What is Hedging? Hedging a Spreadbet

Q. What is hedging?


A: OK, hedging, basically, means it means offsetting your risks. If your company has to buy a hundred tonnes of barley next year to make beer, and you have already agreed the price you will sell the beer at, then you are exposed to the price of barley. You could remove this risk by agreeing a price up-front for the barley, or buy a contract that compensated you if the price of barley were to move up.

A hedge fund got its name because they were supposed to hedge against the risk of the market going down. More traditional investment funds would buy a selection of stocks. If the whole market fell, then even if their stocks did better than the overall market, they could still go down, Hedge funds claimed to have strategies that meant that they were protected from a general market fall (for example, they might buy the stocks they liked, but sell the rest of the FTSE stocks, so if everything moved in line, they did not make or lose anything).

However, most of them do the exact opposite of hedging now, which is to speculate. They take the money that has been invested, borrow a chunk more, and use the whole lot to gamble with. If their gambles win, they make huge returns (as, if you use £10 of your own, and borrow £90, a 10% return on the whole pot doubles your money), but, if they get it wrong, it does not take much of a movement to lose everything, too. Their name does not make much sense any more, for this reason.

This means that hedge funds are generally not a good idea for your pension money, or even for your holiday money. One of the reasons that they tend to have large minimum deposits is to stop small investors, who cannot afford the risk, putting their money in. In a more traditional fund, even if the market goes down a lot (say, 20%), you still get most of your money back.

Because they are lightly regulated, they can trade in pretty much anything that they want. The Bear Sterns fund that collapsed recently was heavily into gambling on mortgage debt. Banks that had lent money to people with poor credit ratings sold the debt on. The hedge fund borrowed money to put up with their own, and bought large amounts of this debt. When the debt started to look more shakey, and became worth a bit less, the fund collapsed, leaving nothing in it at all.

'Hedging is a good policy to protect yourself but, to be honest, you don't see much hedging in spread betting,' says Raymond, a market strategist at City Index. 'Most clients are looking to place short-term trades and most spread betters are looking to make the maximum from the minimum.'

Q. How do I hedge a spread bet?

A: A way to hedge a spread bet is to create an opposing bet. You can even do this with the same provider you're with, but hedging is exactly the same as being flat, except you pay a second spread and margin on the new position. Logically, it would be much cheaper to close the spread bet, and open it again if you want to 'un-hedge'.

Q. Why does hedging rarely work completely?

A: Hedging rarely eliminates the risk completely, a 'perfect' hedge would effectively leave you flat in the market, except with more spread and commissions than closing your original position completely. More often, hedging is used to take out some of the risk, not all.

An example of this might be buying Bund futures and selling 10 year futures simultaneously - the idea is that the two instruments are closely, but not exactly correlated. If I believe that Bonds are going down, but the Bund it too volatile for me on its own, I can take out some of the 'volatility risk' by taking an opposite position in something that should behave in a similar way. As long as the Bund goes down more than the 10yrs (as long as I make more on my short Bund trade than I lose on my Long 10yr trade), I'm in profit. This is known as an inter-commodity spread and you can do this with all sorts of things; stocks, commodities, bonds, etc...

You can do use a similar stratagem with multiple expiries of the same futures contract - as a general rule, contracts that expire further in the future are more volatile than the nearer dated ones - so in the example above, I could sell December Bund and hedge it with September Bund futures - if the Bund goes down as I suspect, I can expect the December future to fall more than the September one, so my profits from the December future should cover my losses on the September future, and leave me a little profit (an "Intra-contract" spread). As the two are highly correlated, this is a much less volatile position that the September future on its own.

In options trading, hedging is a popular way to reduce a type of risk completely. Option prices are affected by more than just the price of the underlying (e.g. Gold, or the Bund). They are also affected by volatility, time, all sorts. Suppose, say an options trader thought that an Oil option contract was pricing volatility too high; he might want to sell the volatility part of the option, but not expose himself to the risk that the price of Oil will have on his position. By using a variety of instruments, he can create a portfolio that hedges out the 'price of oil risk', leaving him just with 'volatility risk', which is what he has taken a view on. This is known as 'Delta hedging', again plenty around on the web.

High roller or what's your betting spread? I'm all over the map, I've
been known to grind it out at the dust joints with the toothless locals
and then hit the roped-off rooms betting $500-$5000
I really don't
like 'action' though, because that's just a euphemism for 'losing'  so
I try to play to win or don't "play" at all...

 ...Continues here - Using Spread Betting for Hedging Purposes: Practical Applications

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