Don't sell up – hedge your bets

Investors can be forgiven for wanting to sell up and wait out the crash in cash. But selling and buying back later can be costly, and there are ways to hedge against - or even profit from - short-term losses on your portfolio without having to offload anything.

By Tim Bennett

published 30 January 2009

in Features

As the grim economic news stacks up and markets lurch from one extreme to the next, investors can be forgiven for wanting to sell up and wait out the crash in cash. But dealing costs and potential tax bills (not to mention the difficulties of market timing) mean that selling up and buying back later can be costly. The good news is that there are various ways to hedge against, or even profit from, short-term losses on your portfolio without having to offload anything.

The put option

'Put' options allow you to pay a one-off premium for the right to sell, say, 1,000 GlaxoSmithKline (GSK) shares, at a pre-determined 'strike' price. The higher the strike, the greater the value of the downside protection and so the higher the premium. So a GSK put option with a strike price of £12.50 a share costs more than one with a strike of £12 because you are more likely to use ('exercise') it.

'Exchange traded' options, such as those listed in the FT (see 'equity options' in the 'markets' section), offer different cover periods, known as 'expiries'. As with car insurance, one month's protection costs less than three, for example. And if you don't need the protection before the put option expires because the GSK share price rises rather than falls you abandon the option and sacrifice the up-front premium. A GSK put option with an April expiry and a strike of £12 per share might cost you, say, 84p per share, whereas a GSK share will set you back, say, £12.40. The price of the option is driven by several factors, the main ones being the GSK share price, the time remaining until the option expires and the 'implied volatility' of GSK shares. The more volatile the share, the more you pay. The standard 'contract size' for Euronext.liffe-listed options on individual UK stocks is 1,000 shares. So the option mentioned above would cost slightly more than £840 (1,000 x 84p) as you will pay a broker the 'offer' price, just as you would buying GSK shares. There's no stamp duty, but any gain on an equity option is subject to capital-gains tax.

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Note the 'break-even point' on your option this is the price GSK's shares need to hit for you to recover the 84p premium. Here it's £11.16 (£12-£0.84). If GSK drops to £10, you would lose £2,400 on your shares (£12.40 £10.00 x 1,000). But the put option premium may also have jumped from 84p to, say, £3. So you now sell the option to bag a profit of £2,160 (£3.00 0.84 x 1,000). That leaves you with an overall loss of £240. Of course, should GSK shares rise, the value of your put option will drop below £840. You could sell it before it expires to cut your loss but the longer you wait and the higher GSK goes, the less you will get.

For a more exact way to hedge your exposure you could try spreadbetting. By betting that the share price of a stock you hold will fall, you can protect against, and perhaps profit from, short-term falls. Let's say you go to a spreadbetting provider such as City Index and 'sell the GSK spread' at £12.40 at £10 per point (here, one pence) and buy it back later (to 'close your position') at £12.10. That's a drop of 30p, or 30 'points', and is worth around £300 to you, offsetting the £300 loss that you'll have incurred on your 1,000 GSK shares and the profit is tax free. However, had the GSK share price risen by, say, 30p, you would pay City Index your spreadbet loss of around £300 but your shares will have risen by a similar amount.

Inverse ETFs can also appear to be a good hedging option. If you hold US blue-chip shares, for example, a Proshares Short S&P 500 ETF (NYSE:SDS) should move up if the S&P 500 index moves down. As such it offers a hedge against your shares falling. But be careful. Your portfolio may not match the shares tracked by the ETF. But even if the match is perfect, the ETF may not give you the inverse performance you expect particularly when volatility is high thanks to daily re-pricing and a quirk in the maths.

Take a stock index currently at 1,000 points. If the market gains 10% today the new index value is 1,100. If it then loses 9% tomorrow it will finish at 1,001, or 0.1% up from where it started. Now take an inverse ETF that is priced at, say, $10 when the index is at 1,000. On day one it falls 10% to $9 and on the second gains 9% to finish at $9.81. That's a two-day fall of 1.9%, which clearly doesn't mirror the 0.1% gain for the index. The effect is magnified on an ETF that offers, say, double the inverse performance.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.