Once you’ve mastered spread betting, you can use it for a lot more than simple short and long bets. Here are some different strategies you can experiment with.
Betting on whether a single stock will rise or fall can be tricky. If you have the luxury of time then you can buy an undervalued company, and just wait for the market to catch up with you. But spread betting tends to be more short term. Even if you’re right about a stock being undervalued, if the wider market falls while you’re holding it, chances are it will fall too.
This is where pairs trading can be useful. This enables you to take a view on whether a stock, a sector or even an entire index is over or underpriced relative to another asset. The idea is you place two spread bets together – one an up bet and the other a down bet. It doesn’t matter what the wider market does – both assets could rise or both could fall. What’s important is the way they trade in relation to one another. So, in the example above, it doesn’t matter if both the stock and the wider market fall. You will still profit as long as your chosen stock falls by less than the wider market does.
So how do you go about pairs trading? First off, you need to identify an opportunity. Perhaps you’ve looked at two stocks in the pharmaceutical sector. You’ve noted on a chart that one stock normally trades at three times the price of the other. But today the more expensive stock is trading at almost the same price as its peer. Why? Maybe there are rumours circulating about the quality of one of the first firm’s key drugs. Or perhaps the market is worried about the imminent departure of its finance director. But whatever the reason for the shortterm dip in the firm’s share price, you think the market has overreacted.
So you could place an up bet on the first firm using a spread bet and a down bet on the second. If you are right, the first firm will rise and its rival will fall back. In short, you are betting that something like the normal three times share price relationship will be restored, at which point – or somewhere close to it – you will close both trades to take out a profit.
There is one major caveat on this type of trade. Just because a relationship between two shares has held in the past, you can’t assume it will continue. This is where homework is vital – if something has happened to either company to change the relationship for good (for example, a regulator has banned one of the firm’s products on safety grounds), then the relationship between the two companies’ share prices will be out of date, and your bet will probably never pay off. Some of the downsides of pairs trading are probably now obvious. You have to pay two sets of spreads and, in case the bet goes wrong, two stop-loss orders. These costs make pairs trading more expensive than a single conventional bet.
That warning aside, the principle of pairs trading can be extended across almost any two bets. For example, you could place a down bet on the S&P 500 and an up bet on the Nikkei 225 – a play on the relative strength of a Japanese recovery versus that in the US. Or, if you think the market has underestimated the double-dip threat, you could bet on a sector you think is too cheap – say defensives such as utilities – against a more cyclical one such as telecoms that you believe is too expensive.
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Three ways to hedge
Despite their deserved reputation as speculators’ tools, you can also use spread bets to reduce short-term risk. This is known as hedging. Here are three short examples.
1. Let’s say you’re planning to buy some FTSE 100 shares in three months’ time when a big slice of dividend income comes in from your existing portfolio. But the FTSE is rising fast. You’re worried that if you wait three months before buying, you’ll have to pay a fortune for the shares. So you could hedge with a spread bet. Place an up bet on the FTSE now. If the index rises over the next three months, your cash profit from the bet when you close it out, plus the dividend income you receive, should allow you to buy roughly as many shares as you could have done had the dividend been paid three months earlier.
2. Or perhaps you hold a large position in Company A. You believe that the next set of results will be poor, and you’d like to take advantage in the short term. But long term you’re happy to hold Company A shares, and you don’t want the expense and hassle of selling up now, waiting, then buying all your shares back cheaper. After all, that would incur trading costs when you buy and sell, stamp duty at 0.5% on the repurchase, and perhaps even a capital gains tax bill on the disposal. So instead, you could keep the shares and place a down bet on Company A using a spread bet. Assuming Company A then drops, you’ll make a tax-free profit on the spread bet when you close it out at the lower price, and not have to bother churning your Company A shares.
3. Finally, let’s say the end of the tax year is approaching (5 April). You have yet to use up your annual capital gains tax (CGT) allowance. Under the old ‘bed and breakfasting’ rules you could sell some FTSE 100 shares through your broker just before the end of the tax year, then buy them back just after to trigger a gain that could be absorbed by the CGT allowance. But now you must complete your sale more than 30 days before the year-end. That’s a long time to be on the sidelines hoping the market doesn’t rise. One way to hedge the problem is to buy a FTSE 100 spread bet when you make your share sale. Then, if the index rises while you are waiting to repurchase your shares, you’ll make a tax free gain on the bet. That will help to fund the repurchase of your shares.