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The bear necessities

Created:

14 January 2008

Updated:

28 January 2008

Written by:

Simon Thompson

Investment manager Peter Bernstein once said: 'Risk is the chance of loss, and for most of history it was viewed as that. There is a chance I'm going to lose. But in the capitalist system, risk is also an opportunity. Nothing ventured, nothing gained is as important to keep in mind as the fear that if I don't manage my affairs, I can get wiped out.' So given my growing concerns for the outlook for the financial markets (Bad Tidings, 11 January 2007), in the past week I have been trawling through dozens of structured investment products to come up with a short-long trading strategy that maximises returns from any market falls while protecting our capital if markets rise.

My preferred product is a Global Bear Market Accelerator Note, SN01, which was issued at £1000 per unit by investment bank Société Generale in February last year, expires on 31 January 2010 and trades on a one per cent bid-offer spread (£1157 to £1167). The note (see http://uk.warrants.com) has been structured so that it tracks the best performer of three global market indices: FTSE 100, S&P 500 and Dow Jones Eurostox 50. Currently, the Eurostox is the best performer, trading at 4233 (55 points above the reference level on issue of 4178), while the S&P is at 1401 (below the index reference level of 1438) and the FTSE 100 is bang in line at around 6203.

The objective of the product is simple: for every one per cent fall in the best performing index (for market falls between 2.5 per cent and 30 per cent from the reference levels), the Bear Market Accelerator will gain 8 per cent in value. However, if markets rise then we only lose one per cent of the Note's value for each one per cent rise in the best performing index. In other words, we are maximising our returns if, as expected, the market falls, while minimising any potential loss if the trade goes against us. As a result, the maximum payout on expiry is capped at £3200 - calculated by taking the initial launch price of £1000 and adding to it a 220 per cent maximum return (27.5 per cent multiplied by 8 times gearing). For this to happen, all three indices would need to lose 30 per cent of their value. I grant you that this may seem unlikely, but it does highlight how the gearing affect kicks in. What's more, the product can be used as a stand-alone hedging instrument to protect an investment portfolio, and can also be held in a Sipp or by UCITS funds, although if held directly any profits from the Bear Market Accelerator are subject to income tax.

It's worth noting, too, that your capital is not protected so, in the worst case scenario, if one or more of the three indices rise by 100 per cent or more at expiry (from the reference levels), the Note would have nil value at expiry. However, this is not an issue as my advised short-long trading strategy is very short-term, and will be long-forgotten by 2010.

In fact, by late spring, I am hoping for the 2007-08 'bear market' to have troughed out, so that we can close out the Note and bank a hefty profit. My index target prices - derived by taking 50 per cent retracement levels from the upmove from trough to peak of the previous bull markets - are 5000 on the FTSE 100, 1172 on the S&P 500 and 3210 on the Eurostox. These levels may seem extreme, but seven decades of history tells us that bear markets have a nasty habit of retracing a sizeable portion of the gains from previous bull markets. What's more, the bigger the previous upward move - all the above indices doubled in value from peak to trough - the deeper the subsequent retracement. In addition, a correction only officially becomes a bear market when an index falls by 20 per cent - as the FTSE 250 registered last week. My target prices above assume a 25 per cent fall from peak to trough in the FTSE 100, S&P 500 and Eurostox.

If I am right, and the above retracement target prices are hit, then the Bear Accelerator would be trading around £2250 by the time the indices trough out - double its current level. But clearly, I could be wrong in my pessimistic predictions. So to protect our capital, the risk averse strategy is to open a long FTSE 100 tracker (iShares: ISF) at the same time as we buy the Global Bear Market Accelerator. Therefore, if the markets rise in value the profit on the FTSE 100 tracker will offset the loss on the Bear Market Accelerator. But if the markets were to fall by more than 2.5 per cent from current levels, then we get eight times gearing to the downside less the one per cent loss on our FTSE 100 tracker for each one per cent fall in the index. It's worth noting that levels of market volatility also affect the Note's pricing. So, if volatility drops, this would adversely affect the Note's price.

To illustrate how this trade works, let's assume that all the indices fall by around 20 per cent from current levels - Eurozone and US indices are historically highly correlated in bear markets - which would result in a £233 loss on our £1167 investment in a FTSE 100 tracker. However, our £1167 investment in the Bear Accelerator will have doubled in value to around £2250, so we will be sitting on a net £850 profit on £2334 of capital tied up on the two trades. And with the FTSE 100 tracker hedge protecting our capital if markets rise, this short-long trading strategy is my low-risk call this week.

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