This year’s volatile earnings season is encouraging investors to hedge their stock portfolios by means of options, exchange traded funds (ETFs) tracking short positions and contracts for difference (CFDs).
At a time when markets are mercurial, many investors are looking to limit their “downside” risk and effectively take out insurance against large losses. While such a stance means they may not profit from a stock’s rise as much as they would without a hedge in place, they should not suffer dire consequences if a company’s shares fall steeply.
There are several ways for private investors to hedge. Two prominent ones are buying options and CFDs.
An option is a “privilege” that offers the buyer the right, but not the obligation, to buy (via a call option) or sell (via a put option) a security at an agreed price during a certain period of time or on a specific date.
Covered call options work best for investors in falling markets, as buyers are unlikely to take up their options if the share price falls below the agreed selling price, or strike price. But the intricate nature of these derivatives encourages many investors to gravitate towards simpler CFDs, which also allow them to take short positions on stocks, indices, foreign exchange markets and commodities.
As with options, the downside of CFDs is that bets are typically made on margin, but less capital tends to be required for large-cap stock positions. For example, to make a £10,000 bet on a blue-chip stock you might have to put down just £1,000. But a fall of just 10 per cent in the share price would effectively wipe out your stake.
To reduce this risk, many providers offer a “stop loss” – a mechanism that automatically closes your position if prices move beyond a certain level.
Unlike options, CFD contracts can be closed at any time. While deals also incur commissions, these are much lower than commissions on share trades, which are typically around 0.25 per cent.
Richard Hunter, head of equities at Hargreaves Lansdown, reports that clients seeking to hedge FTSE 100 stock portfolios with CFDs often apply the “90-10 rule”: about 90 per cent of the portfolio is dedicated to standard equity positions and 10 per cent of the assets are used to take out a short position on the FTSE 100 itself.
If you are optimistic about a particular stock but concerned about the outlook for the wider market, buying the stock and shorting the index is another tactic. “That way you’re betting on the outperformance of the stock relative to the market,” says John Prior, director at Killik Capital.
Pairs trading is another strategy. The idea is to short the stock believed to be overvalued and buy the undervalued one. BP and Shell; GlaxoSmithKline and AstraZeneca; and Thomson Reuters and Reed Elsevier are frequent partners.
Buyers of oil stocks often short the price of crude oil, while mining enthusiasts invested in Rio Tinto or Anglo American tend to short gold. Hedges to protect against further declines in sterling against the dollar are also helpful to investors with stakes in companies such as Pearson, publisher of the Financial Times, which generates much of its revenue in the US.
While hedging is a useful tactic for skilled investors to ride out unstable markets, it carries risks. More cautious investors may prefer structured products, which track an underlying basket of equity indices and promise to return the upfront capital as well as a fixed coupon if these indices do not fall below a particular benchmark. Exchange traded funds, which track short positions, are also popular as they do not require margin accounts. In the past year, ETFs shorting commodities such as nickel or aluminium returned more than 140 per cent (see chart below.)
“Not all of our clients are interested in hedging,” says Hunter. “It’s risky. Some opt to spread their money across different asset classes instead.” He subscribes to the adage that it’s more about time in the market than trying to time the market. “If you are taking a longer-term view, you have to ride out the inevitable bumps along the way.”
