Hedging Against Market Crashes


Q. How do you hedge against market crashes?

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A: You can hedge against a crash by buying the share and selling/shorting the index. This is valid for any size portfolio and will limit your gains in a rising market but as long as your share outperforms the market you will make money even in a falling market. The downside of this is that there are costs associated with it and your shares might go down in a period when the index goes against you.

For instance if you bought €10k of Bank of Ireland at €9.30 you would have 1075 shares. If you subsequently initiated a short spreadbet on Bank of Ireland, betting €10.75 on each cent of decline in share price, you will be left hedged.

Price rises to €9.50, stock is worth €10,212.5 but you owe €215 on your spread betting account.
Price drops to €9.10, stock is worth €9,782.5 but you are up €215 on your spread betting account.

While you have these two positions on, you are not affected by price movements, but you lose out on charges. Realistically, doing this makes sense only if, you are putting in the hedge for short periods of time, otherwise don't buy the stock in the first place.

You can also hedge using covered index put warrants. I have some of these in my SIPP. The principle is that they pay out in the event of a major generalised market decline, thus allowing me to stay invested in stocks that I believe will outperform, even if the market declines generally. AFAIK they can be held in an ISA. If you're interested, I suggest looking here: http://uk.warrants.com/ I'd also suggest contacting Societe Generale to find out whether or not they are eligible for ISA inclusion.

Before using an instrument such as this, I'd recommend constructing a spreadsheet to let you see how they would affect your portfolio in the event of market declines of various sizes and to calculate how many you'd need to buy to provide the level of hedging you want. Personally, when buying the puts, I try to buy ones with a strike price 5-10% below the current index level. This way, they are not generally overexpensive but provide 'insurance' should the market decline by more than this amount. You'll need to form your own opinion on whether the cost of the warrants is justified for the protection they afford, or whether you'd be better off simply selling from your portfolio.

Another way to hedge against market declines would be writing call options... (not one for novice investors as the pricing can be tricky to understand!) :

Example:

Assume one has a HYP worth say £150,000. One would expect this to move roughly in line with FTSE 100 assuming normal HYP rules are followed.

With FTSE currently drifting around 6270 it is possible to sell FTSE Feb 6700 Index Calls for a premium of around 35.

Assuming we sell 2 x 6700 February index calls for a premium of £700...
These calls will expire worthless if FTSE stays below 6700 until 16th February.
We therefore hold on to the premium in this circumstance.
Being short 10 contracts is the equivalent of being short 2 futures contracts once the strike price is hit. At FTSE levels of 6700, that is equivalent of being short the market to the value of £134,000 (not a full hedge). Should FTSE advance to 6700 in that period (an increase of 6.8%) one could reasonably expect our HYP of £134,000 to advance by a similar percentage i.e. an increase in the region of £10k in our portfolio value.

The danger of course is that FTSE could move much higher than 6700 by 16th February which would mean that the premium to buy back the calls would rise rapidly against you and avoiding action would have to be taken by buying back the calls before the premiums get too high or rolling the calls upwards or out to the next month. My theory has always been that FTSE can drop very substantially very fast (E.G. 9/11 situation) but that it normally advances at a much more sedate rate. I am told that over 80% of all options written expire worthless.

This is where I feel the puts really come into their own: your downside is strictly limited (i.e. the cost of the puts) but the protection they provide is unlimited. As you say, however, it is often true that options expire worthless. During the August 'mini-crash' last year, by swapping the warrants I had for others with a lower strike price, I was able to reduce my hedging cost substantially whilst retaining decent protection against a more serious collapse.

Moderate private investors have a huge advantage here so long as they stay flexible and don't let losses get out of hand they should be able to beat the performance of large funds. Hedging, imho is more necessary for big portfolios were one can't sell without trashing the share price. Of course they have lots of folk to help and lots of cash, usually not their own, to cover the overheads of the hedge.

There are of course many aspects to selling and portfolio management, one being to try and keep the same amount of money in a share, i.e. to sell some shares to realize the profits while keeping the original holding and to cut losses before they become significant.

Having cash always at hand is a good thing for when Mr. Market throws a sale. I am not often fully invested. But I remember Jan-March 2003 quite well, when things were cheap, they kept getting cheaper, I kept buying, and was in 'danger' of being fully invested. You always have cash to buy bargains. It means selling something else in your portfolio to switch into the bigger bargain. Forget taking the loss and how cheap the company you are selling is...if there is a significantly cheaper one, sell to buy the cheaper company.

Each investor needs to do their own analysis on the methods that suit them best, considering the nature of their portfolio, risk aversion, time available to monitor the market, experience/sophistication...etc

My father-in-law has a stash of gold bars under his bed. Not only does he get peace of mind in that he has his fortune in diverse mediums such as property, shares and gold, but he claims it also helps his rheumatism!

Q. How does the Volatility Index move?

A: The Volatility Index or VIX as it is sometimes referred to is based on a consensus of the expected 30-day volatility of the S&P 500 index. It is calculated from the nearest two months of S&P 500 options and it is often considered as a key barometer of market fear. A high VIX indicates fear while a low Vix indicates general calmness. A low VIX is a reflection that investors have become complacent and are comfortable with the the steady gains they are experiencing in their portfolios and so are less likely to buy call options. At the height of the crisis in October 2008, the VIX index almost reached 90. Generally speaking, the S&P 500 has an inverse relationship to the VIX. Spread betting on the VIX is covered in more detail in this section.

Q. What about gold as a hedge in a falling market?


I've not really bought into this 'buy physical gold and stick it in your garden' psychology (just yet, lol) but in light of the turmoil in the banking sector, one doesn't quite nowhere to turn. So I would appreciate your comments on Gold as a hedge?

A: Gold has always been a defensive buy, you only have to look at Merrill Lynch Gold & General's performance to verify that. However, rumour has it that in Asia they are not buying Gold unless they have to (weddings...etc) and that the party is largely over. Silver is the new gold because it is used in so many things. On the other hand, quite clearly gold is winding up for new highs. Traditionally, there is an inverse relationship between gold and the dollar which seems to be holding up so far; however as a hedge on the dollar, copper, lead, zinc and silver are doing much the same thing. Personally I don't have a view. All I know is that it is a bit too volatile for me... And should you really decide to stick some gold in your garden do remember to let me know where you live ;-).

Note that in spread betting the gold market is traded per 10c movement. If you opened a of £5 a point. Gold short for instance at $845.2 an ounce and gold fell to $844 you would make £60...But never spread bet the gold market without a stop as the market is too volatile - and make sure that your stops aren't too narrow though as the gold market is volatile.


 ...Continues here - Trading over the Telephone


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