Derivatives like options are particularly suitable to protect yourself against a market downturn. Spread betting can also be used in this respect and the fact that there is no minimum dealing size means that you can hedge positions more accurately.
Suppose you are worried about a fall in the stock market and have a £22,000 holding in a number of FTSE 100 shares. With the FTSE at 5500 this would be technically equivalent to £4 per point on the FTSE. If the index fell 300 points you would lose £1200 on your £22,000 shareholdings. You could hold on to your portfolio and wait for the market jitters to pass or if you are feeling particularly bearish you could exit the market (which would incur dealing costs). Alternatively, you could sell the FTSE at £4 per point with a spread betting firm to hedge potential losses - any losses on your shareholdings would then be offset by profits made from the spread bet. The problem with this type of hedge is that it leaves you in a market - neutral position and you do not benefit from rises in the market (unless of course you do not hedge for the full value of the position) .
However, it is worth noting that spread betting may not be the most appropriate instrument for hedging an entire portfolio of stocks - using FTSE futures or options may be cheaper.
A put option, gives you the right to sell a security at a fixed price in the future. For instance at the time of writing ETX Capital is currently quoting 140.5-146.5 for a November 5450 put on the FTSE 100 (currently trading at 5500). Buying this put option means that you can sell the FTSE at the strike level of 5450 on the expiry date, thereby benefiting from any market downturn.
This option will expire on the third Friday of the contract month but you can close the option at any point before the maturity date by taking the opposite position to the open one.
Take the case of an investor who is undecided as to whether the Monetary Policy Committee's next step will be to raise or lower interest rates. An increase in interest rates would have a significant negative effect on his shareholdings so he decides to buy a put option at 146.5 at £4 per point equal to his shareholdings worth. The break-even FTSE level on this put option is therefore 5303.5 (5450 -146.5). If, on the expiry date the FTSE is trading below this level (5303.5) the put option will be in-the-money and will pay out £4 per point compensating the £4 per point loss incurred on his shareholdings. In this way the investor would insure himself against further drops of the FTSE from the 5303.5 level but still stands to gain if the FTSE moves up.
Interest rates are raised and the index falls to 5150 and the investor receives a £614 payout [(5303.5-5150)*4). This serves as compensation for the investor's £1400 loss on his shareholdings [5500-5150=£350*4=£1400]. The put option has the effect of capping the losses in that further falls within the timeframe of the put option would be covered so even if the index fell by 1000 points the loss would be limited to £786.
The interest rates are left unchanged and the FTSE reacts by rising sharply to 5750. The investor would lose his put option premium (146.5 * £4 = £586) but would gain £1000 from his shareholdings [(5750-5500*4)] netting him £414.
The investor can choose the strike price at which he wants to buy the put option from a selection provided by the spread betting firms. Buying put options at levels lower than the current 5500 FTSE quote are likely to be less expensive as there is a lesser possibility that these will finish in-the-money. Put options with a longer lifetime are also likely to be more expensive.
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