How to use Leverage Safely and Successfully - Spreadbetting and CFDs Part 2 of 5

CFDs
In many ways CFDs (Contracts for Difference) are similar to both Normal Shares and Spreadbets - sort of a cross between the two - a mongrel (woof). As with Normal Shares, you pay a Commission and they are Taxed and you receive Dividends where you get the payment on the Ex Div date (like a Long Spreadbet).

Like with Spreadbets, you can use to go Short, you can do it on Margin (so you get Leverage) and you do not own a Stake in the underlying Company. If you are Short, you lose the Dividend on the Ex Div date - beware.

Like Normal Shares, the Buy and Sell price is exactly the same as the Normal Shares in the underlying Market. With Spreadbets the prices are very different - always wider.

Let’s use the Example from before. In this case, you would Buy 1000 CFDs at 250p to get equivalent Exposure to Normal Shares which would cost £2500. However, with the CFD, let’s assume there is a 10% Margin Requirement so you would only need to put down £250 as with a Spreadbet.

I think with CFDs some Providers will allow you to do Direct Market Access (DMA) - this is where you can actually enter orders into the Order Book which is shown on Level2. The advantage is that it enables you to buy and sell at very good prices - however, unless you are a Big Player with large positions, it probably is not worth the hassle. For more details on this, see Robbie Burn’s ‘Naked Trader 4’ available from Wheelie’s Bookshop on WD2.

Apart from the DMA advantage, I see little point in using CFDs. With Spreadbets you get a similar thing and there is no Tax implication at the time of writing and I expect this to remain the case (although I understand that if all your Income is made via Spreadbetting then the Tax Authorities in the UK might deem it as taxable) - so CFDs seem a little pointless to me really. This is why I rarely use my CityIndex account these days.

Exposure
Arguably, apart from the DANGER Warnings, this is the most important chunk of text in this Blog Series. IT IS UTTERLY VITAL YOU UNDERSTAND THIS BIT. IF YOU DO NOT UNDERSTAND, THEN YOU SHOULD NOT EVEN THINK ABOUT USING LEVERAGE OF ANY FORM.

By ‘Exposure’ I mean the equivalent value of Shares that you Buy or Sell using Leverage. In other words, say you bought £2000 of normal Shares, then your Exposure would be £2000. If you then opened a Leveraged Trade equivalent to the normal Shares as well, then your Exposure would be £4000.

But remember, because the Leveraged Trade uses borrowed money, you would now have £4000 of Exposure but you may only have tied up £2200 of Capital (assuming a 10% Margin (Deposit) level).

It is important to think of any Leveraged Trades in this way - in this example you are LIABLE for the whole £4000 of Exposure NOT the £2200. If the Company goes Bankrupt overnight, then you will lose £4000 NOT £2200. It is vital you understand this. If not, feel free to email me for clarity.

Therefore, if you had 15 Long Spreadbets open with the same Exposure of £2000 each, your Loss if all the Companies went Bankrupt would be £30,000.

Think of Leveraged Exposure as just a clever trick to get you more ‘Firepower’ in the markets - don’t lose your head and start behaving like you are Donald Trump (ha, your hair, LOL) and making £1m bets just because you can. 

I explain this more in Part 3 of this Blog Series which will be out soon, but please put your brainpower into understanding Exposure.

How do I calculate Exposure?
This is different depending on the Instrument you use to get your Leverage. I tend to use Spreadbetting, so my text focuses on this really.

If you remember the Example in the Spreadbetting Section in Part 1, in that case you bet £10 a Point at 250p which gave an exposure of £2500. It really is that simple - but you must be very careful and make sure you have got this right. In other words, you just multiply your ‘Stake per Point’ by the ‘Price of the Instrument‘. So in this case it is like having £2500 of Normal Shares - think of it in this way, it is critical.

Let’s do another one. If you bet £25 a point and the Price is 458p, then your Exposure is £25 x 458 = £11450. (so it would be like having £11450 worth of Normal Shares).

If you bet £17 a point and the Price is 324p, then your Exposure is £5508 (£17 x 324).

Now, these are the Exposures when you open the Bet - as the Price Changes, your Exposure will obviously change. So, if the Price goes up, your Exposure and RISK will rise. If the Price drops, then your Exposure and RISK falls. It’s logical if you think about it.

If you Short a Stock, you must think of it in a similar way. For instance, if you Shorted a Stock at £18 a point at a Price of 436p, then you are Short £7848. So the maximum you can make if the Price goes to Zero, is £7848 and your upside Risk is infinite - you must use a Stoploss.

Note - ‘a Point’ tends to mean a Penny NOT a Pound or Dollar or whatever. This is usually the case on Equities with igIndex but on some things like Commodities, a Point might be different. It is vital you understand this but you shouldn’t be messing about with Spreadbets on Commodities anyway - have you not been listening !!

IT IS VITAL THAT AT ALL TIMES YOU UNDERSTAND YOUR TOTAL LEVEL OF EXPOSURE AND YOU HAVE CASH RESOURCES AT HAND TO DEAL WITH ANY SHORT TERM PULLBACKS. I will address this in more detail further on in this Blog Series.

A Scary Tale
Having explained ‘Exposure’, I can now relate a rather shocking incident that I was involved in many years back. A very good friend was a keen Spreadbetter and he was into placing Bets on everything using Chart based analysis. I won’t go into the pros and cons of this approach, but I just want to highlight the Exposure aspects (ok, you twisted my arm, it is a sh*te approach, guaranteed to lose money !!).

My mate was into anything really (and I am not just talking about trading !! If your reading this, you know who you are, LOL) and would regularly have Positions on Gold, Oil, Platinum, Shares, Indexes, Lean Hogs, etc. Anyway, he was round my gaff one day and was showing me his account (I think this was in the days when I was only just starting out with Spreadbetting) and I asked him what his Exposure was. He said “I have no idea” and then we started calculating it. He had OVER £250,000 at Risk…….after he had got back from the Loo, he started closing Positions !!

You have been warned. It may seem like ‘Magic Money’ but it is your loss if it goes wrong and it can BANKRUPT you.

How to Lose all Your Money
It is vital to understand that Leverage via Spreadbets or CFDs (or any other Instrument) can be used in 2 ways:

• For Daytrading and Short Term ‘Position’ Trading
  
• For Long Term use with a carefully managed Diversified Portfolio of Stocks.
  

To make this very simple, the First way will almost definitely make you Bankrupt. The Second way gives you a fighting chance of making good money - and is a Key Element of Wheelie’s M3 Manifesto (please see my recent Blogs - look under ‘Categories’ for Manifesto).

Daytrading and Position Trading are for proper experts and people who are extremely experienced in ‘Trading’ (as opposed to ‘Investing’ - please see my Blog ‘Are you an Investor or a Trader?’ from November 2014. It is not for normal Humans - you need to be somebody really rather special.

Again, without complexity:

90% of Traders LOSE MONEY.

So, if you go down the Trader route, you need to realise that you are stacking the odds hugely against yourself right from the off. What makes you so special that you will be in the Top 10%? I have probably a vast amount more experience than you, but I am unable to do it. And I have put a lot of effort into trying. Don’t bother - it is virtually impossible.

OK, so you still want to be a Trader. Now you need to realise that the way the Spreadbetting and CFD companies teach you is designed to make you lose money. These companies make more money if their customers trade in high volumes, because they make a bit of money on each trade you do - either in Commissions or from Wider Spreads. Therefore, they teach you in a way that seems sensible, but what they are actually doing is teaching you to Overtrade. This is a schoolboy error but they try to instil this in you. Crazy really.

For more insights on this, nip over to Wheelie’s Bookshop and pick up a copy of ‘The Naked Trader’s Guide to Spreadbetting’ at www.wheeliedealer2.weebly.com.

The second way, which is a Long Term approach, is described in Part 3 of this Series - this gets to the nitty gritty of how I use Leverage in Practice and I think it might surprise you……..

That’s left you on a Cliff-hanger………should be out soon.

Have a stonking weekend and don’t forget Valentine’s day….

Cheers, Wheelie