Careful… most normal investors who use leverage lose
Let’s Have a Quick Chat about Leveraged TradingOne of main problems with spread betting, CFD and forex is leverage. Helping yourself is actually very simple, it boils down to a reigning in of risk appetite.
Spread betting and CFD trading are leveraged and for many traders it is not actually their win:loss ratio that hurts them, but the level of leverage they take on – and usually inadvertently.
Let me give you an example – say you have £5,000 in an account and like the look of Lonmin which is trading at £10 a share.
Now, with margin requirements of as little as 3% at various firms you might be tempted to buy say £10 per point which will cost you an initial margin of £300.
You promptly do this and sit back, looking forward to making a few hundred pounds on your £300 initial investment…
You are in fact controlling £10,000 of stock and the volatility of a stock like Lonmin is such that it will easily move 2-5% on a given a day.
Get your entry wrong and see a 20p move against you (excluding the spread) and you are immediately ‘on margin’ – a place you never want to be, trust me.
Instead of leveraging yourself to the hilt, take a more measured and risk controlled approach and always calculate what the underlying ‘gross’ exposure is (this is also called the ‘notional value’). In this instance my notional value was £10,000.
This gives you a true and clearer reflection of the risk you are taking.
Remember You Are Borrowing From the Spread Betting CompanyWhen you spread bet you are in effect borrowing money from the spread betting company.
As above, with a deposit of £300 you are borrowing £10,000 and using that to trade on your chosen market.
Note this is why the overnight financing fees often seem high. You are paying interest on the £10,000 you borrowed.
My Trading Screen is Never a Sea of Green
Personal Leverage GuidelinesMy own personal rule of thumb when it comes to stocks is as follows: Adhere to the above and you might, just might, extend the life of your account and address the high probability of getting a number of trades wrong in a row without pressuring yourself with the enemy of all traders – the dreaded margin call!
What is Leverage (aka ‘Trading on Margin’)When you spread bet, you are not physically dealing in the underlying asset that you are speculating on, you are just speculating on whether the price of the market will go up or down.
E.g. if you spread bet on Brent crude oil then you are not buying or selling oil, you are simply taking a position on whether the price of Brent crude oil will go up or down.
Leverage ExampleSpread betting is very much a double edged sword.
You only put down a small deposit to cover your total trade size, sometimes as little as 1% of the amount you are speculating on.
E.g. let’s say you think the Amazon share price will continue its rise in the near future, if so you could buy the Amazon spread betting market. Let’s also assume you only want to deposit £200 to cover your trade.
If your spread betting firm gives you leverage of 100:1 then with your £200 deposit you can have exposure to £20,000 worth of Amazon shares.
You are now exposed to the full market fluctuation of that £20,000.
If the shares were to increase in value by 1%, you would make a profit of £200 and would have doubled your initial deposit of £200.
But now comes the nasty part of the double-edged sword… if the US stock fell 1%, you would lose £200, which is the full amount that you initially invested, equating to a loss of 100%.
If the share price fell by 2% you’d lose £400 etc.
And don’t forget that individual shares can easily see a 5% fluctuation in a given trading session.
For worked spread betting examples see:
What is Margin?The deposit required to cover each of the open spread bets on your account is known as the ‘margin requirement’.
When you open a trade, make sure account has enough money in it cover the margin requirement (if you don’t you probably won’t be allowed to open the trade).
Warning: Margin CallsMake sure you maintain the margin requirement (deposit level) when you have negative trades on your account. This isn’t always that easy when the markets are moving both quickly and against you.
When the markets move against your trades you may get a “Margin Call”, i.e. a message from your spreads firm that you need to deposit more funds to cover your trades.
If your margin (deposit level) does not remain above the margin close-out level at all times, then the spread betting firms may close out some or all of your open positions.
(this is because you simply don’t have the deposit on your account to cover any further losses).
The spreads firms will say “margin is there to help you trade responsibly, ensuring that you never overstretch your financial means”.
This is partially true but I think the firms can make the process easier to understand. They could also do more to txt and email you updates on trades going against you.
Remember: Spread betting, CFDs and forex trading carry a high level of risk. You can lose more than your initial investment. These products are not suitable for all investors. Only speculate with money that you can afford to lose. Make sure you fully understand the risks involved and seek independent financial advice where necessary.