Diversification can cure a number of share portfolio ills. It can protect it from sector- and company-specific risk, and from the madness of the rest of the market. But what about when every sector and market is going down? In 2008 the FTSE 100 fell by 31.3 per cent, the Dow Jones by 34 per cent and the Shanghai Composite by 65 per cent. There was nowhere to hide: even other asset classes such as commodities, corporate bonds and property suffered setbacks.

With markets having had an uncharacteristically good run since the start of the year, many investors are inevitably wondering: will we see a correction soon?

A long-only portfolio means holding investments in the belief that they will increase in value. To go ‘long’ is simply to ‘buy’ an investment. Conversely, to ‘short’ is to ‘sell’, because the investor believes the holding will go down in value.

Most private shareholders have long-only portfolios. However, no matter how compelling the investment proposition of a share is, it could fall victim to macro factors and nosedive if the market corrects itself this year.

To help provide some protection, investors can employ some safety net strategies for their portfolios. Of course, when you have chosen your portfolio based on a belief it will provide positive returns, putting in protective measures that effectively question the value of your shares may seem odd. The best way to view the practice is to see it as akin to a life insurance policy; you buy it just in case, hoping you will never need it but feeling comforted by the fact it is there should the worst happen.

Nik Bienkowski, co-founder of Boost ETP, says the recent strong performance of equity markets has led to an increase in demand for ‘short’ and leverage instruments. ‘Leverage instruments have been used mainly to profit from short-term strong convictions in an environment where long-term passive returns have been poor,’ he says. But now that many investors are anticipating a change in fortunes for stock markets, short exchange traded products – the opposite of long-only investments – are being used to ‘not only profit from falling markets, but to hedge downside exposure on investors’ portfolios,’ he adds.

The words derivatives, hedging and contracts for difference tend to conjure up images of money hungry City traders chasing a fast buck, but they can be relatively straightforward and entirely legitimate.

The basis of all these types of trades is predicting the future and judging whether you think a share or index might go up or down. You then put a transaction in place that is triggered by an event of your choosing, which is usually a price point.

Mike McCudden, head of complex products at Interactive Investor, uses the example of buying shares at £1.90. You could purchase a contract for difference that shorts the share, that is to say makes a bet that the price of the share will go down. This effectively neutralises your position in the share. If the shares do go down, the investor recoups the losses of the share price through the gains made by the contract for difference. If it goes up, you are profit neutral because you have paid to have the option in place in case it went down.

Of course, this is a simple version of the trade, and neutralising your position is not the only option. You could short your share by half its value, which would allow you to still profit from the upside but would only give you half the downside protection. Alternatively, you could short your share by double its value if you were fairly certain of a short-term fall in price, to try and make some profit from the loss.

A similar instrument is a traded option, which confers the right, but not the obligation, to buy or sell a certain share at a specific price at an agreed future date. For the bullish investor, who believes a share price will rise and wishes to go long, a call will be purchased. For the bearish investor, who believes the price will fall and wants to short the share, a put will be bought. Either party can action the option. If neither does, it simply expires.

Spreadbetting is a similar concept but, says McCudden, tends to be used by

shorter-term investors. Many people prefer spreadbetting, as gains are exempt from capital gains tax under the gaming laws. The flip side is that if you are not paying tax and you lose your bet, you cannot claim the tax back, as you might on a more traditional financial transaction.

Spreadbetting is simply a gamble on a price or market movement. That makes it simpler in some ways but means it is a more passive way of betting on the market. In the same way that betting at a bookmaker has no bearing on the result, spreadbetting has no impact on the performance of the market or share you are betting on. This means it is not comparable to trading in a CFD, where a market movement is an inevitable part of the deal, because if you are selling, someone else needs to be buying.

Inverse trackers (see box left) are similar to CFDs. Bienkowski believes investors are turning to inverse trackers in preference to CFDs because they are transparent, easy-to-trade products that do not carry the credit risks of CFDs.

A further technique that can be used for an investor more weighted to a particular index or sector is to go long on a strong performer and short a weaker performer. For example, if your portfolio is skewed towards technology, you could look at the best- and worst-performing companies in that sector over, say, five years, and put a long CFD in place for Apple and go short on Samsung. The idea of this practice is that if the sector goes up, the best share should magnify that performance, so that if you are long in that share, your gains will be magnified. The same is true on the downside for the worst performer. This strategy does not have to be sector specific. It could be index-based – on the FTSE 100 or Dow Jones, for example – or geographically based.

All these techniques sound straightforward enough and appear to offer win-win situations. If your hunch proves right and your investments lose money, the protection you have put in place should cover your loss. If your investments do not lose money, well, that is even better. All you have lost is the cost of the trade to buy the insurance instrument.

However, it is important to remember that hedging is not risk free and can be complex. Derivatives such as CFDs are generally best used for short-term plays; costs mount when hedges are in place over the longer-term or are ongoing. A CFD might only cost £10 to put in place, but there will be an annual interest fee, either a certain amount of basis points or perhaps Libor plus 2 per cent, which could eat away at returns, and there is the risk of the strategy working against you.

The hedge may well provide protection, but if it is in place for a year, you will have to be outperforming the market by, say, a further 3 per cent for it to have provided any real benefit. Also, as Darius McDermott, managing director at Chelsea Financial Services, points out: ‘[It] isn’t an easy thing for the man on the street to do.’

He says a third option would be to choose a multi-asset or absolute return fund. ‘Newton Real Return has delivered consistently positive returns over a number of years, and a fund like Artemis Strategic Assets can dip in and out of other assets or even short stocks to give some downside protection,’ he says.

The uninitiated may ask why anyone would go to the effort of putting measures in place to protect a portfolio from downside risk, effectively questioning their own investment decisions. Surely it is easier to simply sell out of the position. However, investing is about the long game, and sometimes a short-term strategy is required while you are waiting for the long-term gain.

How to shield your portfolio with two different products

Using an inverse tracker

Bienkowski uses the example of an investor with £100,000 of equities who is expecting the FTSE 100 to fall by 10 per cent over a week.

In this instance, the investor could buy £33,333 of a three times leveraged short daily exchange traded product for that week, which would cost about £10.

The product is leveraged three times, so an ETP for this amount provides the £100,000 of portfolio protection the investor requires.

An investor can short the FTSE 100 by putting a hedge in place through market makers, such as IG Capital and CMC Markets, to the value of his or her portfolio.

If the FTSE 100 is at 6150 and you trade £1 per point, you effectively have a £6,000 position. So to protect your £100,000 portfolio, you will trade at £16.26 per point.

Interactive Investor adds: ‘For the FTSE 100, during working hours the spread is one point per CFD, and per CFD the margin requirement is 0.5 per cent of the cost. So one CFD on the FTSE 100 is 6150 multiplied by 0.005 (0.5 per cent), which equals £30.75 for one CFD. One hundred CFDs will have a spread of about £100, which is upfront cost, with a margin of around £3,075. The client will also incur a daily financing fee (long trades are debited the daily financing charge, short trades are credited). Once the client decides to close the trade, the margin will be added back to the cash balance.’