How to hedge your bets in a falling market

Having briefly hit a two-year high at the start of the year, the FTSE 100 has had a volatile ride so far in 2011, as events in Japan, the Middle East, and Europe have rattled investors. So what's the best way to hedge against falling share prices?

Obviously, you could just sell up and buy back in. But apart from the fact that getting it right consistently would mean you'd have to be a market-timer of legendary abilities, there's also the small matter of trading costs, such as commission, stamp duty and perhaps even capital gains tax. Here are three alternative options.

1. Short exchange-traded funds

There are inverse exchange-traded funds (ETFs) around that seem to offer investors the perfect hedge they rise as an index falls and vice versa. But 'daily repricing' stops them from doing what an unwary investor might assume. For example, if an index starts at 100, rises 10% one day (to 110), then falls 20% the next, it finishes at 88 a 12% fall over the two days. However, an inverse ETF, starting from a base cost of £100, will fall 10% (to £90) and then rise 20% from there. So it ends up at £108. So a 12% fall in the index over two days actually results in an 8% rise in the ETF. And the longer this goes on for, the wider the gap is likely to get. That makes such ETFs unsuitable as long-term hedges.

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2. Put options

Here you pay a one-off premium for the right to make a cash profit if the FTSE 100 closes below a pre-set index strike level (say, 5,700 points) by a fixed date (say, the end of June). In essence you are buying an insurance policy on a market fall. As the FTSE moves down, the price of the option rises and vice versa. But there are three problems for hedgers using puts. One is that if the market rises rather than falls, you lose most of the premium paid. The second is that in periods of higher volatility, premiums rise anyway (just as they do with insurance products). So when you feel you actually need it, it can be hard to get a decent level of protection at a sensible price. And thirdly, because a put option premium is made up of lots of ingredients including a charge for expected volatility over the life of the option they are relatively complex instruments for novices. Fortunately, there's a simpler product available

3. Spread-betting

Via a spread-betting broker, you could put a downbet on the FTSE 100 for a fixed amount say, £10 a point. You would make £10 per one-point drop in the index for as long as you leave the bet running. So (ignoring the bid-to-offer spread) if the FTSE 100 index drops 100 points, you would make £1,000, helping to offset any paper losses on your portfolio. Or you could short an individual share at £10 for every 1p fall in the share price. In the right hands this is perhaps the simplest hedge.

However, because a spread bet is 'geared' or 'leveraged' it is also risky. For example, your broker will only ask for a percentage of your exposure to the FTSE 100 as an initial deposit. So a downbet at £10 a point when the index is at 5,600 is theoretically equivalent to a position in FTSE 100 shares worth £56,000. Yet your initial deposit might be just 10% of this or £5,600. For more on setting this up and the risks see www.moneyweek.com/SB.

How the carry trade can cause chaos

It seems counterintuitive. Last week the Japanese yen hit post-World War II highs, just as most commentators were trying to work out how much damage nature had wrought on the economy. Surely, the yen should have been dropping like a stone, especially once the Bank of Japan announced it would start a new huge round of quantitative easing? The reversal of one popular trade helps to explain why the yen jumped instead.

• For an explanation of the yen carry trade, see Tim Bennett's video tutorial: What is the yen carry trade?

In a stable international currency market, the 'carry trade' seems like an investing no-brainer. The idea is that you borrow in a currency with a very low interest rate. Enter the Japanese yen interest rates have been close to zero for years as the Bank of Japan has tried to stimulate a flat economy. So you might borrow, say, 100m. You then seek out a currency with a much higher interest rate.

Enter the Australian dollar (AUD) a commodities boom means the central bank interest rate is 4.75%. Let's assume the exchange rate is 75 to one Aussie dollar and the 100m turns into an investment of AUD 1,333,333. Provided the exchange rate doesn't change too much, you can pocket the difference between the 4.75% being earned on the Australian dollar asset and the close-to-zero rate being paid to fund the yen liability. But an earthquake changes everything.

Suddenly you have investors worrying about the impact of a Japanese economic meltdown. How will it affect the US? Australia? Let's say the yen suddenly starts strengthening relative to the Aussie to a rate of 65 to one AUD. Now, if you convert the AUD1,333,333 back into yen, you have 86,666,645. But you originally borrowed 100m.

So you have a problem. Either you unwind the trade and cut your losses before things get worse. Or you fund a 'margin call' in other words, you make up the gap. Either way, you create a sudden demand for yen. And if lots of hedge funds exit carry trades together even professional investors act in herds, so when one panics, they all do you get a surge in the yen. Throw in associated derivative bets tied to the yen and you can get a stampede. Which is precisely what happened last week.