I HATE THIS BLOG. I DON’T THINK IT IS PARTICULARLY GOOD BUT I HAVE GOT TO THE POINT WHERE I CANNOT BEAR TO WORK ON IT ANY MORE. APOLOGIES TO READERS WHO WILL HAVE TO WADE THROUGH A LOT OF CRUD AND REPETITION TO REALLY FIND THE QUALITY HERE AND I REALISE IT IS WAY TOO LONG BUT I JUST CAN’T STAND WORKING ON IT ANYMORE (apologies for using the word ‘Bear’ as well……)
Markets are clearly pretty unpleasant at the moment if you are trading on the Long tack - we are officially in a Bear Market and the Trend is clearly down so it is easier to make money going Short and this Blog should help Readers think about how some very simple Shorting techniques can be applied to ‘Hedge’ a Long Portfolio. In other words it’s about positioning your Portfolio so that when the Markets fall your Short Positions offset the Losses on your Long Positions to some extent. This can have an extremely beneficial impact on your Returns for the Year.
There is another large bonus in addition to the Financial benefits arising from using Hedging - I find that when markets are really nasty and I have a decent sized Hedge in place, the whole experience is a lot less worrying and stressful and it is a lovely “comfort blanket”. In all seriousness, this is not to be scoffed at - if you are calm, unstressed and focused you are less likely to make stupid emotional decisions when the World is collapsing all around you in the depths of panic around a Bear Market trough. This is important because up until now the Selling has been pretty orderly and I expect we will see a truly horrific day when the Fear and Terror and Panic become extreme and people just dump anything they hold. That will be the Capitulation that is needed to clear the Market - I would guess this is still some way off.
Hedging effectively makes your exposure to Market gyrations much lower - if the Markets rise, then your Short Hedge loses but your Long Positions gain. If Markets fall, then the Short Hedge gains but the Long Positions lose.
Missing out on some Upside does not upset me as much as suffering Downside (really the Cost of Upside when Hedged is an ‘Opportunity Cost‘ not a real monetary loss). In a Dream Scenario for me, my Portfolio would gain as Markets move up (and I have been Buying near the Bottom) and then Flatline as Markets Fall because of my Hedging and Selling activities. Imagine a Staircase where the Value of my Portfolio increases with Vertical Up moves and then Sideways Horizontal moves (while Hedged) before more Vertical Up moves. Of course, in reality such a Staircase of Returns is pretty much impossible to achieve, but simply by recognising the concept and trying our best we can probably improve on a situation where no Hedging is used.
Readers who have seen my Compounding Blog will appreciate the concept that if you can achieve 10% or higher Compound Annual Growth Rate (CAGR) year in, year out, then you can get very Wealthy in a reasonable timeframe (your Money doubles in 7 Years at 10% CAGR). The problem is that if you suffer really bad down years (for instance you might lose 20%+ in a Bear Market), then it is very hard to achieve a high and consistent CAGR. By Hedging out Risk and avoiding huge Yearly Losses, you have a good chance of keeping that CAGR nice and high.
Sadly, I get the feeling that 2016 will be one of those years where we are going to be overjoyed if we just take a small hit to our Portfolio. On the flipside, a Nasty Bear Market sets up an incredible Long-side scenario so in 2017 we might be able to make an enormous gain over the year (anyone fancy 30% + for the year?)
Over the last year or so, I am sure I have written, tweeted, spoken, bleated etc. about Hedging a lot but up until now it has been a bit spread out over all sorts of Blogs and stuff and I thought it might be a very good idea to produce one dedicated Blog on the subject which sort of covers everything. I am only really dealing here with Hedging in the way that I use it and not in the wider sense in which the word ‘Hedging’ covers a multitude of practices within the Finance Arena.
This should help Readers make sense of it all and hopefully give me a very quick and easy Blog to bash out as if I am fortunate it should be a Cut ‘n Paste job to a good extent.
EDIT NOTE: After working on this Blog for many weeks I can categorically say that Copy ‘n Paste followed by laborious and difficult ‘knife and forking’ is definitely not the best way to write. In all honesty I should have just wrote the poxy thing from scratch !! It is depressing to say this but I really hate this stinking Blog and cannot wait to get the pig finished - any joy for me of producing it has long since gone and I feel I am just forcing myself to get it done now. I have had some wicked and interesting Blog ideas in recent weeks that I really want to get on with and yet this one is like a huge psychological and unfinishable Ed Miliband Monolith waiting to topple over and crush me..…….
“A Work of Art is never finished, it is just Abandoned” - so I am throwing it over to you lot, Dear long-suffering Readers.
What is Hedging?
In simple terms, Hedging is about putting on a Short Position to offset Losses that will be incurred on a Long Portfolio of Stocks, when Markets look like they are most likely to suffer a Pullback or to go into a Bear Market.
When Markets get in a bad mood and want to fall all the time, an unhedged Long Portfolio of Stocks gets really hammered and you will lose a lot of Money that then needs to be made back - and of course there is no guarantee that Markets will turn up any time soon and you could be sitting on big losses for many years.
Quite often experienced Investors can spot when these sorts of declines are going to happen and they place Short Positions which will gain in value as the Markets fall. The idea of Hedging is that the Short Positions offset the Losses in the Long Positions of the Portfolio - this is obviously far superior to nursing huge Losses which are unavoidable if you do not Hedge. Hedges can protect you against just normal healthy ‘Pullbacks’ in a Bull Market Uptrend (these drops are often around 8 to 10% or so for the FTSE100) but they are even more critical to save your hairy butt in a Bear Market, where falls can be in the order of 20% plus (ladies, you really need to see someone about that hirsuteness). In addition, Bear Markets are characterised by widespread pessimism where Investors anticipate losses and selling continues which feeds the pessimism - it is very difficult to make money if you just Buy and Hold in this kind of Market. But of course it is worth appreciating that holding your Quality Stocks and letting them run up over time is the best (and easiest) way to make Money.
Many people use Short Trades in a frequent, day trading, sort of manner - for me this is way too much effort and I just want to put on one or two Short Positions and then let them run for a few weeks or whatever the time period needs to be - this is so much easier and very possible as regular Readers of my Website will have seen me do.
In an Ideal World the size of the Short Positions would mean that the Losses from the Long Positions is exactly offset - but of course in practice this is not going to happen. My view is that the best way is to try and size the Shorts as close as you can to the Ideal World situation but if it is too big or too small it won’t matter too much. The key point is that if you size the Short on the small side, at least it offsets some of the Losses on the Longs and this is far better than nothing at all. I am not totally sure why but I probably tend to slightly undersize my Hedges - I think about this quite a lot but never really change that habit - bit weird really. Having said that, at the time of writing I have the biggest Short Position I have ever held (although of course my Longs are near an All Time High as well).
The beauty of a Short Hedge is that you don’t need to worry. If the Market moves up after you put the Hedge on then your Short will lose Money but the Longs of course will be gaining - so you stay pretty much Neutral or in line with the bias in the Portfolio to whichever side, Long or Short, is the more dominant. If the Markets fall, then your Short really comes into its own and rises in Value which will offset the Losses on your Longs to some extent - lovely. I think my tendency to undersize my Shorts is because I would get very depressed if the Markets started to properly rally before I removed the Shorts and I was losing money in a rising Market - that would freak me out !!
To an extent, Hedging for me is not so much about making Profit on a Short Trade but more about avoiding losses on my Long Portfolio and it is very much a Risk Reduction technique. A good way to look at it is that you can view a Hedge as an Insurance Policy - if you end up Closing the Short at a Loss, then this was just the Insurance Premium you had to pay to protect your Long Portfolio of Quality Stocks that you want to hold for a long time. Of course you want to keep the Premium as low as possible though.
Hedging can work really well for Short Term Events when you do not want to sell any of your Stocks - or you may have sold a few but you feel that you want to keep the rest. An Index Short might avoid having the inconvenience (and cost) of Selling and then having to Buy back good Stocks. For instance, this would have been a possible trade in the lead up to the Scottish Referendum Vote early in 2015 and it is highly likely that we will need to hedge before an EU Brexit Vote later this summer. One problem of selling all your Stocks is that when the Downmove ends and Stocks start to rally you are “caught with your Trousers Down” as Peter Lynch (‘One up on Wall Street’ book - check out Wheelie‘s Bookshop) would say - with a Hedge it is quick, cheap and simple to Close it out and get fully Long again.
The overall theory behind this strategy is that the total equity (value) of the portfolio will move upwards in ‘steps’. In other words, over the years there will be periods of upward appreciation, followed by a sideways to slight downwards move in the equity, followed by upward appreciation and so on. This will mean that a chunk of upside will be missed but the key is to miss the majority of the downside. When the Hedge is in place, the overall portfolio will have a ‘market neutral’ stance, provided that the Hedge is sized to match the Long Exposure almost exactly.
Once it is determined that a drop is likely (although the extent of such a drop is impossible to predict really), it makes sense to take precautionary action like Selling some Stocks and increasing Cash Holdings and I think the best Safety Tool is to Hedge using FTSE100 Shorts - via Spreadbets or ETFs (Exchange Traded Funds) like XUKS. Other Indexes can be used for basing Short Hedges on but I like the FTSE100 because it is so in my face all the time and it is the Index people and the Media in the UK focus on.
In the Credit Crunch meltdown I shorted a lot of Individual Stocks using Spreadbets - particularly the Banks where I also used a Sector Spreadbet. This was pretty useful and helped to Hedge the Longs - but it is very High Risk and not easy. I do not recommend such Shorting of Individual Stocks as it is very difficult - however, it is possible but I really suggest using a Stoploss as Stocks can rally extremely fast when the conditions are right - and keep Positions small and manageable.
How it works in practice
Right, assuming you have now got your Shorts on, the idea is that you have now reduced your Overall Exposure to the Markets. For example, say you Hedge 30% of your Long Exposure by taking out a FTSE100 Short equivalent to this value. This means that instead of having 100% of your Portfolio Money at Risk, you only now have 70%. The way it works is that if the Markets rise, then your Long Stock Holdings will go up in value and your FTSE100 Short will go down in value. So the Longs and Shorts balance one another and save you from the Risk Event.
The opposite is also true, if the market falls as you anticipate, then your FTSE100 Short will gain and your Long Stock Holdings will fall in value. So you have Hedged 30% of your Portfolio.
In practice I find that it takes some playing around with to get to a Level of Hedging (with regard to the % of your Portfolio you Hedge) that works well and you are happy with. The best approach I suggest is to start small with your Hedges to see how it goes and to understand it, and gradually do larger Hedges as you get the hang of it over the years. It is quite an Art Form to get it right. I often get it very wrong.
Hedging is far easier and less costly than selling Stocks before a Major Market Downturn
If you sell good Stocks before such a Fall, there is a huge danger that you have dumped a really good Stock that you have learnt inside out over time and you know how it moves with regard to general Chart Patterns etc. The chances are that once the dust settles, you will start buying Shares again but you will not buy the one you had before - something else will have been jumping up and down and looking alluring to you. The risk here is that you will be replacing a Great Stock that you know very well with something you don’t really have experience of - it could be a costly error. In addition, it takes time and there are high Costs in selling Stocks and then buying back a few Months later. The dangers are that you will sell too late and that you will buy back in too late - thus missing out on valuable Returns that you could have had.
It is far more cost effective and simpler in terms of time and effort to just put on a couple of Hedges when you think things are going to Drop and to then take them off quickly once you think the Panic and Downturn is over. You also avoid all the hassle of deciding which Stocks to buy when the time comes around and it is safe to buy again. It is also worth remembering that Momentum is a great part of Stockmarket gains - if you sell a Great Stock that has Upward Momentum, you could be missing out on the ‘Free Lunch’ of the Momentum effect as the Stock keeps powering upwards.
As an example, say you had 25 Stocks in a Portfolio and you decide to Sell 8 of them to reduce Risk before a Drop or maybe going into the Summer Period (you are a believer in Seasonal Investing !!). Doing so will cost you a lot of money in Fees and Spreads etc. and then you have to buy another 8 Stocks to replace them (even if you buy the same Stocks you sold, you still have huge Buy Fees and spreads). It is far easier to put on a FTSE100 Short (via maybe a Spreadbet or CFD or by an Exchange Traded Fund like XUKS) which you can quickly take off once the Down period has passed - simple and cheap.
Here’s another way to think about it. Imagine you have a Long Portfolio worth £30k and you buy a XUKS Position worth £10k (for arguments sake let’s say you had the Cash uninvested). In very simplistic terms this is like you just Sold a third of your Long Portfolio in one simple transaction - if you had to sell Shares to the value of £10k, it would have meant deciding which Stocks to sell and incurred loads of transaction costs, not to mention the hassle involved. In addition, once the panic is over and you think things are on the way up again, instead of having to buy loads of Stocks with Hassle and Costs etc., in one simple action of Selling the XUKS Position it is like you just bought back £10k of Stock instantly.
Hedging a Long Spreadbet Portfolio
With my normal Shares residing in my ISAs, Market Drops are not such a huge issue really - of course it is best to Topslice and even put a Hedge on using a Short FTSE100 ETF like XUKS - however, I don’t tend to get too hung up on this with these Long Term Portfolios. They go up, they go down. It happens. Deal with it. Obviously it is great if I have spare Cash to buy a decent XUKS Hedge with but it is less critical than with a Spreadbet Portfolio as I will explain below.
However, Spreadbets are a bit different. The simple fact is that when you have a Long Portfolio of Spreadbet Positions like I do, a certain amount of my money is tied up as ‘Deposit’ or ‘Margin’ and I have to have this to keep the Positions open. Alongside this, I have a Cash amount that moves up and down as the Markets wiggle around - I tend to think of this as my ‘Cash Buffer’.
If the Stocks that I hold as Spreadbets do well and go up, then my Deposit figure rises a bit but the Cash figure soars up fast. If things go against me, and my Stocks fall, then the Deposit figure reduces slowly but the Cash figure just evaporates - it can be quite nasty if you have too much Exposure and if you have insufficient Cash. If this happens, then igIndex will be on the Phone to me asking for more Cash - a ‘Margin Call‘. I have the Cash, but I do not want to use it unless I have to (quick aside - in practice igIndex tend to email me first if I get near my Cash limits - I tend to close some Positions or just pay more Cash in if I need to. It is best not to get near to this situation but it did happen to me in the Credit Crunch when igIndex increased the Margin/Deposit Rates out of the blue - nasty !!)
Therefore, when my Stocks are going well, all is rosy and happiness abounds; but if times are tough, then I have to be fully in control of my Deposit and Cash figures and make sure I have things managed. The best way to do this is to make sure that when Markets are a bit toppy, I reduce my Long Exposure to some extent - but it is the usual ‘Art’ form of deciding what stuff to chop - obviously it is a nightmare it you chop stuff and then it keeps soaring up - but that is how the Markets go sometimes, you will never be right every time and most times you will probably get it wrong with your precise timing. But it is better to be Roughly Right than 100% Wrong. If you look at my recent Trades, you will see that I have been cutting some Spreadbet Long Positions to reduce Leveraged Exposure.
When Markets start to come off the boil, I find that my Cash Balance starts to reduce - this is to be expected and I mitigate to some extent with Hedging. If we have a period of successive Down Days, then I usually find that my Cash Balance drops by fairly stable amounts. For instance, imagine your Cash Balance was £5000 - you might find that each day it drops by perhaps £500, so you know you can ‘survive’ for 10 days before you need to put new Cash in at that rate (or Close some Long Positions). Obviously, you will get better and worse days but you get a feel for how it drops - and it is important to keep on top of this - I tend to monitor twice a Day if things are running a bit ‘tight’ and Markets are bad. At normal times, I only look once a day in the Evening when I do my ‘Numbers’ and I check the Margin and Cash while I am at it.
It’s quite funny though - I nearly always notice that when my Cash Buffer drops to a point where I feel quite nervous and feel a need to pay New Cash in, it nearly always Rallies the next day !! A great Contrarian Indicator maybe? Clearly I am then at a point of Maximum Fear….
By Hedging my Spreadbet Portfolio using FTSE100 Shorts, the offsetting nature of these means that when Markets fall my Cash does not decline at an unmanageable rate. It also means I can have more Long Exposure via Spreadbet Leverage than I would be able to if I did not use Hedging.
In addition, the logic of Hedging using FTSE100 Shorts requires that you have a matching Long Portfolio of Stocks that behave in a similar way to the FTSE100 - if you do not have this correlation, then you could find that your Cash evaporates because your Short FTSE100 goes against you and at the same time, your Long Positions fall - so the Hedging effect does not happen because both Longs and Shorts are losing. Hedging can only work if the Longs and Shorts are in some sort of balance and reasonably correlated inversely.
XUKS is an Exchange Traded Fund (ETF) that you buy and sell like a normal Share. It is provided by Deutsche Bank as part of their ‘DB X-Trackers’ ETF products and it works by giving you the Inverse Return of the FTSE100 on a Daily Basis. To clarify, this means that if the FTSE100 rises by 1% on a day in which you hold XUKS, then the value of XUKS will fall by 1% and vice-versa. In reality XUKS does not ‘track’ the FTSE100 quite so perfectly but it is good enough to use for Hedging Portfolios and can be used in SIPPs and ISAs which makes it really handy.
The reason for the Tracking Error is because it is calculated on a daily basis and has a ‘rollover’ effect when you go from one day to the next - please see the 7Circles link below to better understand this. One drawback I recently heard about on XUKS is that some Brokers (this was TdDirect) will not allow you to use XUKS unless you have filled out a special form because they see it as a “sophisticated product” or some nonsense - your best bet is to get this form signed well in advance of a Bear Market so that when you need a bit of XUKS you can snaffle one up without all the admin mucking about.
Mike at 7Circles wrote an excellent piece on XUKS recently which is a ‘must read’:
As an alternative to using the FTSE100 as your basis for hedging, there are other products such as XSPS which is a US S&P500 Short and XSDX which is a German DAX Short.
There is also a beast called SUK2 which gives you 2 times the movement in the FTSE100 (it uses leverage and I think there is also a SUK3) - this is very risky and should only be used for a few days at the most because it tracks the Index really badly unless it falls in a straight line down, without any Up days in the sequence. For instance, over a period of Days when the FTSE100 is really choppy, the Market might end up down 5% but your SUK2 actually loses money !! Other Leveraged ETFs are available for major Indexes but I am no fan and recommend you do not use any of these products.
There was a discussion on Twitter a few days back regarding a FTSE250 Short ETF (for many people this might be a better match with the make-up of Stock Portfolios) and all that we found was a thing called the ‘Boost FTSE250 Short Daily’ with the Epic Code 1MCS. The thing to watch on these ETFs is that they can be quite illiquid so you may find they are difficult to trade in size and the spreads might be large. This link on Wikipedia may be of use and also lists some other Short ETF products:
Shorting with Spreadbets
It’s really just the opposite of going Long or Buying a Position. You are going Short or Selling a Position.
It works the same way. Let’s say you want to short the FTSE100 at 6830 at £3 a point - then you put in your Amount per Point and you hit the ‘Sell‘ button. You would have a Short Exposure of £20,490 (£3 x 6830). One thing to point out here also is that Margin Requirements for Indexes are tiny - in this case, it would probably be about £75 or something silly. There is a Danger here - don’t lose sight of your Exposure on a bet - just because you can use £1000 to give you exposure of £1,000,000 it doesn’t mean it is a good idea to do it !!
When you want to Close the Short Position, you ‘Buy’ the Spreadbet back. This is the opposite of when you Close a Long, where you ‘Sell’ the Spreadbet. If you find it a bit confusing, note that igIndex have a ‘Close’ button which helps - but on my small Tablet I find that I have to hunt it down.
Shorting Individual Stocks is very difficult and dangerous. I rarely do it in Bull Markets and always use a Stoploss - because your potential Risk is unlimited - a Share you are Short on could go up and up forever !! (and believe me they do have a habit of doing this when I short them - even if they are total cr*p - the Market can remain illogical for a lot longer than you can stay solvent……..)
Conversely, on a Long Position, your Risk is ‘Limited’ to 100% - a Share Price cannot drop below Zero (they do this a lot for me as well !!).
I tend to use Short Spreadbets for Hedging my Long Portfolio via the FTSE100. Please see my Blogs for examples of how I do this - best to look under the ‘Trades‘ category, and of course my ‘Trades’ page is littered with my Shorts.
Contracts for Difference (CFDs)
These are very similar to Spreadbets in that they allow you to go Long or Short on a Stock or Index or many other Asset Classes and you can do so with Leverage. The difference to Spreadbets really is that they are taxable (Spreadbets are Tax Free) and can incur Income Tax and Capital Gains Tax (CGT). The advantage of CFDs is that the Prices are pretty much the same as the Underlying Share or whatever it is you are trading and you can often get ‘Direct Market Access’ (DMA) via these instruments which enables you to place Orders directly into the Level2 Order Book yourself - sounds very complicated to me and for most Long Term Investors this sounds like a lot of faffing about if you ask me.
Spreadbet Providers like igIndex also tend to provide CFDs if you want to use these instruments.
Societe Generale ‘Infinite Turbo’ Products might be worth trying in order to Hedge (go Short) in a Normal Share account. Unfortunately, they cannot be used in ISAs (shame) but are allowed in a SIPP or in a Normal Share Account that does not sit in a Tax Wrapper. David Stevenson in Investors Chronicle has recently been buying some of these Products within his SIPP.
If you do not have a Spreadbet Account, this could be a great way of being able to Short with Gearing and the safety of a Guaranteed Stoploss.
They are very much like an ETF (Exchange Traded Fund) where you can buy them like Normal Shares and hold them for pretty much as long as you like, as they do not have an Expiry Date. However, they incorporate a level of Gearing that you can pretty much choose and they have 100% Guaranteed Stoplosses built in. You can use them to take Positions on all sorts of Underlying Assets like Stocks, Indexes, Commodities, FOREX Pairs, etc. and you can go Long or Short. They appear to be very complicated Products but in reality I don’t think they amount to much more than I have put in this paragraph.
The drawback is that after a lot of looking into these products, I found that none of my Brokers would actually enable me to trade using them !!
This link is to a Blog I did which covers these in extreme detail:
To an extent Cash is a form of Hedge. To be honest, it is a bit of a cr*p Hedge and if I was you I would use the Cash to buy some XUKS - now that is a proper Hedge !!
Trouble is that Cash just stays at the same value when Markets tank so it does not offset some of the Losses on your Portfolio in the way that something like XUKS does. However, Cash is very useful when the Markets have finally bottomed out and are on the rise again because it means you can hoover up the bargains. There is nothing worse than it being bargain time but you are unable to take advantage because you have no Cash available. To avoid this difficulty, you can always make sure you have a certain % of your Portfolio as Cash (say 5% or 10% or something) or you can try to sell some Stocks (or Topslice) when you think we are sliding into a Bear Market etc. A big advantage of Leveraged tools like Spreadbets and CFDs is that you can effectively ‘magic’ money up out of thin air to buy the bargains with.
It is not necessary to fully ‘Hedge’ all long positions that remain open - there is an amount of ‘Natural Hedging’ within the portfolio anyway. This is where on a minute by minute basis your Stocks wiggle around and some are up and some are down and some stay the same. With all these movements, you can find that if you have a large enough basket (you probably need at least 18 Stocks to get this effect working well and spreading across Sectors helps) then there is a lot of ‘Natural Hedging’ within the Portfolio where a lot of the Downside is protected by this diversification effect. It is a huge drawback of focused Portfolios which only hold perhaps under 10 Stocks that they do not benefit from this effect.
Another type of Hedge
In addition to my Normal Trading ISA where most of my Dosh sits and where most of my efforts are focused, I also have my Income Portfolio and Overseas Unit trusts but these take very little effort and they are a Hedge against my abilities as a Portfolio Manager - if I screw up, then hopefully these other Portfolios may do OK and save me from myself !! My Prudential ‘With Profits‘ Bond is also an example of such outsourcing. (This is actually quite a serious point and it is worth Readers thinking about this - are you really that brilliant an Investor or would it be a good idea to ‘Hedge’ your Investing ability by Outsourcing some of the Fund Management task? We have had an amazing Bull Run - was your success down to your Superb Skills or were you just a lucky ‘Monkey with a Pin‘?)
I am fascinated by the Gold Chart - as Tweet Followers will probably know. I hear so many Gold Bulls going on about this and that Gold Stock and how Gold is such a great Hedge and how Gold Shines and lots of other guff………….for me the reality is that Gold is in a Major Downtrend and I see no real evidence that it is a hedge against anything. In fact, with its recent performance I think you can safely say it is a hedge against making Money !!
Options, Warrants etc.
I just realised at the last minute that I hadn’t included Options etc. There is a simple reason for this - I never use them, don’t understand them, and sort of don’t see the point as Spreadbets are so simple. So, I can’t really say much of use here !!
And WTF is the ‘Black-Scholes Model’ anyway?
I have included this for completeness. Bonds are not really a practical Hedge in the sense that things like Spreadbet Shorts and XUKS are but as part of an overall Balanced Portfolio of Assets, Bonds provide a Hedging effect against Equity Holdings - it is more akin to the ‘Natural Hedging‘ effect that I talked about a few hundred words back. This is particularly the case with Investment Grade Bonds and Government Bonds but lower Quality Corporate Bonds won’t provide such a good Hedge.
When to Hedge
Obviously having Hedges in place is a must for Bear Markets (my definition here is a Market where I find it is impossible to make money by going Long on Stocks with the approach and timescales I use - I need to be Short to make gains), but they can also be useful in more normal times and to make money and avoid Margin Calls in Spreadbet and CFD Portfolios when markets just do a healthy pullback within a Major Bull Market Uptrend.
My preferred method when things are going well is to Sell some holdings into the Rally and then to place a FTSE100 Short Spreadbet to ‘Hedge’ my Long Spreadbet Holdings. This can work very well, but timing is key. Obviously as the Markets fall, and my Long Positions probably drop, the FTSE100 Short will gain Cash to offset the losses on the Long Positions. Apologies if that makes no sense, but it is quite complicated if you have never done Spreadbetting or Contracts for Difference (CFDs) before.
In the normal course of things, I tend to try to Hedge using FTSE100 Shorts whenever Markets get generally Toppy and Technical Indicators like the RSI (Relative Strength Index) are at elevated levels. I might not Hedge all of my Spreadbet Long Exposure, but would probably do at least 50%. This means that if we do have a Drop in the Markets, then the gains on the FTSE100 Short should offset much of the Drop on my Long Spreadbets - this just makes things easier to manage as it means a Margin Call (they want more Cash from me) from igIndex is far less likely and I won’t have to bother moving Cash around from my Bank Accounts.
When we get into a proper Bear Market (much of the text prior to this really refers to Big Pullbacks in a general uptrend) and things are really nasty - I cut down my Long Spreadbet Positions hugely and go heavy on the FTSE100 Shorts. I might even start Shorting some Individual Stocks. The key principle is to try to lighten up at the early stages of Bear Markets - this is very hard to predict, but with experience you can use various Technical Analysis techniques to identify when Indexes are rolling over and moving into Downtrends and you can then reduce Exposure and Hedge. For instance, it looks like we are in the early stages of a Bear Market now at the time of writing (January 2016).
A key thing to look for is failure of Major Support Levels. We had a great example of this just recently on the FTSE100 where the 5768 Intraday Low put in back on ‘Black China Monday’ 24th August 2015 failed as Support. This was a clear Sell Signal and I added to my Short Hedges following this event.
Some very simple ‘Seasonal Investing’ techniques will get you in Stocks at the right time and out of Stocks with Hedging if needed - in simple terms, the Summer is a poor time for Stocks but the Winter is superb and that is when you want to be Fully Invested. There is nearly always a Sell-off as the Summer starts and you can be pretty sure there will be a Sell-off just before Winter - it is worth being extremely alert at these times and ready to Sell some Stocks and Hedge if needed. If we do get big drops, you can take advantage to buy in as the Market starts to recover and to remove the Hedges.
For me, the key to coping with tough times is to be ahead of the game. Regular Readers will know that I am very much someone who thinks forwards and looks at likely Scenarios a couple of months out - I am flexible with my Approach but I do not want to be unprepared for outcomes that are fairly predictable and have a high probability of occurring. For instance, the Seasonal ‘Sell in Spring and Buy in Autumn’ pattern is well established and it is dead simple to have this in my thinking as I approach these points in any given Year. If you can think ahead in this way, then you can be ready to Sell as we head towards Spring and you can get some Shorts on to Hedge your Long Term Portfolio of Stocks.
When the markets in general have had a good run up and are looking very toppy (overbought - easiest way to measure this is Relative Strength Index (RSI) up around 65 to 70 on the FTSE100 Daily Charts - any half decent Charting Tool can give you this for free), I try to look for opportunities to sell some of my Stocks or to at least Trim some positions and bank some profits. Alongside this, the ideal approach is to ‘Hedge’ my Portfolio using Spreadbet Shorts on the FTSE100 and/or XUKS.
When Markets move up and I have Hedges in place, I appear to lose out on a Daily basis, but in effect I am just holding back Gains that will come to me when Markets fall - it is usually just a matter of time.
If I fail to anticipate a Market Fall and Sell some stuff and get Hedges on, then as soon as the Panic starts, I will be looking at the Charts and taking avoiding action - usually this means Selling some Long Spreadbets as it is the Leveraged stuff that can really hurt bad. However, the danger is that once we are in the Sell-off, you can end up Selling too late once we are near the Bottom - see my Example below of where I got caught out in 2014.
Anyway, even if I do get Shorts on late, the key is that Hedging protects me from Downside (think of it as Insurance) and I am more worried about Downside than Upside - Upside doesn’t sting like Downside does……
Hedging can be useful when specific Events are due and have a pretty much confirmed time of occurrence - something like the upcoming Brexit Vote is exactly this kind of thing. It is extremely likely that the EU Vote will cause uncertainty in the run up to Polling and Markets will be weak - so it makes sense to anticipate such a Sell-off and make sure you Hedge before the drops start.
Hedging an Individual Stock
Another trick I have used one or two times in the past is to totally ‘Hedge out’ a Long Exposure I have to a Stock. For instance, say I hold a Share that I really like and I think there is just a Short Term issue that is a big worry. In this case, I might actually do an Offsetting Short Spreadbet on the Stock to the same Exposure Amount as the Normal Share position I hold. This will mean that I now effectively have Zero Risk from the Share but I am still in the game and if things get resolved, I just close the Short and we are off to the Races again and I can even add to the Share Position if I think the Stock will now move up nicely.
You might have a Stock you really have strong belief in but it has done an unexpected Profit Warning that you think is a Short Term issue. In such an example the Price can get shot to pieces on the day of the Warning but it then recovers a bit for a few days and then it plunges again. You could use an offsetting Short Hedge to remove further Downside Risk after the Warning.
You can object that I might as well sell the Shares, but the danger in this is that cognitive ‘Recentcy Bias’ (how do you spell that?) may mean I forget about this wonderful Stock and get distracted by something else, and I miss out on the upside. It is not a great solution and I have only done it occasionally but it is another ‘trick’ in the Armoury.
Size of Hedge
Hedges need to be appropriately sized to work well - because I am trying to Hedge my Portfolio of diverse Stocks with in effect a pretty unrelated Index, the FTSE100, I have found that the only method to get this right is by experience and trial and error. If you are Hedging a Portfolio of Normal Shares using something like XUKS, then it is probably not too difficult as you will probably just buy XUKS with whatever Cash you have spare in the Portfolio Account. From many years of mucking around, I find that I probably need a FTSE100 Short that is about 50% of the value of my Shares - this seems to match up quite well. Readers with differing Portfolios might find that they need a very different level of FTSE100 Short to do the job. At the time of writing I have a Short Position which is equal to about 45% of the Value of my Long Portfolio.
In the past my Hedging via FTSE100 Short Spreadbets has worked very well but it has often not been of a large enough size - I will try to do larger Short Positions in future. Part of the problem is that in recent less savage Pullbacks, the size of Hedging I had worked pretty well - because there was a lot of ‘Natural Hedging’ within the Portfolio of Spreadbets where Drops on some Stocks were balanced to an extent by Rises on others. However, on Black China Monday (August 24th 2015 when we experienced savage drops in the Markets) it all went nastily wrong because all my Stocks became closely correlated and fell together so there was very little Natural Hedging effect, and I needed more FTSE100 Hedging.
Stoplosses on Hedges
I take the view that Hedges should be treated precisely as per the name - in other words they should not be seen as ‘Trades’ in themselves and should be more viewed as ‘Insurance’ against falling Markets (Protection). Remember, it is Downside Risk that kills you not Upside Risk - if you eliminate the Downside Risk as much as you can then the Upside looks after itself and you will be a Winner.
If you treat the Short Hedges as individual Trades and try to ‘win’ on them then you will be defeating the whole purpose of the Hedge - it will be counterproductive and self-defeating. What I am getting at here is that I see so many people trading in and out of their Short Positions which they say are supposed to be “Hedges”. The problem with this is that when Markets are really awful (which is exactly when you need a Hedge in place), they are also incredibly volatile (at the time of typing this we are going through a pretty painful Bear Market Leg down and Intraday Volatility has gone through the roof) and if you try to trade this choppiness then you will have closed your Hedge at the very moment when you actually need it and the Market tanks, leaving you with no Protection (and that Hairy Butt hanging out).
I find the best way is to ignore Intraday moves mostly and focus on the Daily Candles and Weekly stuff and try to think ‘bigger picture’. If you pull back on your timeframe and look at the more dominant longer term trends then you will get a much better view of what is really driving the Price and you will realise that the Intraday wiggles are just retracements and moves that are in line with the Major Trend.
If you think more Longer Term in this way and keep your Hedges in place through the tough times then you will have them in place when they are actually needed - in a Bear Market drops can be fast and severe - you must have Protection in place. So, rather than trying to trade in and out all the time for small Wins, pull back and get the really big Win when the Markets collapse and at the same time you protect your Portfolio, and you can sleep at night.
Remember, with Hedging, the name of the game is to protect you from losing money when the Bear visits your neighbourhood and he hasn’t eaten Honey for a while.
If you really must do the old In & Out (after all, we all love a bit of that), then perhaps a good way to do it is to have a ‘Core’ Short Hedge in place and then have a smaller one which you trade in and out of - that one you could use Stoplosses on and all the usual Trader tricks.
I don’t tend to use Stoplosses on my Shorts for the reason that they are hedges. If the Markets fall they protect my Portfolio of Stocks and if the Markets rise, then I lose on the Shorts but I will be gaining on the Stocks and if I have got the sizing right (this bit is critical and takes a lot of time and experience and experimentation to get right) then I am in effect ‘Market Neutral’. Once the dangers are passed, then I can take the Shorts off and get back to normal. The impact is really one of ‘Opportunity Cost’ not actual monetary cost.
Having said all of the above, in a Blog back in 2015 I wrote the following which Readers might find helpful to your thinking:
“I need to think about and possibly experiment with Stoplosses on maybe some if not all Spreadbet FTSE100 Short Hedges. I have found that running a Short Position like this for several Months is no problem but I could have done with more firepower to the Downside when things got hairy. Maybe I could put on a Short with a fairly tight Stoploss and accept that the Price of the ‘Insurance’ it provides is the loss I would take if it hits the Stoploss. This seems logical and is not a problem if I keep the Size of any Loss to a realistic amount - maybe 0.5% of Portfolio Value as a Maximum. It seems fair to risk 0.5% if it will protect me from falls of maybe 5% or more. If I decide to go down this route, then I could start with very small Short Positions and see how it goes - this is always the best way to try out any new Approach or Tactic - try it first in small size and build up if it works.”
Reasons to be Careful, part Tree (geddit?)
It is not necessary to be the ‘World’s Most Perfect Trade Timer’ in order to use Hedging successfully and simple ideas like scaling into and out of a Short Position can help make the overall Trade successful. However, if your timing is usually awful and you get it wrong (perhaps by oversizing the Short Hedge) trying to Hedge against Downside Risk can actually end up costing you a lot of money. It is vital to be very confident that a Downmove is coming because if you get it wrong and the Markets keep going up, you will find your overall Returns hit hard as you pay the Insurance Premium but you did not get a chance to make a Claim. As soon as you realise you have got it wrong it might be best to close the Short Position and enable your Longs to charge upwards with no restraints.
As with anything in this Great Game, if you have never tried a technique before then it is best to start in small size first and see how it goes. Keep it small and experiment and find out what works for you and gives you the knowledge and practical skills to enable you to effectively protect your Portfolio in the future.
I do not recommend you use the geared ETFs - for example SUK2 or I think there is a SUK3 - they are very dangerous products. There is a quirk in the way they are calculated from one day to the next. It essentially means that if the FTSE100 is really Choppy in a sideways direction for a period, then you will actually lose a lot of money just by the mathematics of how they are created. They are only really useable for maybe 2 to 3 days maximum - I recommend you DO NOT USE THEM AT ALL.
If you use XUKS instead of Spreadbets or CFDs, then you need to have Cash. I guess there are a couple of ways you can do this:
One of the beauties of Spreadbets and CFDs is that they are ‘Margined’ products - this means you can use small amounts of Cash to get big exposures - but introduces Risk so you need to know what you are doing. I recommend you read my Blogs on Spreadbetting before getting involved with this extremely useful but dangerous tool.
There is no doubt I need to get better at this Hedging malarkey - I remember a couple of years ago in 2014 I got really caught by it and took a Big Loss - and we don’t want those, do we. Although in that case the Market had clearly ‘Broken Out’ and I had the good sense to close the Short and take the hit before it got much worse.
Hedging is in no way cost free and you can get hit for Interest Charges on Spreadbets and CFDs (Contracts for Difference) which is a pain, and if you Short using these instruments then you have to pay any dividends due (on FTSE100 Spreadbet Shorts you pay a small amount every Thursday when the Market goes Ex Div) - just make sure you are fully aware of the costs of any Hedges.
I think Hedging is a great skill to master as a Long Term Investor. If you can crack the art, then the Total Value of your Portfolio could in theory, produce a Chart over time like a Staircase. In good markets when you are unhedged, your Total Value would go up nicely and when times are tough, your Hedges would mean your Portfolio only drops a bit and then you take Hedges off and you are exposed to the next flurry of Gains and the ‘Total Value to time Chart’ would go up again and then you would Hedge on peaks and get a slight drawdown again and so on - I hope this makes sense, I am not sure it does !! Just keep thinking ‘Staircase’………
The simple logic is that when Markets seem toppy, or you fear a particular Huge Event such as a General Election or like the Greek Elections a few years ago, or the upcoming EU Brexit Vote, you perhaps should Sell some stocks and get your Long Exposure down to reduce Risk. However, you might sell a few things, or none at all, because you like your Current Holdings. So, a great solution to this is to ‘Hedge’ using a Short Position on something like the FTSE100 - I have sometimes used a Short on the FTSE250 or even on the US Indexes - but I tend to stick to the FTSE100 because it is so in our faces all the time.
Hedging in a Nutshell
Right, finally that tedious Blog is over. I have really not enjoyed this one so hopefully Readers will be able to wade through the crud here and actually find something of use - I suspect you will need to be chopping out a lot of ‘Noise’ but you should be used to that because that is one of the largest challenges facing us every day in the Markets !!!
With that out of the way I can get on with some more interesting Blogs,
Best Regards, a very much relieved WD.
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