*** The plusses of spread trading...

*** Protect your portfolio from losses...

*** Benefit from rising and falling shares at the same time... and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

Whenever we discuss trading, we're greedy for the potentially massive profits that can come with it. But, trading can also play a vital role in protecting your investment portfolio. And, if you have an ample selection of shares, discovering a tool, which can do just that is vital to your investment success and to help you sleep soundly at night!

So, today, we're going to explore using spread trading to protect your portfolio. Plus, we'll also check out pairs trading, which is a fabulous way to trade and reduce your risks. With the assistance of a great article I recently read in MoneyWeek, here's what you need to do to protect and prosper in the current market.

One of the biggest benefits of spread trading is its flexibility - you can place up and down trades on stocks, sectors and indices with ease, and trades can be opened and closed at whim. The lack of liquidity that plagues markets, such as corporate bonds, doesn't trouble spread traders. And that combination of features throws up lots of ways to use spread trades.

Hedging

Many investors go to considerable time and trouble to research equity investments they intend to keep for the long-term. But stock markets are prone to short-term volatility and, as many shareholders found out in 2008, this can send perfectly good shares down with the dross. Dumping your holdings in a share or fund in anticipation of a drop is one solution. But that means trying to time the scale and subsequent repurchase (assuming you fundamentally like the share or fund). It also risks a tax bill on the sale - capital gain tax may become payable - not to mention dealing costs, such as brokers' fees and Market Securities Tax (MST) on the purchase.

An alternative if you hold, say, a broad range of JSE shares, is to hold onto them and sell a JSE ALSI (All Share Index) spread trade. You can keep the spread trade open for several months if need be, or until you think the stock market's finished falling. Say you hold R50,000 of JSE shares and the index is at 20,000 points. You could sell a spread trade on the index at R5 per point. The idea is any fall in the index will be compensated by a profit on the short spread trade position.

For example, should the index fall 10% to 18,000 points, your portfolio will drop to around R40,000. However, you can expect the spread trade index price to have moved down 10% too, to around 18,000 points. Having sold at 20,000 points and closed out by buying back the trade at 18,000 points, you make a 2,000 point profit. At R5 per point that's R10,000! Yes, you'll suffer a small bid to offer spread on the trade, which reduces this by a few rands, but the overall result is you have shares worth R40,000 and a cash profit of R10,000, so R50,000 in total. That's hedging.

Pair trades

Taking a view on a single stock can be difficult - not everyone is comfortable deciding whether MTN is fundamentally under or overpriced, for example. However, with a pairs trade, you don't need to worry about that or even whether an entire sector will rise or fall. Instead, you take a view on whether one stock is cheap or expensive in comparison to another.

So you could do some past research into the price relationship between shares that are heavily exposed to retail spending, such as Pick 'n Pay and Shoprite. Once the two prices move out of line, you buy one stock and sell the other. You may, for example, not know which way the retail sector is heading, but be fairly sure Pick 'n Pay is undervalued relative to Shoprite. So you buy Pick 'n Pay at say R10 per point when the price is at 3,000c and sell Shoprite at R5 per point when the price is 6,000c. The total notional value of each trade is the same (R30,000), but if Pick 'n Pay performs better than Shoprite, you make a profit. If you close out your positions when Pick 'n Pay's share price is, say, 4,000c, and Shoprite's is 2,500c, you would make R10,000 on your Pick 'n Pay trade - (4,000-3,000) x R10 - and lose R5,000 on Shoprite (7,000-6,000) x R5. That's a total profit of R5,000. This ignores spreads on both legs of the trade, but these should be fairly small.

And not content with just SA - you can dabble on overseas markets!

Another bonus for South Africans who opt to spread trade is the exposure it gives you to overseas markets. With our exchange restrictions to do this normally means having to apply to the Reserve Bank to take some of your hard earned rands overseas. But with spread trading, it's as easy as trading a share on the JSE! You get exposure to all the major developed indexes, such as the FTSE and Dax, and you can trade currencies like the US dollar and the euro.

You can also use pairs trades if you think one index is overvalued compared with another. Let's look at the FTSE 100 and Wall Street, for example, when on 7 October 2008 they were trading at around 4,750 and 9,500 respectively. You could have sold R10 per point on Wall Street at 9,500 and bought R20 per point of the FTSE 100 at 4,750, once again giving you the same rand value exposure (R9,500) on both sides of the trade. When at their most recent lows - the beginning of March this year - the FTSE 100 was trading around 3,500 and Wall Street was around 6,500. Closing out both trades at that point, your profit on the Wall Street trade would have been R30,000, whilst the loss on your FTSE trade would have been R25,000, making an overall profit of R5,000 (again, before spreads).

Well that's all for this week's delve into trading. Tune in next Friday for your next instalment of how to profit in the world of trading. Have a fantastic weekend!

Happy trading!

Julie Brownlee
for The Investment Academy