Protecting Profits: Hedging & Falling Markets

How to Protect Profits and Make Money in Bear Markets

It is quite natural to think that the best prospect of making money in the financial markets is when the shares are on the rise. With today’s troubled markets, it can be frustrating trying to find profitable opportunities. Fortunately there is a better and more straightforward way to make money from a bear market, and to protect any profits that you have made in your stock holdings.

Any trader should be familiar with the idea of “shorting” a stock, which is a method by which you can make money when share values go down. In brief, you sell before you buy the stock, which means if the price drops it costs you less than you received from the sale. The obvious question is how can you sell something that you do not own, and this is easily answered by saying that your stock broker has access to many shares, and can simply borrow some on your behalf, as long as he make sure he replaces them in due course. It is not a complex process, and the broker takes care of the details with no effort on your side.

But there are easier ways to make money in bear markets, and they can also help you protect profits in an existing portfolio. These include taking advantage of a leveraged financial instrument, such as contracts for difference (CFDs) or spread betting. In particular you can use these instruments as a hedge against falling prices in a shares portfolio. Of these two, spread trading is probably the easiest, so we’ll talk about that here.

Spread betting involves betting on the movement of the price of a financial security, without ever buying or selling the security. One of the advantages of this is that you are not subject to any capital gains tax on your profits, and you do not even have to pay stamp duty as you would when buying or selling shares. You have total flexibility to name your own price, betting any amount, subject usually to a minimum dictated by your spread betting company, and when the price moves in your direction, you receive that amount for each “point” of the move.

Portfolio Hedge

David, has built up his shares portfolio and now has 10,000 shares in Barclays but now feels the need to protect his Barclays shares due to the economic uncertainty. David can protect himself against a market downturn by trading short, either against a particular stock (in this case Barclays), or shorting the index if he has a basket of shares.

Without ‘Shorting’ here is David’s possible outlook:

SHARE PORTFOLIO:

• Barclays shares 10,000 @ £2.50 per share: Total £25,000
• Barclays currently trading at (say) £2
• Current shares loss 50p per share.
• Total value loss £5000
• New Balance Total £20,000

With ‘Shorting’ here is David ’s possible outlook:

PORTFOLIO HEDGING USING SPREAD BETS

• Hedging strategy is to ‘Sell Short’ Barclays shares at £100 per point at £2.50 per share
• Barclays currently trading at (say) £2
• Total gain on spread bet: 50 points (250 – 200) x £100 per point = £5,000
• Loss in Shares Portfolio offset by Gain in Spread Bet Position

This means your losses in the physical shares are being offset by your winnings in your short spread betting position. To be clear, you can also lose money with spread betting if the price moves against the direction you bet, so you are well advised to study spread betting guides and courses to become familiar with ways that you can minimize your losses.

To make money in a bear market, then, all you need to do is use your learned technical expertise to identify a good prospect for a continued decline in price, and take out a bet to “sell” or “short” the financial security. When the price has drop to your target level, you simply “buy” to close the bet and take your profit.

You can also use this technique if you anticipate a short term loss in price on some shares that you hold. If you were to sell the shares, you would be liable for capital gains tax on the profits, so even if you are correct and can buy them back later at a low price, it is cost you some money. The alternative is to keep hold of your shares and to take a spread bet against them. The amount by which they drop will control how much your spread bet is worth, and be a replacement for the loss in value of your portfolio. Many investors rightly feel nervous about the markets with the Eurozone crisis at the moment and are buying blue chip shares and hedging by shorting the benchmark index market.

Long / Short Portfolio

I just don’t like doubling my risk of short trading. I ran a long/short portfolio for some time and found a lot of conflicts. First, if I simply scale out I have locked in profits and have cash at the ready for a buy signal. That’s nice and clean. I can try to improve my drawdown with a stock but what if the scale out signal is wrong? By shorting stocks here is my experience:

I start closing longs and opening shorts. So immediately I’m doubling my trading costs in spreads and broker fees (the accounts get a bigger drawdown). I continue and hopefully the shorts start to make profits as more of the longs reduce profits, so I’m no better off until I have over 50% shorts v longs. Even then I’m at an overall loss because of costs. With a big fall in the market I might eventually run an overall profit as the shorts gain traction but when the market eventually reverses back up I have it all to do again. I have the double costs of closing the shorts and buying new longs. I have to watch shorts reduce their profits as the longs start to run into profit. So for the initial period of the BUY signal I don’t make a profit. The end game is that you pay a hell of a lot to the brokers and market makers and unless there is a 2008 type fall you stand very little chance of getting much overall profit. If the market ends up only retracing say 10-15% you would probably come out with a much bigger account drawdown than by simply locking in profits and waiting for the next bounce up.

For me the emotions of long/short trading are not worth the risk. You will only come out on top if you manage to hit the right market at the right time, which requires a lot of luck. Bear in mind that a big chunk of the market fall happens before you get the scale out or sell signal. The opposite happens on the reversal up.