Who is correct? Is it the purveyors of doom who cite rising global economic uncertainty as the reason why the recent stock-market falls are the beginning of a new and serious equity bear market? Or is it the bulls, who say that fundamentals remain strong and recent falls constitute a mere' healthy correction' and that there will be a strong rebound as confidence returns?
Both cases, at the moment, could be well argued. The fact remains that no one is sure what the next move is going to be and the next couple of months are crucial. Investors, having seen their year to date gains largely wiped out in a matter of days, are understandably concerned. These are nervous times.
Faced with this uncertainty, what actions can the private investor undertake?
Let's take an investor with an £11,500 holding spread through a variety of FTSE 100 shares, or indeed in a FTSE tracker. Theoretically with the FTSE at 5750, the investor's holding is worth £2 per point on the FTSE. If the FTSE were to halve to 2875, the chances are the investor would have lost around £5,750, half of his or her holding. If the index falls 200 points, the investor will have lost £400.
A confident investor could hold on to his portfolio but if the current market jitters do escalate into a full-blown market tailspin, he is left nursing serious losses. On the other hand, if he is feeling particularly bearish, one option is to exit the market - to cash in his profits of the last three years and sell his stocks, and re-enter the market when his confidence returns. This leaves him not only incurring dealing costs but vulnerable to a rise in the market.
An alternative method of hedging his potential losses would be to utilise the spread-betting markets and 'sell' the FTSE at £2 per point. Theoretically, any losses in the actual market will be offset by profits made from the spreadbet. Again though, the investor does not benefit from any rise in the market as he will have to use the profit from his shareholding to cover his spread-betting losses.
If only there were an insurances scheme that enabled the investor to protect himself from a serious downturn but still have exposure to any upside potential? Well, there is. Here we bring in the options market. Previously only accessible to the institutional investor, options are now accessible for the private individual via spread betting.
One form of option - a put -gives the holder the right, but not the obligation, to sell the underlying at a fixed price, the strike price, at a fixed date in the future. A buyer of a put option knows at the outset his maximum possible loss and so avoids one of the regular pitfalls of the spread-betting market, the spiraling losses.
At the time of writing spread-betting firm IG Index is currently quoting 125/133 for a July 5750 put on the FTSE 100. If you buy this option, it means you can sell the index at the strike price of 5750 on the expiry date, therefore benefiting from any falls in the market. The actual payout will be dependent on the level of the FTSE taken in the morning on the expiry date of the option, the third Friday of the contract month, in this case July.
As with the majority of spread-betting contracts, the holder of the option can close his position at any point before the expiry date by taking the opposite position to the open position. If you bought the above option by buying at 133 to close the option straight away, you would have to sell at 125, losing money due to the spread.
Our investor is undecided about the market. He realises this is a crucial time for the equity markets and depending on how sentiment changes, the FTSE 100 could move strongly in either direction.
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He decides to buy the put option at 133 and at £2 per point, the amount his shareholding is worth. The break-even FTSE level on this option is therefore 5617 (5750-133). Below that level on the expiry date, the put option will pay out £2 per point, offsetting the £2 per point loss the investor makes on his 'real' shareholding. The investor is basically insuring himself against the FTSE falling below 5617. However, while the investor insures himself against a downturn he also gives himself the opportunity to benefit from FTSE gains.
To illustrate the possible outcomes, let's take two possible scenarios:
The bears are correct and the index falls to 5250 before the settlement date in July. The investor receives a £734 payout on the option as the spread bet will close at the difference between the strike price and the closing level, which in this case would equal 500.
As he opened the bet at 133 he receives £2 per point on the difference between 500, the closing level and 133, the opening level.
This £734 offsets the £1,000 loss on his shares. His loss on the FTSE below 5617 is totally covered. If the Index falls 1000, 2000 or 3000 points his overall loss will be capped at £266.
It was merely a blip and the FTSE rebounds strongly, increasing by 500 points to a year high of 6250.
The option the investor bought will be worth zero (you wouldn't' t exercise the right to sell the Index for 5750 if it was worth 6250) and the investor will lose the 'insurance premium' of £266.
This amount (133*£2) is the maximum loss he can make whatever the final Index level. The value of his shares has gone up £1000 so his net worth has increased by £734.
If, of course, the investor had completely hedged by selling short £2 per point at 5750 he would have made zero profit as his profit on his shareholding would have been totally wiped out by his loss on the spread bet.
Effectively, in these examples, for £266 the investor insures his £11,500 shareholding against index falls below 5617, while keeping upside potential. In this uncertain market - what price piece of mind?
The investor can also choose the strike price at which he wants to buy the put option from a selection of levels offered by the spread-betting firms. Buying insurance on your portfolio by buying a put option at a level lower than the 5750 level will be less expensive as there will be less chance that the option will be worth money at expiry.
For example, a 5000 July put is, at the time of writing, quoted at 15.8/19.8. This would involve a smaller 'insurance premium' and, still using the £2 per point example, any upside would be reduced by only £39.6.
However, the investor is only insuring against falls down past the 4980.2 level. He can also choose to insure for a shorter or longer time-span than July. The general rule is that the longer time to expiry, the more expensive the option. An August option will be more expensive than a July option with the same exercise price bought at the same time, which in turn will be more expensive than the June option.
The downsides and concerns about both spread betting and derivatives in general are well documented and in many cases, especially for the private investor, warranted. High levels of gearing can be achieved and large profits and losses can be accumulated very quickly.
However, used in the correct way the private investor can exploit the opportunities offered by the spread-betting firms to hedge whole portfolios or indeed individual shares. Buying a put option on an index is a trade that contains a maximum loss to the investor, the amount of which is known at the outset.
As an additional benefit, if the market did crash and you had such a hedge in place, the profits made on the put would not be liable for capital gains tax but the losses made on your shares could be offset against any profits.
The derivatives market is widely used by institutional investors to hedge their positions as well as being a way to speculate on the markets. Now they are becoming more and more accessible to the private investor. Like any form of investing, the individual needs to understand the product and be comfortable with the risks involved.
With such ambiguity - global inflation worries, dollar weakness concerns, Middle Eastern tensions - in today's economy, it is always worth considering the possibility of hedging your portfolio against potential losses.
To that end spread betting, when used with discipline, can be a useful and valuable weapon in the arsenal of today's sophisticated equity investor.
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