Exposure, Risk and Hedging Positions Out Of Hours

Whenever you take a position in the market you take on risk. There is no position without risk. If you buy some shares you risk losing the capital you’ve invested. With a house you risk losing your capital, repossession if you don’t make your mortgage payments, and total loss from flood or fire unless you’re insured. Even if you put money in the bank you risk losing some of it permanently – if it’s a large amount and the bank goes tits up – and also the loss of its use while you get compensated by the FSCS – they don’t move quickly!

There is no way to enter the market without risk of some sort. With a house, or car, or possession of a tangible nature, it’s easy to understand the insurance needed to protect it. The people who claimed to have had their lives ruined by the criminals who robbed the Hatton Garden Safe Deposit Company were wrong. The cause of their suffering was being too arrogant, or too greedy, to insure against loss. They did it to themselves and I have no sympathy.

So back to our world of investing, how do we insure? Well, firstly we have to understand when, as much as how, we have risk. The biggest hurdle is when the markets are closed, or when you simply can’t access them because of a technical failure, for instance. In the latter case, if you need to make quick moves, this means back up internet, wired mouse and keyboard etc.; and having your broker’s phone number to hand when there’s a power cut, and so forth.

Weekends are the highest risk. During market hours it’s easy to have things like options, or covered warrants to hedge your risk. If you get the sums right and your investment falls significantly, the money you’ve paid for your short spread bet, or your put option, now covers your losses. Great, so where’s the problem then? First off, the option market is not open as long as the futures market, which is what your spread bet is most likely a derivative of. So overnight you aren’t protected at all by your options. But worse than that the whole weekend!

Here’s a Sunday night session I took advantage of, but which cost many dearly. Suppose the futures move a lot on Sunday night. “Does that ever happen?” you ask. Yes it certainly does. The session I’m referring to was the Sunday night/Monday morning of the Japanese tsunami. As it was the tsunami hit, and things went from bad to worse. But let’s say the tsunami hadn’t done much damage. Then markets would have fallen out of fear, and could have taken out your FTSE 100 spread bet while you slept, for example. By Monday morning when the options open they would have been unaffected as markets would have already bounced back.

Where does that leave you? Exposed. Short against a rising market with your position taken out at your worst acceptable price. If it had been Saturday night and the market gapped down for the Sunday night open of the futures then, unless you had a guaranteed stop loss, you might have had your spread bet account wiped out plus a margin call for the balance of the loss. Don’t forget you can lose more than your account balance on spread bets in certain circumstances. If your hedge was on the same account it might have been closed out at the Friday close to cover these losses. It’s a tricky business.

The only way to really hedge a position for total safety over the hours the market is closed is to exit the position, and place it again when they open (at a better or worse price), or take an equal and opposite position, bearing in mind you’ll have to be able to take at least one of those positions off the table when the market opens, even if it does move a long way. At that point you may find you’ve protected a loss making position and you have to take the hit or expose yourself to more risk chasing a now volatile price.

This is a serious matter, and one most people choose to ignore completely.