Can You Afford The Risk?

When you woke up on 14 May 2012 you may have been happy to read the news that “Sony shares tumble to 31-year low amid record losses”. Happy because this would be your chance to take punt on a world-class company that was now trading price-wise at one tenth of its former glory. This could turn out to be the bet-of-the-decade, but could you afford to take it?

Whereas in a multi-thousand pound account this should not be a problem, in your “starter account” capitalised at £1000 and with your 1% money management criteria mandating a risk of no more than £10 per trade this trade may simply be unaffordable. This is because, although the price of Sony shares shown on Yahoo! Finance and Google Finance charts would have been in the order of 15, the price displayed by your spread betting company would most likely be 100x higher (not that it’s really a different price) at 1500. On a minimum £1-per-point bet your £10 maximum risk would imply a stop order at 1490, and this doesn’t even account for the additional five-point bid-ask spread. A stop order placed this close to the current price is highly probable to stop out, especially since the price had fallen by almost 7% the previous day.

In order to stay within your money management criteria in this case you would need to employ a very tight stop (with a high probability of stopping-out) or a much wider distance-to-stop (with a high impact of say 100 points if it does stop out). But you can’t afford a £100 risk on a single trade in a £1000 account, not least because the true worst-case risk (if the company goes bust overnight) is actually £1500!

In this scenario you would have to take a rain check on the potentially lucrative trade and look for something with a lower price a little closer to home. Unless you were willing to recapitalise your account, relax your money management criteria… or simply take a risk (not recommended), that is.

Note: If you margin is just 10%, that means that your leverage is 90%. Cumulative leverage happens when you have many positions open at the same time. If they turn out all to be winning trades, then great; but if several go wrong, you will feel a sense of doom and will be seriously in the red. As such, it is prudent to always keep and eye on margins and positions.

Learning to Embrace Leverage

Some people get awfully excited about leverage, and not in a good way, but sometimes I can’t help wondering ‘What’s all the fuss about leverage?’

If you are a homeowner or buy-to-let property owner then you are also almost certainly leveraged. For example, if you bought a £1,000,000 house using a £200,000 deposit then you’re leveraged by a factor of 5. If house prices fell by just 20% then ‘on paper’ your asset would have lost £200,000 of its value and your deposit investment has notionally been wiped out entirely. Even worse, if the house burnt down and you’d forgotten to insure it, then you would lose five times your original investment and would receive a ‘margin call’ (in all but name) from the mortgage lender for the balance of £800,000!

Most people have been in this sort of position, and so they manage their leverage by a) insuring the bigger house or b) buying a less expensive £200,000 house using a £40,000 deposit and a £160,000 mortgage while keeping the same £160,000 on deposit – ideally at a high rate of interest – just in case it is ever needed to settle the mortgage.

It’s exactly the same with spread betting whereby you can make the equivalent of a £1,000 ‘investment’ using a £200 deposit (for example) and using the remaining £800 risk capital provided by the spread betting company in exchange for their financing charges. If the full £1000 that you are truly ‘risking’ is too rich for your blood then just don’t do it, or apply a guaranteed stop order to reduce your risk to a more manageable level, or deploy a much lower £40 deposit so as to risk only the ‘leveraged up’ £200 that you can truly afford to risk.

A Leveraged Misunderstanding

I read recently on a popular investment web site the tale of an investor whose first foray into spread betting lost him his entire £500 deposit on a £5,000-equivalent investment in Aviva shares. By my reckoning he lost exactly the same amount that he would have lost on a £5,000 Aviva investment in a traditional share dealing account – no more, no less – simply because the share price fell. And yet he vowed to walk away from spread betting.

Interestingly, one guy who commented on the article (or perhaps who commented on my comment about the article) at suggested that‚ it is a mistake to assume that all spread-betters are day traders buying on margin and I agree. He went on to explain how an investor with £100K to invest in shares could purchase these by depositing £10K in a spread-betting account (at 10% margin) and could put the remaining £90K in a high-interest account. This makes spread betting a very low cost way of trading because interest from the 90k residual deposit should offset interest charges from the SB account.

Kulvir Virk, CEO of SVS Securities Plc stated: As a broker we get to see many different trading strategies from many different types of client. Whilst we offer high leverage, 1:400 in some cases, this is a maximum which should be used carefully with close attention to money management. We see clients with good trade ideas losing on the back of playing too big, because even an excellent trader or excellent trading system could lose 10 or 20 trades in a row. Money management must account for the worst case scenario, and I would say that this is at least 50% of the basis of a good trading plan.

The Bottom Line on Leverage

The bottom line is that spread betting and other leveraged trading is not inherently more risky than other forms of investment because, hey, the leverage is only a multiplying factor. The secret to loving leverage is this:

If your chosen financial instrument is leveraged at 5x, then just stake one-fifth of your intended amount. Or take out insurance in the form of a guaranteed stop order.

When looking to spread bet a trading idea, research the product to determine the asset’s normalised volatility relative to the broader market – i.e. its beta.

Remember: Using as much leverage as your provider will allow will magnify the volatility of a historically volatile instrument, to the point that it becomes unmanageable. High gearing could result in your position being closed through lack of funds from only a small change in price, regardless of whether the trade proves profitable over your set time horizon. Conversely, gearing up by using leverage on a less volatile instrument can help you generate bigger returns from smaller price moves (relative to the broader market) while still meeting the demands of your risk profile.

If spread bettors can differentiate between products which are inherently volatile and those that aren’t, then the ability to both see a trading idea through and to maximise capital efficiency with an appropriate use of leverage will supplement trading success with a more robust and empirical understanding of risk management

Margin Calls: Can I Lose More than My Initial Deposit?

Yes you can. If you deposited £100 with the spread betting company and found this amount to be sufficient (thanks to leverage) for placing a £10-per-point bet on a single 100p-per-share stock (total risk=£1000), and if this company went bust overnight, you would find yourself owing the spread betting company the balance of £900 that you hadn’t deposited; unless you had fixed your risk absolutely at £100 by placing a guaranteed stop order at 90p-per-share.

In a less extreme example: if the price of that particular stock halved overnight you would find yourself owing the spread betting company an additional £400 that you had not deposited originally. In the past, it may have been likely for you to receive a ‚margin call‛ – a telephone call or email urging you to deposit additional funds immediately in order to keep your losing position open. In reality, these days it is much more likely that the spread betting company will liquidate the position (and any others that you hold) in order to settle as much of the debt as possible; and then call you for the rest of the money.

Even in the normal course of events you may find yourself at various times receiving some form of ‚Liquidation Warning‛ email containing words along these lines:

‘Please take this email as notification that the funds on your account are now considerably below the margin requirements for your position(s).

Please make sure you take the appropriate action necessary to cover your margin, we may without further notice to you close all or part of your positions in order to take your account off call. Positions will be closed at the current market levels at the time we close them. You will be liable for any debit balances that may arise from the closure of the position(s) and this will be due immediately.’

If you’re quick enough, it may be possible to make good the shortfall before your open positions are closed, but it’s better to be prepared by having an adequate surplus balance than to deposit additional funds in haste. Many good traders would advise you never to meet a margin call by depositing more cash, because maybe it’s telling you something about how over-leveraged and under-diversified you are.

Counter-Party Risk

One of the commonly ignored risks is counter-party risk, or the risk that the spread betting company you are dealing with goes bust. This can happen, as former clients of MF Global and World Spreads are all too aware.

Diversification can play a role in reducing the counter-party risk. As well as diversifying across different equities and other financial markets, it may be a good idea to diversify across spread betting companies. Not only to guard against them going bust, but also to guard against a particular trading platform being unavailable when you must make that trade.

The good news is that if you are classed as a retail client (which you most likely will be) in the UK, and if you hold an account valued at no more than £50,000 (correct at the time of writing) then you should be covered by the Financial Services Compensation Scheme (FSCS) in the event that your spread betting counter-party company goes to the wall; but it may take a little while for you to see the return of your cash as clients of MF Global and WorldSpreads discovered.

World Spreads Woes, and the FSCS Payout Timeline

16 March 2012: At close of business, spread betting company World Spreads was placed into special administration by the Financial Services Authority (FSA) due to accounting irregularities and amid suggestions of a shortfall in clients’ funds.

30 March 2012: Administrators KPMG sent closing statements to clients of World Spreads and its white label spread betting partners (including Ladbrokes) in order to clarify the prospective claims from clients… who will have had all of their open positions closed and converted to a cash value.

The FSCS made good on any losses from the WorldSpreads collapse, but this experience underlines the importance of spreading your risk by running accounts with several of the spread betting companies.