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Concepts Of Trading A Leveraged Product

How Leverage Works
Written by Andy

What do we mean by a leveraged product? Leverage is the concept that with a relatively small outlay you can make much bigger profits or losses. A leveraged product is simply a means of ‘gearing’ your investment up, so that you’re controlling a larger position, but only paying now for part of that overall position. What this does mean is that any gain or loss is magnified, simply because the position you’re controlling and exposing yourself to is much larger than the amount of money tied up in that trade. Effectively, it means that we can make greater use of our money, controlling larger amounts of stock. We can trade it either Long or Short and make money in whichever direction the stock is moving; providing of course, we trade in the direction it’s going!

As a property buyer for instance you might have experienced this: say you buy a house for £150,000 and settle a £50,000 with the rest of the balance borrowed as a mortgage. Now suppose the property value rises to £200,000 and you decide to sell it. Ignoring costs you would have receive £200,000, pay off the £100,000 mortgage and keep £100,000. So you’ve doubled your initial deposit of £50,000 for a 33% rise in the value of the property.

The same principle applies to the stock market. You will find many examples of leveraged products available for trading. They are all ‘derivatives’, which is a word you may have heard, and wondered about. It’s quite simple really, examples of derivatives include Futures and Options, and many other things that are invented for the purpose. “Derivatives” are simply financial instruments that ‘derive’ their value from another, but don’t include direct ownership of the other. You don’t pay out enough money to own the other, but your payment still gives you control.

Remember that CFDs are traded on margin, meaning that the trading account must maintain a minimum percentage specified by the broker. Margins are calculated in real-time and displayed to the trader on the account overview screen or trading platform. If the margin drops below the minimum required level the funds should be replenished quickly or something termed a margin call may be made. A margin call is when the broker, sometimes without informing the client, automatically closes a trader’s open positions.

There are many books simply on leveraged products, but for the sake on what you need to know the above is enough, and you really should know what I am talking about anyway.

For a normal gearing of up to 10 times, an investment of only $10,000 can command a position of $100,000 in the stock market.

CFD Trading – Leverage and Trading Strategies

Magnus Grimond explains a pair of investment strategies that can reap huge profits – or losses.

They account for as much as 40 per cent of the daily turnover of the London Stock Exchange. Tens of thousands of people use them regularly and their number is growing at more than 20 per cent a year. But they are not shares as we know them.

Contracts for difference (CFDs) and spread-bets have become increasingly popular since the market turned in the spring of 2003. Both allow the buyer to go long on a share, index or currency, thus benefiting from its subsequent rise in price; or to go short and cash in if the price falls.

This is a double-edged sword, however. If the bet goes the wrong way, the losses, theoretically, can be limitless. Because only a fraction of the cost of the underlying investment is paid for when the bet is placed – it is bought on margin – the effect of movements in the underlying price are magnified. Profits or losses can snowball. The more mainstream private client stockbrokers still regard them a little sniffily, possibly with good reason. Anecdotal evidence suggests that most spread-betters lose money.

Angus McCrone, a director at a CFD broker, says that this is certainly not a market for the uninitiated. “People think it’s easy to make money, but actually it’s very difficult,” he says.

Clive Cooke, chief executive of City Index, one of the bigger brokers in the market, says that a typical private client holds a position for only about three to four weeks. “Generally speaking, it’s for people who would like to benefit from a short-term movement in, say, a share price or an index.”

CFD holders ultimately pay the difference between the buying and selling prices. This is deemed to involve an element of borrowing. Every day you hold a long position, you have to pay a financing charge, because you are effectively borrowing money to hold the position.

“The typical rate is 2.5 per cent above base rate, which is 7.25 per cent at the moment. So on a notional £10,000 contract, you would pay £725 interest a year, or a daily interest charge of £1.98.

“That’s if you are long. But if, say, you thought that the stock was going down and you shorted the stock, your account would be credited with interest at 2.5 per cent below base rate, or 2.25 per cent currently.”

More important is tax. While there is no stamp duty on spread-bets or CFD purchases, any gains made on the latter do attract capital gains tax (CGT) at up to 40 per cent. This makes spread-bets, which are free of CGT, the weapon of choice for most punters.

As well as the tax advantages, spread-bets are simpler in many ways. Commission, financing and the effect of dividends are rolled up in the “spread”, the difference between the buy and sell prices quoted by the broker at any particular moment.

You decide what you want to bet – let’s say £10 for every penny rise (called a point) in a share. If the price rises, your gain is the difference between the two prices, multiplied by £10. If you believe that the price will fall, you do the same thing in reverse by “selling” the shares.

Mr McCrone says that a spread-bet or CFD could help to provide insurance for someone who wanted to protect holdings from a fall in the market without selling the share.

But Mr Cooke gives warning that “people should have in their mind set amounts that they are prepared to lose on spread-betting, and not use money earmarked for an Isa”.

Ultimately, most people would be better off sticking with an Isa. Spread-betting and CFDs are strictly for those with the time and talent to apply to them.

CASE STUDY: Quick learner aims to stay on top of the charts

Martyn Grant, left, reckons that he has had only one down year in the five or six since he started spread-betting and trading contracts for difference.

“I lost money in my first year and learnt a good, hard lesson,” says the 43-year-old property entrepreneur from Wiltshire. “I held on too long with no stop-losses.

“I didn’t know what I was doing, which is true of most people – they merely scour the bulletin boards for recommendations and then buy without looking at anything else.”

Bulletin boards, such as those run by ADVFN, the financial website, can be useful, but Mr Grant tends to ignore rumours and tips from other people. “I have sat in so many brokers’ offices in London and have heard so many stories,” he says. “As soon as they hear a story, brokers pass it on.

“Unless your dad owns the company, or you know someone who works in it, there is always someone else who knows more than you – and that shows in the charts.”

Mr Grant relies on graphs of a company’s share price for direction on how to bet. “The graphs pick up that there is something going on,” he says. “For example, if the chart is bottoming out and there is a lot of trading volume.”

He calculates that his annual profits have ranged from 30 per cent in 2000, when he went short after the technology bubble burst, to about 900 per cent last year.

“Most of my bets are long. I am still a bull,” he says. “I think this is just a correction in a long bull market, but in a couple of days my view could change and I could become the biggest bear ever.”

Mr Grant prefers to use smaller brokers, such as Luke Securities, for his bets. And though he believes that he could devote less time to his activities, he actually spends much of his working day looking at market screens.

As for day trading, he says: “There’s no money in day trading: it’s a mug’s game.”

CFD Leverage Examples

This means if you wish to enter a position of 1000 BHP Shares at $35 each, usually you would need to front $35,000. Using contracts for difference, trading on a 5% margin, you would only need an initial deposit of $1,750.

An example is the easiest way to show the power of leverage.

If you had $1,750 to invest, and wished to purchase BHP at $35 and sell at $37, a standard trade would look as follows:

BUY: 50 x $35 = $1,750.

SELL: 50 x $37 = $1,850.

PROFIT = $100 or 5.7%.

Using the power of leverage the above example reads as follows:

BUY: 1000 x $35 = $1,750 (5% deposit) + $33,250 (95% borrowed funds).

SELL: 1000 x $37 = $37,000.

PROFIT = $2000 or 114%.

As you can see the profit received after using leverage was far greater than without. It is important to note, that losses are also magnified when using leverage.

Beware very Low Margin Requirements

One identifying characteristic of CFDs is that they have relatively low margin requirements as compared to other types of leveraged investment vehicles. CFDs can trade using as little as 10% of the value of the underlying asset. However, traders should be concerned with the minimum margin requirements and ensure to only borrow as little as possible. The lender, i.e. the contracts for difference provider, is generally focused on the maximum margin requirements, which does not mean that the trader should be. Margin is usually expressed as a percentage and just because your broker offers 300% margin does not mean that you should use the entire borrowing capacity provided. Using leverage can be advantageous in some circumstances, but traders should be able to cover the full value of any trades they make.

Leveraging can work just as well for you as it can against you. Leverage is normally expressed as a ratio. It is not what your CFD broker will allow you to use, but rather, it is what you decide to use. The prudent application of leverage is imperative since regardless of how small the initial margin is, traders are always responsible for the full market of the trades that are executed. A lower deposit margin paid upfront just means that smaller price movements have larger impacts on trade outcomes.

The main reason for people blowing out their accounts is over-leveraging, i.e. making use of the lowest margin when it is not needed. It is important to keep regular share sizes in all CFD trades and never to over-expose yourself to a trade that you may believe is the perfect set-up. Even the most perfect trade set-ups can go wrong in a flash.

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