Australian (ASX) Stock Market Forum

The Hedge

Jun 16, 2017
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Lets Start with this: copied from the interweb.
What Is Hedging?
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.

Although some of us may fantasize about a world where profit potentials are limitless and risk-free, hedging can't help us escape the hard reality of the risk-return tradeoff. A reduction in risk will always mean a reduction in potential profits. So, hedging, for the most part, is a technique not by which you will make money but by which you can reduce potential loss. If the investment you are hedging against makes money, you will have typically reduced the profit you could have made, and if the investment loses money, your hedge, if successful, will reduce that loss.
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Jun 16, 2017
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From the other thread:

  1. You forgot to mention that the CGT on the hedge will only be paid if your investments net a profit for the financial year.(includes the hedge profits)

    The whole point of a hedge is that you don't have to sell the underlying.

    So either the hedge is unsuccessful and you pay the hedging cost plus losing the equivalent capital gain of the underlying, or the hedge is successful and you pay the hedging cost plus CGT (discounted or not) which erodes the total hedge profit vs underlying losses.

    Darc Knight likes this.
Jun 16, 2017
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The point of a hedge is to reduce loss(including loss in a profitable position). Allowing you to keep the position open if desired ,and allowing management of the open position(s).
For me the hedge gives you choices.

Lets take a hypothetical eg .much simplified
First the no hedge
You enter the ASX equity market at the very top with $100000 invested.
The market goes bearish and within a week your portfolio is at $95000
You can sell now or hold. Whats your plan?
You decide to hold . a few months pass by and now the portfolio has dropped by 20% to $80000
Now what do you do . What is your plan?
Sell or hold , these are your choices.

Now the hedged portfolio
Same entry time and capital $100,000
At the start time you put a short on the ASX 200 index at say 200 points below the current index value.
prefferably under a significant support level.
within 1week your portfolio is down 5% to $95000
the index short gets triggered 1 contract on the index is now worth $25 per point .
over the next 3 months the index drops 500 points.
you have made $12500 (equity not realised profit)excluding costs.on the short You will need to pay full tax on this profit (when realised)at your marginal tax rate (derivitaves dont qualify for the 12 month CGT rule I believe), if your investments (all of them property, art etc) net you a realised profit for the financial year and you have an income above the taxable minimum. Let say you are on 30% tax rate.
your portfolio is now valued at $80000.

You have -$20000 equity in the portfolio and $12500 in the short .so you are - $7500 overall instead of the -$20000 with the no hedge position.
Now you have some decisions to make.
1. Keep both the short and equity positions open for the 12months if You think you can realise a profit then ,closing the short as the equities go to BE or better still on the way back up and realise a profit with the short.

2. Close the equities for loss of $20000 and keep the short open(perhaps realising a profit eventually)
3. Close both the short and equities and take your $7500 loss paying no tax on the hedge if your investments lost for the year . If you made investment $$ during the year the tax paid on hedge will be $3750. Hey you still made investment $$ after the terrible start in your equities well done.
This is where I would be happy to pay the cost(tax ) of being in profit for the year with other investments taken into consideration (ie selling property , gold ,etc)
4. close any one or more equities ank keep the short on
5. Close the Short and re-invest the $12500 or do whatever you like with it.Put it into a leveraged cfd account and trade the coming bull market!!!??( dont forget to put aside about 30% for the tax man if you dont re-invest)
And leave the equities to fester for a while.

Im sure there are other scenarios you can think of. you get the idea
As you can see ,for me its about choice. Not Tax, Tax only gets paid if you make $$ over $18000
The above example is an indirect hedge and could well go against you.
A direct hedge would be in the equities themselves with short positions. Hard to do in Australia, so we use CFDs.
As you can see you have many more options when hedged .
Only 2 options when not hedged hold or sell.
With the hedged option we can still keep the crappy equities AND walk away with some cash in the hand.
While I agree that effective tax management should be considered , i dont believe it should override firstly making a profit, and if that cant happen , reducing your losses. These should come before reducing taxes in that order.
The eg above does not include holding costs for the short , which should be tax deductable ?
So Investo Boy .........................
Jun 16, 2017
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if your investments (all of them property, art etc) net you a realised profit for the financial year and you have an income above the taxable minimum.
This part is incorrect You will pay tax on the (realised short profit) if your income is over the $18000 threshold.
reducing the realised profit . still a realised profit with negative equity is better than just negative equity. ie reduced loss
Jun 16, 2017
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Another example. This time a direct hedge using a CFD.

You Buy 1000 shares (not CFDs) in company XYZ 9 months ago at $20.
They are now at $30:xyxthumbs +$10000 equity.The market is looking shakey and you would like to lock in your profit.
However you would also like to minimise CGT paid if you can.
What can you do ?
You could sell a portion and keep another portion locking in some profit but market risk on the rest
You can sell now , and realise the $10000 profit but pay your marginal tax rate in the full amount( eg 30% of $10000 = $3000 so you net after tax $7000
You can just hold and wait and hope the market or XYZ does not take a dump taking your profits with it.
It may also increase in value .
You can take a perfect direct hedge, locking in your profit while waiting the 3 months to be eligible for CGT discount , however there is opportunity cost and interest on the short to be paid.

Let do the Math.

Scenario A covered above , just close out now and run! net you $7000 after tax

Scenario B . No Hedge and hold for the next 3 months .

B 1. Price goes to $35 at the 12 month period and you then close :xyxthumbs $15000 gross x 50% CGT discount = $7500 profit x 30% TAX rate = $1500 tax paid Nets $13500 .Best case scenario.

B2. Price stays at $30 at 12 month period you then close for $10000 realised profit .
CGT discount 50% so pay tax on $5000 @ 30 % = $1500 $10000-$1500 $8500 Net after tax

3. Price goes back to $25 :mad: at 12 months for $5000 profit x 50% discount = $2500 gross x 30% =$750 tax $5000- $750 = $4250 net profit.

4. ASX announces investigation into XYZ for ball tampering:eek: stock gaps down to $15:(
$5000 loss you realise the loss and have a long hard think. Sure you can offset the loss against other capital gains this year or in the future.some consolation . howver I am keeping this as simple as possible for now this is the only stock we own,.

Scenario C. Full hedge at current price $30 using short sold cfd. For now we assume commissions are the same as for ordinary share purchase,negating those costs for simplicty sake.. However there is financing cost of 5%pa.
May be less for short sell.
non dividend stock( for simplicity , you pay div with short sold stocks))
Lets calculate the cost of cfd finance for the 3 month period. 5% of $30000 = $1500 / 365 = $4.11 per night x 90 days =$370 this is the cost of the hedge. Will this be worth the money to save on the tax using the CGT discount you can now receive?

Scenario C 1.
Price goes to $35 while fully hedged at 12 monthso_O
realised gain onXYZ $15000:xyxthumbs realizes loss on hedge -$5000 -$370 finance cost are not deductable I believe.
so we get CGT discount on $15000 profit = $7500 then deduct the capital loss on the hedge -$5000
= $2500 x 30% tax rate = $750 tax paid. Gross profit is $15000 - $5000 =$10000 - $750 tax
= $9250 - $370 finance costs $8880 net profit afer tax and costs. We can see that we are $4020 less net profit than with the same scenario not hedged. Opportunity cost.
But we are $330 better off than if the on hedged XYZ shares stayed at the same $30 price at 12 months. With 0 Risk

Scenario C 2. Hedged price stays at $30 at 12 months
$10000 profit x 50% CGT $5000 x 30% =$1500 tax $10000 -$1500= $8500 - $370 costs $8130 net Profit. We can see that we are $370 less profitable than the non hedged $30 close scenario.
The cost of insurance if you like.

Scenario C 3. Price declines to $25 while hedged

Profit on XYZ share s $5000 / 50% CGT discount = $2500 + $5000 realised from hedge .(no CGT discount) = $7500 x 30% tax = $2250 net Profit is $10000 - $2250 $7750 - $370 costs =
$7380 . We can see the same scenario un hedged nets $4250 so we are $ 3130 better off hedged.

Now the nasty ball tampering event:eek:
Scenario C 4. Stock Gaps down to $15 Realised loss on XYZ = - $5000
Realised profit on Short CFD $ 15000 No CGT discount on CFD $15000 -$ 5000 loss on XYZ shares.
= $10000. x 30% tax = $7000 -$370 finance $6630 net profit compared to same scenario with no hedge at a realised loss of $5000 we are $11130 better off. Still better off than the non hedged $25

Shares bought at $20 x 1000 hedged at $30

Summary > Close at 9 Months Net profit $7000
Close at 12 Months no Hedge $35 Net Profit $ 13500
Close at 12 Months Hedged $35 Net Profit $ 8880
Close at 12 Months no Hedge $30 Net Profit $ $8500
Close at 12 months hedged $ 30 Net Profit $ 8130
Close at 12 months no hedge $25 Net Profit $ 4250
Close at 12 months Hedged $25 Net Profit $7380
Closed at 12 months no Hedge $15 Net loss -$5000
Closed at 12 Months Hedged $15 Net Profit $6630

clear as Mud right ? We can now make an assessment on what to do .
These numbers assume the ATO allows you to claim the CGT discount (if you are not a trading business!) while hedged , I believe they do . Also worth investigating if CFDs and futures can claim CGT discount , from my limited research it looks like you can ! fairly grey area however.
if there is someone here who can check the numbers I would appreciate that .
I like Basic Maths! home from work today sick so nothin much else to do anyway .