Hedging with Spread Betting
Spread betting is not just about trying to earn a bit of extra money, it also has some seriously practical uses too! You can use spread betting for hedging. You may have heard this term before and thought hedging was the preserve of big business, or something you pay a gardener for! All a hedge means is an investment to limit your loss, simple eh? Set your level suitably and you will be well protected!
Definition: hedging is protecting an existing holding or asset, should it fall in value, by making an equivalent investment that offsets or reduced potential losses. This allows you to leave your share holding undisturbed in the event of an unexpected price fall.
Spread betting is often used to hedge a physical share portfolio [say within individual savings accounts (Isas) or personal equity plans (Peps)] 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. Whereas hedging with physical shares incurs both stamp duty and brokerage charges, a spread bet avoids these extra costs. Whereas hedging with physical shares incurs both stamp duty and brokerage charges, a spread bet avoids these extra costs.
Example
David owns a portfolio of mainly FTSE 100 shares with a total value of £40,740.
He thinks the FTSE 100 index is going to fall. He could back his judgement by selling his shares, waiting for the market to fall, then buying them back at the lower price. The problem for David is that he has large gainst on his portfolio, and if he sells the shares, capital gains tax charge will arise.
An alternative is to hedge his portfolio against a fall by selling the FTSE 100 index short. The idea here is that if the FTSE does fall as expected, any drop in the value of the individual shares in David’s portfolio will be offset by profits he makes by going short on the index. Let’s say that David takes the spread betting route and see what the effect would be:
Action: He sells £10 per point of the FTSE 100 future at 4074 points, when the quote on the index is 4074 – 4080.
Scenario 1: The FTSE drops by 10% to 3666
Assuming that David’s individual shares all fell by the same % as the index, his portfolio would drop in value by £4,074 to £36,666
– If David closes his spread bet by buying the FTSE 100 Future at 3,666, his gain would be (4074 – 3666) X £10 = £4,080.
In other words, his portfolio losses would be matched by profits from his short position.
Scenario 2: The FTSE does not drop, but stays at 4074
– If the FTSE does not fall as David expects, buy stays at 4074, and assuming that his individual shares reflect the index, his share portolio would be unchanged in value at £40,740.
– When David comes to close his short position by buying back the FTSE 100 Future he will have to do so at the higher side of the spread let’s say 4080. His loss of the spread bet will be limited to the spread of 6 points X £10 = £60.
Scenario 3: The FTSE does not drop, but rises to 4150
– If David’s prediction is completely wrong and the FTSE rises to 4150, his share portfolio will rise in value in proportion to a value of £41,500.
– His losses on the spread bet will be approximately the same. He will have to buy back the FTSE at 4150, and will make a loss of £760 – £10 per point on the difference between 4150 and 4076.
There are several key points to note about this hedge:
- Because it was set up as a counterweight to David’s share portfolio, whatever the market did (whether it went up, down or sideways), his overall position was largely unaffected. The hedge kept him in a market-neutral position.
- It enables David to take precautions against a market fall without actually selling his shares and incurring capital gains tax.
- The price of that insurance was low. In the situation where the FTSE did not move, David’s cost was just £60. He may have been wrong about the FTSE, but having the hedge in place gave his peace of mind on his share portfolio and, at just £60 he may have felt that was worth paying.
You can hedge your traditional portfolio by placing an equivalent short spread bet in the same or similar market.
Keep in mind that more often than not the best hedge is to exit your position. Complicating things doesn’t help you in trading.
But hedging has other uses too. For instance you could spread betting on interest rates (also LIBOR) to protect against any spikes in interests rates which would impact upon a tracker mortgage. Spread betting on interest rates is a little more complicated, a buy bet means you think interest rates will go down and a sell bet means you think it will go up.
You could place a spread bet on gas to “Insulate” yourself from the rising cost of heating bills! Heating bills have risen massively in the last few years and with further rises tipped for the future, this could save you a small fortune.
The list is endless, how about hedging off more risky investments in your share portfolio, hedging off other spread bets, protecting against currency fluctuations when travelling abroad or even future petrol rises!
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