Contracts for difference can allay equity losses
AS YET, it isn’t clear whether the recent stock market falls are the start of a sustained bear market or a temporary bull market pullback. Kathleen Brooks of Forex.com says, “we are not in bear market territory yet”. Either way, investors should be familiar with ways to hedge themselves against short-term threats using contracts for difference (CFD). Particularly given the pervasive danger that individual stocks might fall off a precipice.
Black swans can cause the price of individual companies to collapse. Elliott Winner of London Capital Group points out that “18m people in the UK own – directly or non-directly via a pension – BP shares.” Following the oil spill, “people saw thousands being wiped from their portfolios as BP fell from over £6.50 to £2.90 within two months.” Winner says: “Investors who were familiar with derivatives saw this as the perfect hedging opportunity to hold the physical and sell the derivative.”
David Jones of IG Markets points out that if you have a portfolio of blue chip shares and are worried about broader market weakness “you could short sell the equivalent pound amount of FTSE 100 CFDs.” For example, Jones says if you had £115,000 worth of shares, then selling two FTSE CFD contracts with the market at 5,800 gives you an exposure of 5,800 times £10 per point, times two contracts, which equals £116,000. “If the FTSE drops 10 per cent you make money on your short, which hopefully offsets the majority of losses on your physical portfolio,” says Jones.
Plain 1:1 ratio hedging is not the only option. David James Norman, author of a number of books on CFDs, points out that overweighting short CFDs is an option if the market looks particularly bad. Norman says he uses this technique to cover 100 per cent short-term downside risk to the long portfolio, and to make a profit by being about 20 per cent overweight short CFDs – long 100/short 120.
Using CFDs to hedge your equities position is a useful tool for many investors, but Jones warns “it shouldn’t be used as an excuse to hold onto a losing position.” He suggests that sometimes selling out of the physical shares and looking at your position with a fresh pair of eyes is the right thing to do. Malcolm Pryor of www.spreadbettingcentral.co.uk agrees; his preference “is to exit the underlying, rather than keep the underlying and hedge.”
In his latest outlook, Invesco’s chief economist John Greenwood, predicts that despite slower growth, major markets should avoid a double dip recession. If he is right, you probably won’t need to short any of the major indices any time soon. However, if you have long-term investments tied up in the FTSE 100 and
one of its top constituents has a disaster of the sort that damaged BP, a simple short-term CFD hedge should protect your position, or if you up the ante, might even turn a profit.