Trading derivatives can conjure up images of overnight wealth or wealth destruction. A reason is leverage, where speculating on an asset class can quickly magnify profits and losses for a small up-front outlay.
Contracts for difference, a popular financial instrument among speculators, are also an effective weapon in preserving wealth when acting as a hedge. Global derivatives broking house IG Markets says that an investor with a $100,000 equity portfolio during the global financial crisis could have protected its value by taking a short position in the ASX200. A fall in the value of an investor’s equity portfolio value could have been offset by gains in a short ASX 200 position. In this case, the aim was to preserve capital rather than build it.
An investor fearing a market correction can sell an equivalent number of CFDs over their stocks to protect underlying share value. If their stocks fall in value, their CFD positions will gain. Tim Howkins, global chief executive of IG Markets, says investors will effectively use this strategy because they don’t want to crystallise a profit and pay capital gains tax at a “particular point in time”. “They eliminate their exposure by shorting the equivalent stock as a CFD and it’s certainly a valid use,” he says. “But most of our clients are trading CFDs as a speculative activity.”
CFDs are leveraged instruments traded under an agreement to exchange the price difference in an underlying asset between opening the CFD and closing the position. CFDs mirror movements in the underlying asset class, whether it be Australian and international equities, indices, foreign exchange and commodities. Howkins says: “One of the beauties of CFDs is that clients can switch between asset classes. If they are bearish about the market, investors tend to move in to indices and short the index. They switch back to speculating on individual stocks when they’re more comfortable with the performance of equity markets.”
Sticking to investment objectives is crucial when trading leveraged instruments, Howkins says. He is big on strategy and discipline, saying buying and selling levels should be clearly established before trading CFDs. “Investors should know at what level they plan to take a profit or a loss,” he says. “I think the worst mistake an investor can ever make is to decide on a stop loss level then move it out a bit further as the market approaches it. So what starts off as a short term trade becomes a longer term trade in the hope of a market turnaround and that be a costly mistake. Once you’ve started a trade, stick with the strategy.”
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Howkins suggests inexperienced CFD traders write a log as to why they are doing a trade. “The reason is, it’s very easy to convince yourself (mentally) that you didn’t have a one-day profit objective, but a four-day profit objective if it doesn’t go well,” he says. “The paper doesn’t lie if the trading objective is written down. Most clients when they’re starting out will put a stop on every position, so they will always know the maximum amount they’re risking. And that’s one of the key things about trading is knowing when to get out.”
Balancing risk and reward is essential to an astute CFD trading strategy. Howkins says investors can do more profitable trades than losing ones, but still end up in the red under a flawed trading strategy. “If you’re trading style is always to cut your profits very quickly, so you only ever make 20 points of profit, but you’re prepared to take 50 points of loss, then you can have two thirds of your trades being profitable and yet you’re still going to lose money overall,” he says. “So you should be aiming for a sensible risk/reward ratio.”
Howkins says taking profits too early and running losses too long is a typically flawed strategy, particularly among inexperienced traders. “We put a lot of effort into educating individual clients; we do seminars and webinars and one of the key points we stress is managing risk,” he says. IG Markets offers educational courses and opportunities for new investors to gain experience and build confidence by trading online for small amounts of “real money”.
First Prudential Markets general manager Matthew Press says successful CFD investors and traders stick to a strategy of taking profits and cutting losses. “Successful traders and investors incorporate losses as the cost of doing business and would rather take several small ones rather than leave a position open in the hope of a recovery,” Press says. “You can always regain a CFD position on the same asset, but always be in control of the downside on every position.” Press says investors lose money when everyday distractions unwittingly cause them to leave positions open. “Investors must understand their trading environment and adjust it accordingly to meet their initial objective of doing the trade,” he says. “Don’t do a trade if picking up the kids from school is going to get in the way of the objective.”
Press says an investor who loses 50 per cent of original capital will have to make gains of 100 per cent to break even. ‘‘So if you’re objective is to make a profit of 20 per cent a year, then it’s a long way back,” he says.
Press says a combination of long and short CFD positions over equities is often an effective strategy. An investor bullish about the China story may take a long position on a resources stock. The same investor concerned about the impact of higher interest rates may take a short position on a retail stock.