How to profit from market turmoil

published 20 August 2007

For a while earlier this year, as the FTSE 100 glided calmly up to new heights over 6,700 points, it seemed as though equity risk (also known as volatility) had been well and truly sidelined. Well, now we know otherwise. Volatility is back with a vengeance and in recent weeks the top shares, far from following a smooth upward trend line, have ricocheted around like balls in a pinball machine.

Although these dramatic price swings might scare some investors, others remember Warren Buffett's advice and are greedy when others are fearful'. It is possible to make lots of money from volatile conditions as long as you know how to profit from falling, as well as rising, prices.

So what's the best way to go about this? Well, shorting individual shares is possible, but by far the easiest route for a typical retail investor is via a fairly simple derivative the spreadbet. These are quick, cheap and tax free. On that last count, they beat a similar product, the contract for difference', or CFD, and there are many ways of using them to make money when stockmarket conditions turn hostile.

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So, I could place a down bet (also known as shorting', or selling') on the FTSE 100 from its current level of, say, 6,100 points with settlement what the loser pays the winner at £5 per point. Let's now assume that, having placed the bet, the index drops by 50 points to 6,050. I'm now winning, but I need to cash in. So I contact my broker again and ask to close' my position (which means buying back the contract I sold earlier).

Firstly, the broker needs to make money and does so via the spread'. In reality, I would have been quoted two prices say 6,099 and 6,101 for the index when I phoned to sell it and also when I decided to buy it back say 6,049 and 6,051. So in fact my winnings would have been 6,099 6,051 = 48 points x £5 = £240. As a rule, the longer the period of the bet, the wider the spread and the more the broker is charging you to trade. Spreads are generally lowest for bets that only remain open until the end of the trading day.

Secondly, a broker won't take a bet without some form of security, or collateral, in case an unscrupulous client is tempted to walk away from a losing bet. How much you need to deposit with your broker depends on the market chosen. The amount is simply the bet size, say £5, multiplied by a deposit factor' set by the broker. If this was, say, 100 for my bet on the FTSE 100, then the required deposit is £5 x 100 = £500. This is handed over up front, typically using a debit or credit card.

The most important thing to remember is that with spread betting your losses are theoretically unlimited. Markets and stocks can move against you rapidly, so it's vital you put a stop loss in place. This ensures that, had the market risen in the above example, the broker would automatically close out my losing bet once the market reached a pre-agreed level above 6,101. You pay a little extra for this cap on your losses, but it's well worth it.

For investors who are not gamblers by nature, there is another way of using spread betting. This time the objective is not to make money, but rather to avoid losing it. This is called hedging. Say you hold a portfolio of FTSE 100 shares and are worried about the impact of the credit crunch. You could dump all of your shares and then wait in the hope you'll be able to buy them all back at cheaper prices. But this is a pretty risky strategy.

For a start, there's all those trading costs broker charges every time you buy or sell, stamp duty on the repurchase and even capital-gains tax if you've already made any profits. And that, of course, is leaving aside the fact that market timing is notoriously difficult it's never easy to know the exact top or bottom of a market. If you're unlucky, you may even end up having to replace your shares at higher prices than you sold them.

A better strategy might be to hold onto the shares and hedge any fall in the market using spreadbets. For example, say you hold £20,000 of FTSE 100 shares and the market falls from, for instance, 6,500 points to 6,200 points. The losses on the portfolio would be around 4.6%, or £923. However, had I placed a down bet on the index using a spreadbet at £3 per point then, much as in the first example given earlier, I would recoup a profit of around £900 (£3 x 300 points), which almost offsets my losses.

With pairs trading, the direction the underlying assets move in is irrelevant what you care about is relative performance. As long as the share or index you are buying falls by less than the one you are selling, or rises by more, then you will profit. The downside is that this means two sets of trading costs, to open and close the pair of trades, so to make money you need to be confident enough to place a decent-sized bet.

So what might be a good pairs trade just now? Many commentators, including The Daily Telegraph's Tom Stevenson, have said that they believe the FTSE 100 represents better value than the FTSE 250. This seems reasonable to us, as mega-cap' stocks have underperformed their smaller mid-cap rivals in recent years. This is mainly because they have been deemed too big to be taken over and so have missed out on the wave of bid speculation that has pumped up the rest of the market. Now, in the current market upheaval, both indices have suffered falls.

However, if you believe this theory, then the FTSE 100 should fall by less than the FTSE 250. To profit from this, you would take out an up bet on the FTSE 100 and a down bet on the 250. The amount you bet is a function of the bet size, which could be as low as 20p per point, or much higher, say £10. You can place this type of bet for just a day, a few weeks or even months. The important thing is to judge the size of your bets properly so that falls or rises of equal percentage point sizes in both indices would simply cancel each other out.

If you're feeling particularly brave, you could bet on market volatility itself. How can you do this? For the last few years the financial markets have measured volatility using the Vix index, also known as Wall Street's fear gauge'. It basically shows how volatile options traders expect the S&P 500 to be over the month ahead. A high Vix reading, say 30 or more, suggests heightened fear in the market, whereas in calmer times the reading tends to be low typically below 20. As stockmarkets fall, volatility, and therefore the Vix, tends to rise and vice versa (because historically markets typically fall much faster than they rise).

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.