How to use Leverage Safely and Successfully - Spreadbetting and CFDs Part 1 of 5

Introduction
I suspect this will be a Blog that gets read a fair bit - hopefully it will unravel the mysteries of using Leverage like Spreadbetting but will also show Readers how I exploit the Advantages of Leverage and minimise the Dangers - which are considerable.

I had been loathe to do too much on Leverage on my website previously as I didn’t feel I should encourage 'Newbies' too much as they could get in a right flippin' mess. In the event, I reluctantly ended up shoving Robbie Burn's Spreadbet book in Wheelie's Bookshop as I thought it would be better if Readers had at least a little understanding because I get quite a few people asking me about it. Quite scary really because I think the conventional approach to Spreadbetting is extremely dangerous and the ‘teaching’ from the product providers encourages what I consider to be methods that are guaranteed to lose you money.

Anyway, I now take the view that it is not my Role to wipe Reader’s butts - that is why you purchase Andrex (ok, Tesco Value, you skinflint - but I appreciate you are trying to minimise costs so you can invest more). In addition, using Spreadbets to gain Leverage is a Key Element of my M3 Manifesto - so it makes sense for me to explain how I do it Safely and Successfully (for the majority of the time anyway !!)

Probably the most important realisation I want you to take away from this Blog is the following:

Spreadbetting and CFD providers will teach you the WRONG and DANGEROUS way to use Leverage.

I will explain this fully in the coming text. As you probably are beginning to expect, The WheelieDealer has very unusual ways of doing things and I suspect you have never read anything like this before.

Advantages of Leverage

• Use of ‘Free’ money to make you more money - hurrah, we like that !! Clap, clap, clap……..
  
• Use of ‘Other People’s Money’ - if you have read ‘Rich Dad, Poor Dad’, you will get the concept of OPM. You do it with a Mortgage, so why not do it with Stocks?
  
• Can give a useful boost to your Annual Returns. If you can make 10% on a normal Share Portfolio, then a bit of controlled Leverage could add maybe another 3% or so. Compounded over time this makes a massive difference to your wealth. From the ‘Law of 72’ (see my Blog from October 2014), compounded at 10% it will take 7 years to double your Capital - at 13% compounded it only takes 5.5 years.
  
• Enables you to keep a Cash Pile parked to one side in a Bank Account which can be used for other Emergencies if needed.
  

Disadvantages of Leverage
It is incredibly Dangerous. If you want to go Bankrupt, then using Leverage is the easy way to do it. It will not be fun either. Quick and Miserable - sure fire route to the Poor House.

I cannot stress this enough. It is F***** DANGEROUS (a nod to @A1Mhigh there who I know loves US style blogsters). You will get your arse kicked hard. Best to stay away really.

God (or David Icke) knows why I do it.

The other Danger is that you might actually be good at it. This will result in you making money and getting more wealthy. People will hate you, your Wife or Husband will take advantage, your Kids will demand more crap, you will have to trade in the car you love for something Flashy and German, you will have to get Gold Metal Gates. 

Yuk, who wants all that silliness?

What Instruments can be used to get Leverage?
I mainly use Spreadbets but I do have a CFD account with CityIndex. Options just confuse me although I think they have a good aspect in that you can only lose a defined amount of money. Very specialist area and to be honest I don’t see the point of them - you can get the same attributes via Spreadbets (you could use Guaranteed Stoplosses to limit your possible loss) and you get the benefits of no Tax. In addition, using my method, dealing in Spreadbets is hardly any different to dealing in Normal Shares - you don’t need to understand the Black-Scholes Options Pricing Model to figure out value - you do it already on your Normal Shares.

The following techniques can be used to exploit the Benefits of Leverage:

• Spreadbetting
  
• CFDs
  
• Options
  
• Warrants (similar to Options I think)
  
• Margin Account - this is a Share Dealing Account where you can borrow money at pre-defined terms. Very common in the US I think. Not sure how many people use them over here in the UK - pretty rare I suspect.
  
• ETFs - some Exchange Traded Funds have a Leverage element in them - for example, XUK2 enables you to get twice the movement of the FTSE100 on the Short side. Very dangerous instruments though - suitable for only short periods like a few days due to the way that they are mathematically calculated on a Daily Rollover.
  

Spreadbetting
Spreadbets enable you to make or lose money on a wide variety of Instruments - pretty much anything you can name - Indexes, Individual Stocks, Commodities, Bonds, House Prices, etc. and many non-financial things like General Election outcomes, football matches, horses, etc.

Seeing as we are really concerned with Shares, the explanations here really apply to equities. Whereas if you buy a chunk of Normal Shares, you own a stake in a Company, if you use a Spreadbet to get the same Financial Exposure, you do not get any stake in the underlying Company - you are just ‘betting’ on a price movement.

As I mentioned earlier, you get the wonderful advantage (and horrendous risk !!) of Leverage. To open a Spreadbet Position, you need to put down a Deposit (sometimes called Margin, or Collateral, or Security or something like this) but the rest of the Exposure is lent to you by the Spreadbet provider.

I think an example is needed. Imagine you want to buy a Stock which is priced at 250p to Buy in the normal market. If you buy 1000 shares, this will cost you £2500 (let’s ignore Stamp Duty and Commission fees etc. to keep things simple and let‘s also ignore Sell, Mid, Buy prices).

Alternatively, you could buy a Spreadbet in the Company to get the same Exposure where you would bet £10 A POINT, which would mean £10 x 250p = £2500.

However, with the Spreadbet let’s imagine the Deposit (Margin) is 10% - this means you only need to put down 10% of the Exposure - which is £250.

Now, let’s imagine that your buy has turned out nicely and the Share Price goes up by 10%. For your normal Shares, you will gain £250 on the £2500 that you spent on the shares - a 10% Return.

With the Spreadbet, you would get £250 profit on the £250 you put down as Deposit - a return of 100%. So the advantage is obvious, but of course it works the other way as well, i.e. If the price drops, you lose big.

The clever term is that use of Leverage is more ‘Capital Efficient’ - i.e. You are making the most of your limited Capital.

With Spreadbets you can also go Short, where you make money if the price falls. This is also done on ‘margin’ so is Leveraged.

There are some aspects of Charges to understand as follows:

• The Spreadbetting Provider makes money from charging a wider ‘Spread’ between Buy and Sell prices than in the underlying market. For instance, a stock could be 101p to Buy in the real world and 99p to Sell. But for a similar Spreadbet, it could be 102p to Buy and 98p to Sell - so the Spread is wider which costs you money.
  
• However, despite the above, there is no Commission Fee or Dealing Fee like there is on Normal Shares. Also, there is no Stamp Duty. So, in practice, the costs work out very similar.
  
• On Long Spreadbet Positions (where you have bought a Spreadbet), you have to pay Interest on the borrowed part of your Exposure. For a ‘Quarterly Bet’ which has a defined 3 month lifespan, the Interest Fee is included in the Spread. For a ‘Daily Funded Bet’ or similar, you are charged LIBOR plus 2 or 3% (I think that is the igIndex charging structure, I suspect it varies across the Providers and is something you need to be sure of) and your Cash Balance gets deducted this amount at the end of each day. Because of these Interest Charges, I suspect that my Approach would struggle if Interest Rates are very high - but I have been mucking about with Spreadbets in this way for about 8 years and never had this problem. In reality, if Interest Rates went this high, then Equities would be bad investments anyway - good time to Short !!
  
• For Short Positions (where you Sell an Instrument) you have to pay a ‘Lending Fee’ with igIndex - this is a new thing and a pain really. I do not know if other Spreadbet providers charge the same. I must say that since they introduced it I am far less interested in Shorting.
  
• If you are Long a certain Share, on the Ex Div date you will receive the Dividend Payment - i.e. you get it much earlier than with a Normal Share. This applies to Daily Funded Bets (DFBs or Daily Rolling Bets), for Quarterly Spreadbets, the Dividend is already allowed for in the Spread. Just for info, Quarterly Bets can be done at different periods - I think it’s like ‘expire end March’, ‘expire end June’, ‘expire end Sept’, ‘expire end Dec’ - to be honest I never use them so not really that bothered !!
  
• If you are Short a Share or Index etc., you will PAY the Dividend - it is subtracted from your Cash Balance for DFBs and for Quarterly Bets it is in the Spread when you open the bet.
  
• As the value of your Bet rises or falls, the Margin is automatically adjusted so that it always stays at a set level of the Exposure. For instance, in the above Example, if the Price went up 20% and the Exposure grew to £3000 the corresponding Margin would still be 10%, which is £300 rather than the £250 you started off with. For information, what would happen here is that your ‘Margin’ total on your Account (let’s assume you just have this one Spreadbet open) would go up to £300 and the ‘Cash Balance’ (or ‘Cash Available’ etc.) would grow by £450. This is why your Cash just balloons fast when the Markets go your way but this Cash can evaporate like a bullet in tough Markets which go against you.
  

I use igIndex because they have the widest range of Stocks to place bets on and they are the Market Leader by a long way and have a superb range of interfaces on PC, Fone, Tablet etc. I nearly always access via my 10” Tablet with Android App or on my Fone. Lovely interface and simple to use - has graphs but they are a bit limited really - ok, for a quick check. I find the PC interface a bit ‘busy’ but I know many people like it. I suspect it is more geared to Day Traders who are on it all the time like busy banshee bee things.

I am not really 100% clear on this, but my understanding is that Spreadbet Companies ‘Hedge’ the Bets on their platforms by matching Buys with Sells. For example, if Bill Buys a Spreadbet of £10 a Point on Vodafone and Charlie Sells a Spreadbet of £10 a Point on Vodafone - then the 2 effectively cancel each other out - so the Spreadbet Company has no Risk itself from the trades, and just makes its ‘cut’ on the wide spreads.

OK, that is simplistic. In reality, the bets vary in sizes and the prices paid change all the time (don’t we know it !!). However, the complex computers they use do this matching in Real Time and I believe that where there is an inability to match (imagine they get a Buy bet that doesn’t have a Sell bet to match against), then the Spreadbet Provider can automatically go into the Underlying Market for Normal Shares and take a Position to offset the Risk in the Spreadbet that was placed. It’s complex stuff and you don’t really need to know it but when you hear that the Spreadbetting Provider is betting against you, this is nonsense - the large, reputable, companies do not do this.

For more details on how Spreadbets work, pop over to igIndex’s Website and / or pick up a copy of Robbie Burn’s ‘The Naked Trader’s Guide to Spreadbetting’ from Wheelie’s Bookshop www.wheeliedealer2.weebly.com.

Part 2 will go into CFDs and the important of calculating Exposure and managing it. I expect to issue this in a couple of days - gives us all time to recover…….wd