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

The Weekend Australian - Review - - Wealth - Toni Case is the man­ag­ing ed­i­tor of Com­pareShares. com. au

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

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