker fund, sheltered from tax in a £10,000 individual savings account (Isa) wrapper. If you are concerned that the FTSE might be vulnerable to short-term weakness and you don’t want to have to exit your Isa, you can hedge any downside with a spreadbet. Suppose the FTSE is trading at 6,400. Dividing the £10,000 by 6,400 returns of £1.56 per point. This means that you could take a short position for £1.56 per point. Should the FTSE decline by say, 8% to 5,888 – you will make £799, which is about the same amount you would have lost on the FTSE tracker. As such again, you will be able to profit from short-term moves, whilst keeping your core investments within the Isa.

Standing Aside

In what circumstances does it makes sense to utilise a spread bet hedge? If you believe that the market is likely to experience a drop in the short-term but still wish to hold to your onto your shareholdings, a hedge against an expected drop in the short-term makes sense. Most spreadbetters love volatility since without directional movement in the stock markets they cannot make a profit. It is worth noting, however, that there is a fine line between trading a volatile market and one that is too volatile to be predictable. Wild swings in the indices – such as those we’ve witnessed in August 2011 – can make it hard to place stop-loss orders, for instance. While you may be right on a market’s direction, your trade may end up getting prematurely stopped-out by a temporary price volatility spike. Also, you can’t always rely on your spread betting provider permitting you to trade at the exact moment you want when the markets are really turbulent. So how to go about trading these markets? Well, here’s a trading strategy you’re unlikely to hear from your spread betting provider: do nothing. Always bear in mind that most of the times standing aside by the sidelines may be the best strategy and that in general the more time you spend invested in the stock markets, the higher the risk that you will someday be hit by an unforseen event.

Note: Hedging is mainly a short-term strategy i.e. it will work best if you are relatively certain that an index or stock will move in one direction over the short to medium-term. Spread trades left open overnight may incur a financing fee.