Spread Betting Strategies and How to Reduce Risk
Andrew Porter - 10 May 2008
This article is for information purposes only and does not form a recommendation to invest. The value of an investment may fall and losses may be significantly larger than the original stake. Spread-betting may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Spread-betting is extremely risky as the name implies, and most spread-betters lose money, but it is possible to reduce the risk involved or to use it in conjunction with other investments to reduce their risk. One general equity trading strategy which is often quoted is to cut your losses and run with your winners. When applied to spread-betting this can be interpreted as using a stop-loss close to your opening price and a limit set a significant distance away so your losses are small and the wins are big. In theory, if you get half of your predictions correct you will win more than you lose. If however you set the stop-loss too close to your opening price you can be correct about the general direction of the market and yet your stop-loss is triggered just by the volatility, resulting in many small losses and occasional big wins.
To be more analytical about the probability of either the stop-loss or limit being triggered would require knowledge of the volatility of the index or share you are trading. The volatility of the S&P 500 index is published and can even be traded or spread-bet. VIX is quoted as a positive percentage and represents the expected volatility of the S&P 500 index over the next 30 days. Similarly volatility indices are available for various other markets (although not the FTSE indices) Alternatively the variance of share-prices (or their standard deviation) may be easily calculated using a spread-sheet and historic prices. Volatility is important in the derivation of the Black-Scholes equation for option-pricing and is used to determine the probability of an option's strike-price being met which is a similar problem and could be applied to the relative placement of stop-loss and limit in this or any of the strategies below. The Black Scholes equation however also takes into account the risk-free interested rate which makes it more complex. Keeping the maths simple, the value of a non-dividend paying share or index (S) at some time in the future can be derived as follows:
dS = Sμdt + Sσdz
where:
dS is a small change in S in small time dt
μ = mean return
σ = standard deviation or volatility
dz = uncertainty
dS/S = μdt + σdz
Assume ST is normally distributed such that:
dS/S ~ N{ μdt , σ√(dt) }
and
dz = ε√(dt)
ε ~ N(0,1) i.e. standardised normal distribution with mean zero and unit variance
From that we can see that the volatility σ is very significant especially for short durations. Spread betting is typically used for short-term trading of index or share futures where the market direction has already been priced into the future price so the first term of the equation may be ignored. The spread for the bet will also vary according to the market volatility and the duration to expiry of the future so this may also be used as an approximate guage of σ. The stop-loss and limit should therefore be set after considering market volatility, the size of the spread and the expiry date of the future.
A simpler approach is to observe past data for the index or share in question and determine what you consider to be a small and probable daily move and what you consider to be a large and improbable move. The probability of a move of any given magnitude in a financial variable is usually assumed to follow a Gaussian distribution, a bell curve, with high probability of small changes and ever diminishing probabilities for large positive or negative moves in the variable. Deviations of more than 3 standard deviations would be considered extremely improbable (this may not be entirely accurate as very large moves caused by market-moving events are perhaps more common than this would predict and are difficult to predict. The so called "Fat Tail" distribution)
An Alternative Less Risky Strategy
An alternative and possibly lower risk trading strategy would be to set a stop loss at a point that is improbable, but affordable (i.e. in the rare occurrence of it being triggered you will not be wiped out) and set the limit at a point that is highly probable, such that the potential losses are large compared to the possible win, but the probability of the win is significantly larger than the probability of the loss. The probability of a small movement in either direction is far greater than a big move as described above.
Plimit = N.Pstop (Probability of stop-loss vs limit being triggered)
ΔSstop = -n.ΔSlimit
where N >> n
This results in many small wins and the occasional large loss. The sum of the losses should on average be less that the sum of the wins. It also means you could be wrong a lot of the time, or have no idea about the market direction and still make many small wins triggered by the volatility in the market. This may not sound like any more of a low-risk strategy, and involves a lot of work for little reward, but it is a low-risk way of getting into the trade. Monitoring the progress of the bet and then adjusting the parameters allows the winnings to be improved if the market moves in the way you hoped. You will often be in a small winning position and once you are ahead by more than the minimum spread for the index, you can move the stop-loss to a point that guarantees you a win (if you are using "guarnateed" stop-loss. With a standard stop-loss there is a chance the index will gap-through your stop-loss, but the guaranteed one costs more in terms of a larger spread) The limit may then be moved for the possibility of a larger win. This may be repeated if the index moves in your favour. If the market moves against you however, the bet will be closed with a small profit.
Hedging Strategy
The only truly low-risk use of spread-betting is to hedge against market falls in conjunction with a long-only portfolio. If you have a portfolio of shares, unit-trusts, investment trusts etc. which is highly correlated to an index e.g. the FTSE100, then every day the value of the portfolio will fluctuate but it would cost a lot in trading charges and stamp duty, to try to trade in and out. If a spread-bet is used to short the index when you perceive the index to be high, using what ever method you prefer. e.g. technical analysis (The easiest example is when the market is range-trading and the index hits a resistance level) The share portfolio will have made you a profit which if the market falls will be wiped out again. The spread-bet will however make a profit as the market falls which can be taken once you perceive the market to be relatively low (e.g. a range-trading market hits a support level). A stop-loss can be used a small distance above the opening price, so if the market continues to go up (i.e. breaks through the resistance level in the case of range-trading example) you will still gain from your existing portfolio. This is a good risk reduction method. It has disadvantages versus a put option or warrant, but the returns are tax-free (although losses cannot be offset against CGT) Another advantage of going short is that you make a profit as the market goes down, but you still get the dividends from the share portfolio.
Home
Contact
EDA Services
CV
Financial
Phtographic
Other
Home Contact EDA Services CV Financial Photographic Other