This one comes with an extreme wealth warning. Hedging anything is counterintuitive, sometimes hard to understand and subject to margin calls. It is easy to screw up bigtime. Do you own research, and then cross-check it. The first time I tried this I lost £500 before bottling out. Under some conditions your losses are theoretically unlimited. There be dragons in this swamp. You get my drift 🙂
Hedging an investment basically means purchasing a financial instrument that moves in the opposite direction to another. People have all sorts of reasons for wanting to do this. The first time I came across it was with my company sharesave schemes. Another potential opportunity is for people saving for a house deposit to track the deposit with house prices. I will deal with that further down, though to do that you need balls of steel…
In this I talk about using financial spread betting. Some companies offer contracts for difference which are another hedging tool, I have no experience of CFDs but you ought to at least be aware of their existence and consider them as well if you have a need to hedge shares, where they are more transparent. There are differences in capital gains tax liability, and the way margin charges appear – it is in the spread and rollover for spread betting, as an explicit daily charge for CFD
With sharesave you take out an option to buy shares in your employer at an agreed and known price, usually at a discount to the current market price. You then save an amount, up to £250 a month, with a bank. After three or five years, you can exercise the option, ie buy the shares with the proceeds of the bank investment, or get your money back. Obviously if you have any brains you don’t buy the shares if they are below the option price, though I’ve seen people do it…!
Taking one of these out is a no-brainer, it is a classic one-way bet and it’s rude not to take part. The simplistic way to look at this is that if at the end of the 3 year period, the share price is higher than the option price, then buy the shares and sell immediately, instant profit. If the share price is lower, take the money and let the option lapse. I’ve been doing these for years, and sometimes I end up taking the money, sometimes I’ve done okay on the shares. As a general rule if you are an ordinary grunt not paid in stock options it’s probably unwise to have long-term shareholdings in your employer for any other reasons. You’re already highly exposed to your employer’s financial health – redundancy is more likely if the employer is squeezed. You don’t want to have a load of your financial wealth tied up in them too. The only exception is if you work for Berkshire Hathaway…
In the past you could drop a sharesave contract and use the allocation on the next year’s options, but HM Revenue has closed that. My company had a few years where the share price basically went down the toilet for years on end, so I was glad to have this possibility to just drop and sign up for new options. I am now maxed in a three and five-year scheme taken at a very good share price – it’s risen 100% on the option price now.
One wrinkle that it took me far too long to spot was that I should always aim to put the same amount of total money into a 3-year and 5-year scheme. Though diversity has no meaning in a single company share, the performance of a 3 year option may be different from a 5-year option, so temporal diversity is worth having.
Because this is a one-way bet, I improve my odds by exposing myself to both time frames – if one bombs the other may make good. I used to always go for the 5 year option because the option price was lowest until I jumped to the value of diversification. With the new HMRC rules that you can’t drop previous allocations, sharesave investors should aim to have equal exposure to all options.
Hence in the first year put in £50 pcm, split £31.25pcm in the three year scheme and £18.75 pcm in the five year scheme. That buys you £1125 of each share option if taken to maturity, ie 60 lots of 5 year contributions and 36 lots of 3-year contributions. Do the same the next year and the one after that, in the following year 4 your three year option will come out leaving you £81.25 option space to allocate rather than £50. And so on – a spreadsheet will help you track the strategy. Fortunately I avoided all this complication, and this doesn’t apply to me any more as I won’t be buying any new sharesaves after my current one comes out in two years time because I don’t expect to be working there any more.
So what’s all this got to do with spread betting? What that does is allow me to lock in a particular price at any point in the three-year term of a sharesave contract, though because of rollover costs it is best for the last year or two. Say I have an option to buy 1000 shares at £1 each in MegaCorp, and the share price rises to £1.50 after two years. I decide that this is good for me, but obviously I can’t count my chickens yet, as the share price may tank.
So I go to IGIndex, and place a spread bet on MegaCorp as a sell option. Things to watch for here is that IG sell options on a pound per point basis, ie lumps of 100 shares. So I only want to sell 10 IG options on MegaCorp, not 1000! The way to test this is to ask what happens if the share price move up a point. For my shareholding it will move £10 (1000 shares time 1p). To redeem my IG option I need an extra 10*£1, neatly cancelling out the rise. What this does is it clamps my overall return – if the price rises my options on exercising do better, but my spreadbets cost more, if the price falls then spreadbets compensates for what I lose.
The added bonus is that my downside is limited on the shares themsleves. Say the price tanks to 50p. I liquidate my IG options on the three year term end day, banking (150-50) points * 10 IG options * £1 = £1000 and also collect my £1000 sharesave stake, letting the option lapse, rather than exercising it and losing £500.
If MegaCorp does well, and soars to £2, then I take a bath on my IG options, having to pay them (200-150) points times 10 (IG options) times £1, kissing goodbye to £500. On the other hand, I exercise and sell the share options, finding that for my stake of £1000 I now have £2000, out of which I must pay £500 to IG. So I have made an overall profit of £500, which is what it was when I decided to lock in the £1.50 share price of MegaCorp.
What can go wrong? Well, if I lose my job in the first three years the options die, which is a bummer if I am sitting on IG options that have risen. A takeover of MegaCorp is one of the circumstances which makes redundancy and a share price rise likely. A more subtle hazard is if the share price skyrockets, say to £10. Now the cost of closing the IG option would be 900points * 10 options * £1 = £9000. It isn’t a problem to carry that obligation, remember the shares on option exercise can underwrite the obligation, or the price will fall and the obligation goes away, but IG tend to like you to have a reasonable cover for liabilities, so they may demand you fund your account with some proportion of £9000 or they will close you out. That proportion is typically 10-20%, ie up to about £2000 cash you have to keep with them until closeout at the end, so you may end up having a lot of working capital sterilised, or have to close the position, exposing you to losses on a precipitous share price drop. The moral of the story is be careful out there.
Another application is for employee share incentive schemes. These are a means of purchasing shares in your employer with pre-tax money. Now when HMRC are saying they won’t steal 41% of your money before you get a hold of it then it pays to listen up – I was able to buy £125 worth of shares a month for the price of £74 difference in take-home . The downside is you buy the shares but they are embargoed for 5 years, though you do get the dividends. As it is my company’s shares tanked, though overall I’ve still come up as the dividends have been good and so the composite loss is < 40%.
Hedging works just as well for those and if I’d known about it I could have saved myself from the losses as the shares tanked. Ain’t hindsight a wonderful thing. Unlike the sharesave options there are actually bought, so losing your job doesn’t clobber you if the shares have risen so the IG index options are in the red, as you actually have the shares even if you can’t get your mitts on them until the 5 year embargo has expired.
For all this talk about using spreadbetting to hedge shares, this is an application where CFDs are probably the more correct tool for the job, and I will investigate that approach before doing this.
How to use hedging with house prices
For God’s sake don’t even think about doing this until you have understood the options, have convinced yourself I’m not talking bollocks, and you have explained the plan to someone else and they agree it makes sense 🙂 I feel a little bit odd describing this because my personal belief is that house prices will tank because mortgage lending requirements are tightening, and there are requirements that people actually pay back some of the capital rather than taking an interest-only mortgage. Doing this in a falling market is a nutty thing to do.
But I also remember what it felt like as a first time buyer watching house prices race away from me. So who am I to impose my forecast expecations on you, make your own mind up, though you might want to read the cautionary tale first, buying a house at the 1988/9 peak was the most monumental personal finance cock-up of my whole life 🙂
The problem first time buyers have is that house prices are at high income multiples. If the average salary in the UK is £22k and a two-up-two down in my area is £130k then the income multiple is 6x. That’s obviously dear, but it also makes saving a deposit in a rising market almost impossible. If you need a deposit of £13k and you’re paying rent of say £6k you need several years to get there even if you eat ramen every day. The gripe was that house prices race away, so where you need 13k in the first year you need 15k the next year because thet two-up-two-down is now £150k, so it is an endlessly moving target racing away from you.
Now if you do believe house prices are still going to go up, you could hedge the deposit, buying house price call options to protect your deposit percentages. If your target is £13000, then if house prices go up 10% you need another £1300 to still have a 10% deposit. Once you’ve got your mortgage and house you’re on the ladder, and presumably want prices to race up to 10x earnings multiple so you can laugh at all the upturned faces below you.
At the time of writing, IGIndex are currently citing UK house price indexes for September 2011 at 153p, so if house rices go up by 10% this will rise by 15 points. At £1 a point, I need to buy 87 points to make up my £1300 (ie 15*87)
I need to deposit £666 to be able to do that, but if prices go up I am protected. You can reduce that stake by using stop-losses, at the expense of risking getting bounced out on spikes and crystallising losses. You can see how much this insurance is costing me – there’s a three-point difference, so if I buy and sell on the turn I pay £261. This is how IG make their money. A more subtle way they make money is you’ll observe this bet lasts a year, so next year I’ll have to roll it over for another year (assuming it takes two years to save my deposit). As I understand it rollover bets only incur half the spread, so Mr First Time buyer will be rushed another £130 every year. This game isn’t cost-free, but it’s cheaper than finding the extra £1300. Conversely, he takes a stiffing if prices fall, but there again he needs less deposit anyway so no great harm done.
There are other wrinkles, too. For a start, what is a house price index? How do you test IGIndex’s value? TFS offer some guidelines, but is IG’s product a derivative of that? It is easy enough to qualify the spread betting price for a ordinary share – look it up in the FT, and the spreadbet future price ought to bear some resemblance to the current price with an influence from the history, but housing is hard to gauge.
This is for a average UK house. You’re not buying one of those. The London market is totally anomalous, for instance, due to the distorting effect of the City and foreign wealth not grounded in the UK. Sometimes the market for flats is different from that of detached houses. Sometimes the South goes in a different direction to the North.
Bear in mind that IGindex’s house price future is a futures index. They are not a guarantee of future property returns but rather are dynamic forward prices that are subject to change, this isn’t the same as even shorting the Halifax house price index, although the value should converge towards the maturity date.
I am toying with using this in the other way. To short the housing market a bit, along the same rationale as the sharesave scheme, to protect the gain I have made on the house since I bought it. But it needs thinking about, and I will first use spreadbetting or CFDs to hedge my employer share schemes. I have quite a lot of these, and my employer is on a roll at the moment.
Oh, and why did I lose £500? I had the general theory right but failed to account for the scaling factor of the £1/point. Be careful out there, there are a lot of subtle ways to screw up royally in this spread betting lark.Although he was talking about the music business, I think Hunter S Thompson could have been talking about spread betting
“The business is a cruel and shallow money trench, a long plastic hallway where thieves and pimps run free, and good men die like dogs. There’s also a negative side.”
I’ve never had enough skin in the game for it to matter for me, but for those with more courage/foolhardiness than me the proceeeds of spread-betting are apparently free of capital gains tax. IGIndex just happens to be the spread betting firm I used, there are others out there. Particularly in house price futures, you would do well to find a more narrowly drawn index that matched your locality, indeed if it is London I’d say this is essential.