Leading on from the last 2 parts of this Blog Series, I now move onto the actual mechanics of how I go about getting the Advantages of Leverage from Spreadbets whilst reducing the Risk and keeping things easy and manageable.
Long Term Portfolio Approach - ‘Mirroring’
The simple Logic is that I do a 'mirror' of my Normal ISA Share Portfolio as a Spreadbet Portfolio. Say, as an example, that I had £10k of Aviva shares, then I would 'mirror' as a Spreadbet by doing about £20 a Point (AV. price roughly 490p ish now) which would mean an Exposure of near £10k which would be like the Share position. So, I do this with all my stocks and it means that the 'Risk' is spread across them all just like in a Share Portfolio. This means I probably have as many as 35 Spreadbet Positions open at the moment.
The mathematical logic is that if you make 10% on the Normal Share Portfolio then you should make 10% on the ‘virtual’ Spreadbet Portfolio - but of course you have done this with much less Capital to support the positions - so your return is probably near 100% on the Capital tied up. I am describing this simplistically, in practice there are a few nuances but that is essentially the approach.
Of course there are things like Interest Charges that eat away at returns so 10% on Normal Shares is probably more like 7% on the Spreadbet Exposure - However, any Successful Hedging done via FTSE100 Shorts will boost that return in the Spreadbet Account. A 7% overall return would probably be around 70% return on your Capital anyway.
I tend to avoid doing Spreadbets on the Higher Risk tiny AIM and Small Cap Stocks that are in my Normal ISA Shares Portfolio - sometimes I do not have a choice as igIndex won't let me do some of them anyway - they are not available on the igIndex Platform. This is a problem of many Spreadbet Providers and a reason why igIndex is by far the best one. Many do not have the range of smaller companies that igIndex can do bets on - this makes many of them useless really.
There is a certain beauty in the Mathematical Logic of this technique. The Logic basically says that if you can make 10% on a Portfolio of Normal Shares, then you should be able to make around 7% to 8% on a ‘Virtual’ Portfolio of Spreadbets with equivalent Exposure. But it is of course much more Capital Efficient (I know this is repetition but it is important that Readers understand this).
An important concept to grasp is that when we buy any Share Position, we always think (believe) that it will go up, but we all make mistakes and returns on Individual Stocks are to a large extent unpredictable anyway - if you do not agree with this statement, then maybe you are Overconfident? Maybe I am Under confident !!
Anyway, what I am saying is that I can never be sure how an Individual Share Buy will do or even how a handful of Share buys will do. But, I can have a fair degree of confidence that over time, on average, I can make about 10% per year on a Large Basket of Stocks - I have managed this for many years. It is this property and high level of certainty that I am using to create my Spreadbet ‘Virtual’ Mirrored Portfolio.
If you create a Spreadbet Portfolio with only a small number of Positions, say, 6 or maybe 8, then you run a huge Risk of them going wrong and wiping out your Cash, due to the gearing aspect. All it takes is for one to go horribly smelly and your spare Cash in the Account just evaporates - and the Spreadbet Company will be chasing you with a Margin Call demanding more Cash.
In addition, the logic of Hedging using FTSE100 Shorts requires that you have a matching Long Portfolio of Stocks that behave in a similar way to the FTSE100 - if you do not have this correlation, then you could find that your Cash evaporates because your Short FTSE100 goes against you and at the same time, your Long Positions fall - so the Hedging effect does not happen because both Longs and Shorts are losing. Hedging can only work if the Longs and Shorts are in some sort of balance.
Hedging effectively makes your exposure to Market gyrations much lower - if the Markets rise, then your Short Hedge loses but your Long Positions gain. If Markets fall, then the Short Hedge gains but the Long Positions lose.
It is for this Number of Positions reason that the majority of Spreadbet users are going very wrong. If you only have a few Positions, say, 6 Trades live or something, then you run a huge Risk that they could all (or the majority) go against you and wipe you out fast. By having a Large Portfolio of Spreadbet Positions, there is a certain amount of ‘Natural Hedging’ where the down movements of some Stocks are counterbalanced by the Up movements of other stocks. I think the minimum safe number of Spreadbet positions is probably about 15 and you must have diversification across Sectors, Sizes, Industries, geographies, etc. As I mentioned earlier, I probably have about 35 Positions open at the moment.
If you have a Portfolio of just Small Cap stocks, you run an enormous Risk if you leverage it up too much and get over-exposed. Small Cap stocks (and AIM especially) can fall off cliffs in difficult markets and falls of 15% on an individual stock on a particular day is not unusual. If you have Stocks like this in your Spreadbet Portfolio and nothing else to give some ‘balance’, then you will get in trouble.
Sometimes if I have no Cash spare in my Normal Share accounts I will buy a Stock just by using a Spreadbet - however, in practice I have found that the best approach is to buy as a Normal Share first and then to mirror as a Spreadbet - horses for courses I guess and some people may find they can do it in a similar way but differently, if you get my drift.
Here’s another quick example to illustrate the ‘Mirroring’ idea. Imagine you have a Normal Shares ISA with £40,000 worth of stock in it, made up of 20 shares with £2000 in each. Using the Mirroring technique and keeping things safe, you could create a ‘Virtual’ Spreadbet Portfolio with the same 20 Stocks but maybe with just £1000 of equivalent Exposure in each. So you would then have a Spreadbet Portfolio with Exposure of £20,000. This is exactly the kind of approach I use. To support such a Virtual Portfolio, you would probably need about £3000 of Margin initially and maybe another £2000 as a Cash Buffer to leave in the account and give some wiggle room. In addition, I would suggest having another £5000 of Cash in reserve that you could use fast if you had to would be a good idea.
However, in the example above, remember that YOU ARE LIABLE FOR THE £20,000 - if all your Stocks go belly up (calm down, it’s not going to happen) then you lose £20,000. This is why you must control your Exposure.
It is also important to establish some ‘Position Sizing’ Rules for your Spreadbets. For instance, your Rules could say that you buy £1500 in Normal Shares and you buy the equivalent of £1000 Exposure via a Spreadbet. Probably the best way to understand this is to look at my Blogs on ‘The WheelieDealer Approach to Position Sizing’ from October 2014.
Added Finesse and Timing
Another small tweak is that I like to 'stake build'. So, what I tend to do is use the Charts (you have no doubt read my Blogs on OPAY Technical Analysis and these are exactly the Indicators I use to help with timing) and buy a Normal Share Position first. Then, if it starts to move up and Candles, RSI and MACD etc. line up, I will add to the Normal Share Position with a Spreadbet Position - this means that I tend to back the early Winners and the Losers don't get a topup - so my Weighting is biased to Winners rather than Losers.
However, if a Loser drops down enough and gives Buy signals, I am not averse to Averaging Down but you gotta be extremely careful - please refer to my Recent Blog ‘Is Averaging Down the root of all Evil?’, from January 2015.
When Selling, I will often Topslice by selling the Spreadbet Position first (note, sometimes I have more than one Spreadbet Position on the same Stock) as it is more ‘Risky’ than the Normal Shares.
However, a word of caution here. I do these little tweaks and stuff but I sometimes wonder if I am just fooling myself. Perhaps I would make more money (and things would definitely be easier) if I just used a straight ‘robotic’ mirroring of my ISA Portfolio and just bought Normal Shares and Long Spreadbets at exactly the same time and Sold them at exactly the same time. Not sure, I need to investigate this more but it does play on my mind. I sometimes think I am too clever for my own good and that is a bad trait for Stockmarket Investing !!
As you may know from reading my Blogs, I have a bit of a 'mental'
issue with Stoplosses on anything - so my Approach to Spreadbets is pretty
much the same as with Normal Shares. The exceptions to this are that I use Stoplosses on Short Trades on Individual Stocks - although I rarely do them anyway; and occasionally I would use a Stoploss if there is a Special
Event - like for example with Avanti Communications’ (AVN) satellite launches perhaps. So, on the whole, just like on my Stocks, I don't use Stoplosses.
I just hate spending a lot of time researching a Great Stock and then timing my Buy only to get stopped out by some silliness - I sort of think that if I need a Stoploss on a Long Position, then I have not done my Research Properly and I am using a 'Safety Net' that I should not need. As a Long Term Investor, do I really need to be Stopped out on a 10% drop? If I was more of an Active Trader, then I guess I would use Stoplosses - but actually, I am just too lazy and Sloth-like in my Investing Approach.
Remember, if you are doing things the Right Way (and you have the Right Stuff !!), then you are buying a Stake in a Company that you want to hold for years and years - why let a silly gyration kick you out of a great Company? Do you think Warren Buffett does that?
However, I think the best Approach is to just copy your normal Investing style. What I mean by this is that you should treat your ‘virtual’ Spreadbet Portfolio exactly as you do your Normal Shares Portfolio. So, if you normally use Stoplosses on your Normal Shares, then it is probably advisable to do the same with Mirrored Spreadbets - stick to your methods and just treat Spreadbets as if they were just more Stocks.
It might be helpful to re-read my Stoploss Blog (’To Stoploss or not to Stoploss, that is the Question’ from November 2014) after you have digested the information above.
OK, that’s enough for today - it should give you a good idea of how I take advantage of the Leverage in Spreadbets and the ability to go Short. In the next couple of Parts I will explore more details around the Dangers and nuances of Spreadbets.
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