Three ways to hedge your bets in volatile markets

There are plenty of reasons to fear for the health of the global economy, from the possibility of a double-dip in the US to a slide in the global shipping index. So what can investors do to protect their painstakingly constructed portfolios from further share-price falls?

Sell now, is one answer. But it's not a helpful one. After all, if you've been buying the defensive income stocks we favour, you'll give up any dividends. Also, you may trigger a capital gains tax bill not to mention the fact that you can't be sure of selling at precisely the right time. A better bet is to hedge your portfolio against price falls. Here are three ways to do it:

1. Spread betting

Spread betting is associated with betting on prices rising or falling. But you can also use it for short-term hedging. Say you hold 100 Rio Tinto shares and are worried about a drop. You could sell the IG Index spread of 3,148.8-3,155.7 for £10 a point (or £1 a point if you own just ten shares). As Rio Tinto falls, the spread then drops to say 3,115.1-3,122.3. You could close out and take a profit of 26.5 points or £265, ie, (3,148.8 3,122.3) x £10. That won't match the paper loss on your shares (thanks to the spread), but it should be close.

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2. Inverse exchange-traded funds

But if you prefer to stay clear of spread betting, there is an alternative the inverse exchange-traded fund (ETF). A standard ETF tracks a given index. An inverse ETF as the name suggests offers a 1% gain for every 1% loss in an index. And a leveraged short ETF might offer twice or even three times the inverse index performance. This type of product is relatively cheap. It also avoids the need to actively short a share or index yourself.

However, there are downsides. Finding the right ETF can be a problem. FTSE 100 inverse trackers, for example, have been slow to launch (although Lyxor has one in the pipeline). Then there's the issue of daily repricing. Take the ETF Securities FTSE 100 Super Short (2x) fund. Say the FTSE 100 is at 5,000 when you buy, then drops to 4,900, then 4,800 over the next three days. Overall the FTSE is down 4% (200/5,000). If the fund starts at £1,000, then daily repricing means your fund gains 4% (2 x 2%) to stand at £1,040 after one day, then gains another 4.08% on day two (since 100/4900 is a 2.04% drop, which is then multiplied by two).

So the FTSE is down 4% but your fund is up 8.24%. Not a huge difference but over more time, and in a volatile market in particular, that gap can magnify which can work for you or against you. Besides, you may want the flexibility to abandon a hedge should your shares actually rise rather than fall. Enter options and covered warrants

3. Options and covered warrants

In theory, options and covered warrants offer the best of both worlds. You pay a one-off premium for a 'put'. This gives you the right, but no obligation, to offload shares at a pre-agreed 'strike' price within an agreed period (before the contract 'expires'). So should your shares fall you can exercise the option and dump them, or cash the option in for a profit (the difference between the premium you paid and the new premium quoted for the same option). Or should your shares rise instead, you can just abandon the option and suffer the up-front premium.

Say you get a 12p premium per share for a put option on 1,000 shares and a strike price of £2.50 per share. The two key numbers are the cost of the option here £120 (which you pay no matter what you do afterwards) and the price for the underlying share that sees you at least break even on the option at the expiry date. Here that's £2.38 (250p-12p).

Several factors affect the premium you pay. The longer you want protection for, the more it costs. So a six-month option costs more than a three-month and so on. Next, there's the strike price. On a put option, when the fixed strike is above the price of the share the option relates to, it is said to be 'in the money', and will be more expensive. 'Out of the money' options, where the strike price is set below the related share, are cheaper.

Volatility is also important. The higher it is, the more option writers will charge for cover. You can get a rough feel for this by looking at the CBOE Vix index. At around 25, it is well off its 2008 peak of 89, but still above its 20-year average of about 19. For options on single stocks, a glance at its one-year price chart is a good idea. For example, a BP option is not cheap just now.

Finally there are 'funding costs' for equity options. These are interest rates and dividend yields. On a call option, the fact you are only paying out a small proportion of the price of a share means that the higher money-market interest rates are, the more you will pay. With dividend yields it's the opposite call options don't pay dividends, so the higher the yield on shares, the cheaper a call option. Puts are the exact opposite (see the table above).