Bed & Brexit by Proxy – Hedging Against Volatility

I wrote in my last post about the risks to your portfolio of volatility around the time of the EU referendum. This applies whatever the outcome. In this post I’m going to outline how to use spread bets (or CFDs) for hedging, assuming that, for whatever reason, you don’t wish to close and re-open your positions.

In the US it’s quite easy to short stocks. Here it’s not so simple, but there are more attractive alternatives. The most obvious is spread bets/CFDs. Of course you don’t have to hedge using the same medium as the investment itself. In fact doing so would simply neutralise your market position. That’s not a bad idea, but the possible ramifications are dependent on the P&L on the position to start with. Let’s say you have a position which is up and you’re trying to protect the profits. There is a difficulty in knowing when to remove the hedge. If the hedge itself goes into profit as well (or instead), then you may start to wonder if that is now the best side to be on. If you are good at making that sort of decision then fine. But it can create trade management difficulties if it doesn’t suit your style. The other thing you have to check is that your broker will allow you two equal and opposite positions. They may simply close your winning trade when you place the other trade, and they may also not aggregate your margin. Clearly, there is no risk if you hold two equal and opposite positions with the same broker, but if they use margin for the hedge then you may come a cropper there. In fact if there is huge volatility they may increase the margin and give you a tinkle for some readies having done so.

Another consideration, and this is critical, is that you never use stops with hedges. You run the risk of closing a position at a loss and then holding a less considered, and possibly worse risk, position on the other side. For example, you hedge a position and the market swings a huge distance in one direction, and then back the other, very quickly. If you’re sitting there you could possibly react, but if not then both your positions could get stopped out at a loss. It’s a game not worth playing, especially since one presumes you are hedging to limit or eliminate risk, not multiply it!

Other alternatives for a hedge are Covered Warrants and Options, which are not linear products like a spread bet but carry changing rates of return and also decay with time. So that’s a more complicated calculation and you really need to understand those products before you go hedging with them. Do it wrong and you may be exposing yourself to even more risk.

Calculating how much to put on a spread bet is important. If you multiply the stake by the price, then that should equal a stock holding value, for example. So if you held 1,000 Rolls Royce (RR.) and the price is £6 then you need to hedge £6,000. A short spread bet of £10 per point at 600p would do the trick. Of course it’s a slightly imprecise science as the spread is a cost, and so is the nightly roll-over charge, but it’s not far off: a cheap insurance policy.

But let’s say you want to hedge a number of positions in the FTSE 100. There is a way of doing so without having loads of margin used up and with as good a degree of accuracy, and that will be the subject of my next post: Beta hedging.