Spread bets are most commonly used for speculating on financial markets. But although their primary use is for taking risks, it is equally possible to use them to lower your overall risks.
Selling GBP/US$ (as a hedge on a foreign currency transaction)
You may want to hedge, or lock in, an exchange rate now for an expensive 'once in a life time' month long holiday to the USA for you and for your family. You know that you are going to spend £15,000 during your family vacation in three months time. You want to hedge that exposure now against any adverse movement in the exchange rate, so you do the following:
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You call a spread betting firm and they are quoting GBP/USD for 3 months time as 15610/15630. You sell £1 a point at 15610 as a hedge for your £15,000 spending money, as you do not want the pound to get any cheaper against the dollar. (i.e. you are betting that the GBP/USD will go down and you will gain £1 for each 'point' it goes down)
At the time of your holiday, the spread betting firm is quoting 15030/15050. You buy back your £1 and close the bet at 15050, thus making a profit of £560. This will effectively mean that even though the exchange rate had moved against you, the profit from the trade with the spread betting firm has offset this.
| Closing price: | 15050 |
| Opening Price: | 15610 |
| Difference: | 560 |
| Profit on Bet: | 560 x 1 = £560 (Tax Free) |
Of course, if the exchange rate had moved up, then you would have lost to the spread betting firm, but gained through a better exchange rate for your holiday.
Let's say you have a £7,000 ISA in a FTSE 100 tracker fund, and you think the FTSE is going to fall. Rather than get out of the ISA, you could hedge your exposure with a spread bet. Say the index is trading at 5,404. You simply divide the £7,000 value of your ISA by 5,404, which gives you a figure of £1.30 per point. You can then go short on a spread bet by £1.30 a point. If the FTSE does fall - let's say by 8% or so, to 5,004 - you will make £630, which should be the same as the amount you have lost on the FTSE tracker. You can make money from short-term fluctuations, while keeping your capital within an ISA.
Note that when you are hedging, you will probably want to deposit a larger deposit than the bare minimum. When hedging, you don't use a stop-loss order, as your hedge would be ended if your stoploss were triggered. This means keeping sufficient funds in your trading account to cover any large moves against your position.
Let me give you another example of hedging a share portfolio. If I have a large exposure to the US or UK stock market and I think that the stock market is set to fall in the short to medium term, I could simply go out and sell all of my shares and buy them back when I think that prices have bottomed.
However, buying and selling a portfolio of shares is costly, you have two sets of broker's commission, and stamp duty of 0.5% when you buy back your shares. Note to mention that if your portfolio has done well you will have a capital gains tax liability. The cost of selling a portfolio and buying it back again could amount to up to 7.5% of the total value. And suppose you are wrong about prices falling? Having disposed of your shares you would have to buy them back at a higher price later.
The better and simpler alternative is to place a DOWN BET on the FTSE 100 if you have a UK portfolio or the DOW JONES/S&P500 index if you have a USA portfolio.
Let's take an example. Suppose you hold the equivalent of £100,000 in FTSE 100 shares and are worried about a double-dip recession and that prices won't hold at present levels. You check the FTSE 100 index market and you see it being quoted at 4999-5001 when the index is trading at 5000. So you go short at £20 per point (£100,000/5,000) and sell the index at the 4999 level. Over the next two months the index falls 15% to 4,250. Thus, your shares portfolio is now down by approximately £15,000.
However, the new spread quoted by your spread betting firm is now 4249-4251. So if you close the spreadbet, by buying it at 4251, your profit would amount to 748 points (4999-4251). At £20 per point, that would amount to a tax free gain of £14,960 which helps a lot in offsetting your share losses.
So you still hold your shares, but alongside you are running a financial bet. Now that financial bookmakers are also offering individual bets, you can also hedge an individual share, for example: suppose I hold 10,000 BP shares, rather than sell I could place a £500 per point DOWN bet on BP which will protect my share position.
Of course here we're not talking about making profit but its good to know what can be done by hedging. I have hedged my portfolio several times to protect me from exchange rate fluctuations.
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