Can I hedge potential returns on a protected plan?
|Investment | Specialist
Asked by webwiz, submitted
19 May 2013.
I have a holding in NDFA Twin Option Kick out Plan Dec 07 (now Meteor) which will pay out 104% after 5.3.2014 if the FTSE 100 is over 5853.5 and the Nikkei 225 is over 12972.1. Both indexes are looking good at the moment but there are still 10 months to go and I am feeling nervous. Would it be possible to hedge my investment by buying an option at those index levels for next March?
Answered by Justin on 28 June 2013
This plan promises to pay 18% a year with the option to end early on each plan anniversary if both indices are higher than their starting level - something that hasn't happened to date due to the Nikkei being lower. However, the Nikkei has surged over much of this, before falling back a bit of late, so you're in with a chance of a payout at maturity - equal to 18% a year x 6 years = 108% - provided both indices are above their starting level on 8 May 2014.
If either index is lower on 8 May 2014, you'll get back your initial investment in full at maturity provided neither index has fallen by more than 50% of the start level at any time during the 6 year term. Otherwise, you'll lose capital on a 1:1 basis based on the index which has fallen the most.
Could you hedge your bets? Difficult, as even if you buy an option it probably won't compensate for the 108% return you'll lose if either index is lower than its starting level. For example, let's assume you put £10,000 into this plan originally. You could buy an option giving you the right to sell the Nikkei at 12972 next May. if the Nikkei finishes at 12970 then you won't receive the 108% return on your £10,000, so you've lost out on £10,800 of growth, and the option will be almost worthless meaning you'd have lost money on that too. If the Nikkei plummets then your option would have more value, but still maybe not enough to cover your lost 108% return.
You could spread bet on the Nikkei (or FTSE), aiming to make a big profit if the index falls in value. But this is very high risk, if the index rises you could lose a significant amount of money, potentially wiping out the returns you would then probably get from the Meteor plan.
If any readers are smarter than me in this area, please post ideas below - I can't see a sensible way to hedge the gain that might be lost in the above example.
Meanwhile, fingers crossed the indices don't end up below the start level so you get your pay out.