Calculated bets can help reduce risk
CFDs can be a handy tool for reducing risk in your portfolio during more volatile markets, writes Toni Case
MANY people become superstar traders and investors during bull markets when the majority of share prices are heading north. But these same people are the most likely to nurse war wounds when markets correct — when falling share prices provoke margin calls and account balances tend to contract.
It’s widely touted that trading CFDs is risky, and this can be true in the wrong set of hands. Less known is that CFDs can also be used to reduce the risk across an investment portfolio, to make calculated bets, and to make reasonably safe’’ profits. In fact, some professional CFD traders say that CFDs are less risky than trading shares because of the added flexibility of being able to short- sell a CFD, which means that you can make money from price falls. This enables traders to employ fairly sophisticated hedging strategies.
As a rule of thumb, leverage on CFD trades should be at most 10 to 1 — this means that a $ 1000 deposit should be leveraged to at most $ 10,000 — and you should never risk more than 10 per cent of your account on a single trade. Most CFD providers also recommend the slow and steady approach when entering a trade called ‘‘ scaling into a position’’. So rather than putting the full $ 10,000 into the initial trade, they recommend placing a small amount in first and then slowly increasing this amount if the trade moves in your favour.
Many professional CFD traders will not enter a trade without placing a stop loss to halt escalating losses. In brief, a stop loss involves placing a sell order in the market at a pre- determined price. Let’s say that you bought share CFDs on Rio Tinto at $ 145. You could put a stop loss at $ 140. This means that if the Rio Tinto share price hits $ 140 the stop loss would automatically sell you out of the trade.
The big question for many traders is: where do I place my stop loss?
Tight stop losses, which are placed at 1 or 2 per cent away from the entry price, will limit losses but will also increase the chance of price volatility nudging you out of a trade. Wider stop losses, at say 10 to 20 per cent away from the entry price, will mean a bigger hit to your portfolio if you are stopped out, but will also spare you from being shoved out of a trade due to meaningless ( only in hindsight) market wobbles.
There is no rule of thumb for placing a stop loss. The notorious Turtle traders — a group of 14 commodities traders in the US who boasted annual returns of over 80 per cent — employed wide stop losses of around 10 to 20 per cent as a norm. Less experienced traders would be well- advised to consider using tighter stop losses than the Turtle traders.
All firms offer stop losses on CFD trades but not all firms offer guaranteed stop losses, which are safer.
Let’s say you buy Oil Search shares for $ 4.60, and you place a stop loss at 2 per cent away from the share price at $ 4.51. Should Oil Search shares fall to $ 4.51, your stop loss will be triggered, closing you out of your trade. But let’s say that overnight, the price of oil fell sharply, and Oil Search opened significantly below its previous day’s closing price ( this is called gapping). Since Oil Search did not trade at $ 4.51, but instead fell directly to $ 4.38, your stop loss would not have been triggered at $ 4.51. This means that you would be down significantly more than you’d bargained for.
A guaranteed stop loss, however, will absolutely guarantee that you’re closed out of the trade at $ 4.51. For this reason, CFD firms will charge you a premium for using a guaranteed stop loss.
A related point worth mentioning is the trailing stop loss, offered for free by a number of CFD firms. In the example above, let’s say that Oil Search shares spiked, rising from $ 4.60 to $ 4.70 within a couple of hours. A smart trader may choose to move their stop loss to $ 4.70, and effectively lock in 10 cents per share profit. If Oil Search shares continued to move higher, the trader could continue to move the stop loss higher; alternatively, if the shares started to retreat — hitting the stop loss at $ 4.70 — the trader has made a decent profit with, admittedly, much less stress.
Hedging is a sophisticated strategy regularly employed by the big end of town such as professional traders and fund managers, particularly hedge fund operators. Many say that CFDs are one of the best hedging tools around, which means that hedging strategies are now available to ordinary investors as well.
Hedging your bets can feel a bit like you’re trading against yourself, because in a sense you are. You are simply aiming to reduce your risk. Think of it as taking out insurance, in an attempt to reduce the impact of a negative event.
In essence, hedging involves taking out an opposite position so that any losses from one position are offset by gains in the other. For example, a loss in your share portfolio would be offset by a gain from your short’’ CFD trade.
Let’s say that you hold a sizeable share portfolio consisting of BHP Billiton, Rio Tinto, a couple of the big banks and so on. Heightened sharemarket volatility, bad news emanating out of the US, and a change of government in Australia are making you nervous. Rather than panicking, and calling your stockbroker to sell you out of the lot ( remember, there are tax consequences to deal with when you sell), you could short sell a CFD over an index, such as the S& P/ ASX 200.
This means that if the overall market does fall, you will make gains on your CFD trade. Likewise, if the market continues to go up, losses on the CFD trade will be more or less offset by gains in your share portfolio.
Price movements: Fairly sophisticated hedging strategies can be employed