Go back to Using Financial Spread Betting as a Hedging Tool

Sector Spread Betting

Sector spread betting has now been around for more than 10 years, but the recent turmoil in financial markets which has seen some firms losing half their market valuation in months has highlighted the risks inherent to investing in individual shares.

This is where betting on a sector can come in useful as it allows you to take a broader view. The way sector spreadbetting works is that an investor wins or loses depending on how a group of shares perform; you don't need to predict the share that is likely to outperform a sector; thus sectors empower investors to punt on broad trends. Also, sectors bets are often safer as they don't experience the wild swings of individual stocks; for instance in the last years it was a common sight to see a stock moving some 5% to 10% or more in just one day, however sectors can offer less volatility than individual shares in that they don't usually move more than 2% on a daily basis. This is because while bad news can have a marked effect on a company's share price, the effect on a sector is usually diluted unless the whole market is moving down.

The FTSE 350 Index of UK shares is a useful starting point, because it is divided into sub-indices. For example, a punter who uses a spread-betting service such as IG Index can speculate on the FTSE 350 Banks sector, which includes the likes of Lloyds TSB, Standard Chartered, HSBC and Barclays.

A bearish investor who believes that the current credit crunch will eventually engulf British banks could bet that the index will drop from a bid-offer spread of 10,270/10,330 (as recently offered) to say, 10,200/10,250. If he sells at 10,270 and closes the bet at the offer price of 10,250, he makes 20 points. At a bet of, say, £5 a point, that is a profit of £100. Of course punters should prepare for an adverse price move by agreeing to close out a bet at a pre-arranged level. Such spread betting is free of stamp duty and can be done online.

While he might be bearish about banks, the hypothetical punter might expect retailers, particularly sellers of everyday household items, to fare relatively well compared with other sectors if the economy cools off. The reason: people will continue to buy basic items such as groceries.

The FTSE 350 General Retailer sector includes companies such as WH Smith, the stationers and bookshop; Alliance Boots, the pharmacy and beauty products retailer, and J Sainsbury and Tesco, the supermarket giants.

The investor could punt £5 a point, for example, that the FTSE 350 retailer index rallies from around 2,316/2,330 to say, 2,350/2,364, buying at 2,330 and selling at 2,350, a 20-point, or £100 pound gain.

The advantages of sector betting is that investors can spread risks without the chore of researching hundreds of individual shares, points out Simon Brown, chief executive of ProSpreads, a spread-betting business. "Those [punters] that trade equities often stick to a sector because they are familiar with it and how it reacts to certain kinds of news," he adds. By placing a spread bet on a sector, traders can trade a trend without leaving themselves exposed to the possibility of an unexpected jump or fall in the share price of one specific company.

But there are also problems. For a start, an investor concerned about the credit crunch who sells the whole banking sector will miss out the fact that some institutions, such as HSBC, are highly exposed to the credit crunch, while others, such as Lloyds TSB, don't seem to be.

Punters should check the make-up of each sector because one company can account for a relatively high proportion of an index's total value and hence distort it. In the FTSE 350 Chemicals index, for example, ICI -- currently a takeover target and hence enjoying highly valued shares - makes up a relatively high weight, with only three other businesses in the index: Victrex, Johnson Matthey and Croda.

Sector betting makes it easy for investors with strong views but little time or inclination to pick individuals firms to put their money where their mouth is. But they should always remember that there are no real short cuts in wealth management.

Gibson from Galvan Research and Trading says that a problem with sector betting is that that because the sector indices comprise so many different components, it is more difficult to conduct any fundamental research on them. 'The banking sector, for example, contains Asian-dominated companies such as HSBC and international businesses such as Barclays and RBOS, as well as the largely mortgage-based UK banks, all at different weightings,' he says. 'This makes the fundamentals pretty hard to assess, so people can only really trade them technically.'

Also, since sectors are cap-weighted as like the main FTSE index means that potentially a few large constituents can dominate a sector's performance as is the case with GlaxoSmithKline (GSK) and AstraZeneca (AZN) in the pharmaceuticals sector.

Betting on Sectors: Sector Investing

Spread bets on sectors work in a very similar way to trading individual equities. Suppose you decide the supermarkets are going up in the near future. Your spread betting provider quotes you a price of 4182-4201. You buy at 4201. A couple of weeks later, the spread is 4502-4520. You decide to sell at 4502. So, your profit amounts to 4502 - 4201 = 301 points.
Studying sectors allows you to measure the sentiment of the markets for that specific sector as opposed to having to check the companies as a separate entity. Also, you can use this as a tool for further research. Although companies in a sector usually rise and fall in tandem there are times when they diverge.
Sector Indices are only available from a select group of providers - At City Index, each contract provides an exposure of £1 per index point and the margin requirement is 7.5%. The company arrives at its prices by adjusting the current spot price - which is calculated once per minute through the day by FTSE International - down by 0.2% for the bid and up by 0.2% for the offer. With City Index quoting the tobacco sector spread bet at 22207 - 22319, margin funds of £5100 would allow the purchase of three contracts for an exposure of £66,957. If over the two days the sector strengthened with the quote at 22500 - 22570, the position could be closed for a profit of £543.
In the UK, the sector indices are based on the FTSE 350, which covers 96.8% of the All-Share index by market capitalisation. There are 48 sectors, the biggest ones of which are usually available for spreadbetting. The mining and financial sectors tend to be very popular with spreadbetters; this can be attributed to their volatile nature offering punters short-term trading opportunities.
Note that some sectors provide a more diversified exposure than other - for instance while the automobiles & parts sector only contains one or two companies, general retail and support services each have more than 20.
Sectors very often do react to changing economic conditions as expected. Shares in 'cyclical' industries - such as mining and chemicals - do indeed perform better when the leading indicator points to an improving economy. Likewise, 'defensive' sectors - tobacco and food producers, for example - have recorded their best results when the indicator was signalling a slowdown.
Interestingly, you can also use sector indices take advantage of seasonal cycles, such as the tendency for the mining industry to outperform the general market during the initial three months of the year, or electricity's winning record in the third quarter. So for instance to speculate on the mining sector outperforming the market during the first three months of the year, you could do a long trade on the sector and a short rade on the FTSE 100 index.
A sector index is especially good for trading longer term trends as it does not experience the same level of intraday volatility encountered when trading in individual stocks. In fact trends can be both long term and substantial.
The contract lengths for Sector Betting range from Daily to Quarterly only. Some spread betting providers also offer rollover trades.
Specialise in one or two sectors and learn as much as you can about each company that is listed in that sector.
If you follow a stock regularly look at a chart of the sector and of the major index for the region. There is no point in fighting a losing battle if the index is falling and you are expecting a major rally on your share price.
Do keep in mind that within each sector there are just a few heavy-weight companies that affect whether the sector moves up or down - for example within telecoms there are BT and Vodafone.
Beware that sector betting is often an illiquid market and the spread of risk usually means that sectors do not offer the full potential to make the large returns of some individual bets. For instance a short bet on a company that warns of a drop of profits is likely to do better than one on that's company's broader sector. Also, spreads on sectors tend to be wider than on individual shares.
You will be surprised how close the UK and US sectors track each other.

Market Sectors

Aerospace & Defence
Banks
Beverages
Chemicals
Construction & Building Materials
Electricity
Electronic & Electrical Equipment
Engineering & Machinery
Food & Drug Retailers
Food Producers & Processors
Forestry & Paper
Gas Distribution
General Retailers
Health
Household Goods & Textiles
Information Technology Hardware
Insurance
Leisure, Entertainment & Hotels
Life Assurance
Media & Photography
Mining
Oil & Gas
Personal Care & Household Products
Pharmaceuticals & Biotech
Real Estate
Software & Computer Services
Speciality & Other Finance
Steel & Other Metals
Support Services
Telecommunications Services
Tobacco
Transport
Water

Sector Constituents

Sector Constituents (from City Index)

(26 Kb)

To get an overview of a sector's constituents you can also go to http://www.selftrade.co.uk/market-data/uk-shares/sector-list.php.

Looking at the above market sectors it is easy to see which market sectors would have a knock on effect on another. Some sectors such as Oil & Gas would have a knock on effect to most areas.