There are many, many different ways to use correlation as your hedging strategy when spread betting shares, and below I have listed several that I use regularly, but there are many others, which I’m sure you will be able to find for yourself. It just takes a little time, effort, research and analysis to come up with other combinations and ways of hedging your positions. All of the strategies outlined here can be modified and adapted to suit a variety of markets and instruments, and are all simple to understand, and easy to execute. So let’s look at some of those that I use for spread betting shares.
This is a very simple strategy which involves finding two shares which correlate well either negatively or positively and them setting up the hedging position. As an example let’s look at two shares in the UK FTSE 100, BP and Royal Dutch Shell. Both shares are in the same sector, both are major constituents of the FTSE 100, and as a result we feel that there could be a correlation between the shares. We would start our analysis by first looking at their share price charts over the same timescale, superimposing one chart over another to see if the pair correlate and if so how closely, and as we thought the charts show a strong positive correlation. Our next step might then be to compare the five basic investment ratios for each company, and for this we would look at the PE ratio ( Price / Earnings ), the Price/Book ratio, the dividend yield and cover, and finally the gearing and interest cover. Our analysis reveals that BP looks undervalued relative to Shell and additionally from a technical perspective, looks set to rise. Finally we look at the oil sector chart which reveals that the sector is looking strong overall, and overlaying both charts on the sector reveals a good positive correlation here as well. With the main FTSE 100 index looking strong we decide that a buy bet on BP looks a good spread bet, with a sell bet on Shell as our hedging strategy. What we are hoping for here is that our analysis is correct, that BP rises faster than Shell, and we are able to make a profit between the two bets, one of which will now be positive, and the other which will be negative ( assuming both shares rise with BP rising faster than Shell). You could of course get lucky and the Shell share price holds or even falls while BP rises!
The next issue of course is how much should you bet on each share. Assume that BP is currently trading at 500p per share and Royal Dutch Shell B at 1750 per share then we need to set up our spread betting strategy such that the trade is balanced and that every 1p move in the real cash market equates to an equal move for our hedging strategy. Looking at the current share prices we need to place a buy bet with BP at £7 per point, and a sell bet with Royal Dutch Shell at £2 per point. This gives us a notional value for each trade of £3,500 ( BP – £7 x 500 and Shell – £2 x 1750) which is now balanced. If our strategy is correct and BP moves to £550 whilst Shell only moves to £1800, then at this point we could close out for a profit of £3,850 – £3,600 = £250. A small profit perhaps, but a substantially lower risk than a ‘naked’ up bet, and certainly less stressful, and one you are likely to let run a great deal longer than a simple long position ( in my view at any rate ).
Now I can hear all the protesters reading this and saying – oh that’s fine, but what about the cost of the two spreads. Yes that’s true, with any of these strategies there will be the cost of two spreads, but a small price to pay in my view. The above strategy can be applied in many different ways, and of course it is also very easy to find shares which correlate inversely as well, so as one goes down the other goes up, but remember with these that you will need to place the bet in the same direction, otherwise you will have no correlation in place at all and simply be doubling your position!
An interesting variation of the above is to use the correlation of a share price with the principle exchange as the hedge. In this case we would look at the share price and its performance against the main index, in this case the FTSE 100. Once again we would compare our share price chart with that of the index to identify any firm relationship, and based on our analysis we could then place a hedge with the index as our safety mechanism. For example we may feel that our share price, based on past performance and our analysis is likely to outperform the index over the next few weeks, and we would therefore construct a balanced hedge strategy as outlined above. However in this case we are not comparing like with like, and as we will see in the next example in the commodities section, this adds a further complication to our calculations! Alternatively we might decide to use the sector index as our hedge, and as yet another alternative ( and recent new addition ) some spread betting companies are now offering the VIX as a spread bet, so here again we could use this strategy using this index as our hedging mechanism. The permutations and combinations are almost endless, and provided the hedging strategy is balanced correctly ( both for the movement in each instrument as well as the correct unit size) will protect your positions from major losses as a result. No one can guarantee a win every time, but using this spread trading strategy should give you a much better chance of success in the longer term and also reduce the emotions in your trading decisions.
Finally, you also have the option to ‘load’ the trade if you are feeling confident. Whilst we have talked about a balanced trading position in the hedge, you can of course bias the trade in one direction or another. Suppose you were feeling very confident in your analysis for BP and Shell, then you could decide as result to ‘weight’ the trade to the upside, by betting £8 per point on BP rather then the original £7. Naturally the more heavily biased then the greater your profit, but the greater your loss should it go wrong, so be careful. My advice is start with a simple balanced strategy and build up your experience slowly, and only begin to bias trades after having traded the same instruments and markets for some time.