02 Jan 2012
A recent study conducted by researchers at FXCM, a leading forex and spread betting company, shows that forex traders with smaller account sizes are less profitable than traders with larger funds in their accounts.
Researchers at FXCM investigated thousands of forex accounts held at the company and identified a pattern: smaller accounts lead to less profitability. According to the report the reason lies in the level of leverage used. When account funds are lower, traders tend to leverage their accounts too much while traders with larger accounts are more averse to leverage and trade with more parsimony.
The following table and chart show the percentage of profitable trades and leverage per account funds.
Traders with less than $1,000 in their accounts engage in much more leverage than traders from other groups. On average, these traders leverage their account 26 times. As a result only 20% of them run a profitable balance from forex trading. As account funds grow, traders become more averse to risk, reducing their leverage. A direct effect is an increase in profitability.
FXCM researchers explain that new traders are inexperienced in the forex market and tend to open accounts with fewer funds than experienced traders. The smaller the account size the less risk averse a trader is. In order to make decent gains, a trader needs to engage in high levels of leverage, risking too much. The trader is not much concerned with losing it all and will make risky trades. To change his attitude towards risk, the trader needs to guess market direction too many times in a row given his limited account size. That is an unlikely scenario, and the trader end losing all his funds.
The research made at FXCM for forex accounts applies to spread betting in general. In prior articles we have been advising traders to avoid risking more than 2-3% of account funds in a single trade and to avoid levels of leverage that are higher than 3-5 times the account size. When leverage is higher than that, it is very unlikely a trader can survive any drawdown. Inexperienced traders don’t think about the possibility of losing several trades in a row but that is a probability that must be accounted for. Just think on the roulette game as an example. The probability of a number being red or black is roughly 50%. Nevertheless it often occurs that the number comes 5,6, or even more times of the same colour in a row.
In order to check the leverage for your account you can use the following formulas:
Leverage = Notional Value of Trades / Account Size
Notional Value of Trades = Sum for all positions[ (Market Price X Stake) / Unit Bet]
Let’s suppose your account is currently valued at £5,000 and that you hold the following positions:
- FTSE 100 quoted at 5,430 with a £4 stake
- DAX 30 quoted at 5,700 with a £4 stake
- EUR/USD quoted at 1.3025 with a £4 stake
First of all, let’s compute the notional value of your positions:
- FTSE: 5,430 X £4 X 1 = £21,720
- DAX: 5,700 X £4 X 1 =£22,800
- EUR/USD: 1.3025 X £4 / 0.0001 = £52,100
Now, it is easy to sum it all and get the total notional value, which is currently £96,620. Using the second formula above, we get a leverage value of 19.32. That is probably too much and you should reduce it to avoid being caught off guard. To avoid losing too much you would need to set too tight stops that will put you out in a very short time. If you instead set a wider limit then you can end losing too much on these trades. Let’s say you set a stop 1% below the current price. Stops for FTSE, DAX, and EUR/USD are then held at 5,375.7 – 5,643 – 1.2895, respectively. If these trades are closed at the stop level, you can lose up to £965.2, almost 20% of your account funds. One way or another, the probability of ending with no funds in your account is high.
Given FXCM research and what was said, you should either increase your account size to help reduce leverage, or directly reduce your exposition while keeping funds. You should set a reasonable leverage level, and then adjust positions to fit that level.
01 Nov 2011
It is not likely that a scam could last for more than 35 years, involve such a large number of people, and be regulated by FSA. Nevertheless, some people make negative comments about spread betting, raising doubts on the behaviour of some spread betting companies.
Financial spread betting started in 1974 with the creation of the “Investor’s Gold Index” and it is estimated that there are more than 1 million spread betters in the UK. The activity is subject to the Financial Services Authority (FSA) strict regulations as any other type of trading in the UK. Some providers are also exposed to further scrutiny because they are public traded companies, as is the case of IG Index and Capital Spreads.
Let’s take a closer look into the arguments often raised by scam theorists and try to understand and disentangle them.
- Spread betting has no pricing transparency and carries high transaction costs
The argument: “When you buy and sell, you’re not really dealing with the market but rather with a counterparty – the spread betting firm. The product you’re trading is just an over-the-counter contract made between you and the provider. You will receive take-it-or-leave-it price offers from the firm, resulting in higher spreads and lower liquidity.”
It’s true that you’re not trading the market directly and that you pay higher spreads. But zero commissions means more transparent prices and for most trades the spread is lower than commission fees faced elsewhere. It’s true that you may find yourself in the uncomfortable position of depending on your provider when you want to close a position but taking into account the huge competition that comes not only from the UK nowadays, it wouldn’t make sense for any reputable firm to risk annoying its clients for the sake of a few spread points.
- Spread betting firms want you to lose, because the more you lose the more they gain.
The argument: “Any profit you make means a loss for the firm, incentivising them to make it as difficult as possible for you to make a profit by skewing spreads or even suspending momentarily the market when you want to close a position.”
The idea that your profit is your provider’s loss is not correct. Most providers cover their books in the market (at least partially). So the money they lose to winning clients is won back through their hedging trades in the stock markets.
It is very hard and costly to find new clients, and clients are not interested in losing money recurrently. Earning money directly from client losses would not be a smart route to follow. Spread betting providers benefit more from getting low and consistent commissions from happy clients than from clients who lose their initial deposit very quickly.
- The name says it all. It’s betting.
The argument: “Spread Betting is a form of gambling, and cannot be considered as investing. Bets on a spread are just like bets in a casino!”
The name financial spread betting is not a fortunate one. The word “betting” is automatically connected with gambling. Although gambling is a legitimate recreational activity, we know that gamblers generally lose in the long run. Also, spread betting is often associated with sports spread betting which in turn associates it with gambling again.
In spread betting you bet on price movements like you do on any derivative contract like share options, for example. “Betting” is an inappropriate and unfortunate name. Spread betting is regulated by the FSA and not by the Gambling Commission. Unlike gambling, research can give you a profitable edge.
- Most people lose money
The argument: “It is said that only 1 in 5 spread betters end up a winner. The odds are greatly in favour of the spread betting provider.”
While it is true that only about 20% of spread betters are long term winners, studies have shown that a similar percentage of traders in more conventional financial markets lose money. So this is not something that applies just to spread betting.
So why do most traders lose money? What most novice traders need to understand is that you can’t expect to master trading when you start out – just like you can’t expect to master dentistry or sports or anything else in a week. You must take the time to learn the intricacies of the markets you trade in, and do some fundamental research and technical analysis. It’s a time-consuming activity. A large number of people open accounts with low starting account balances, gearing their positions to unthinkable levels with very high likelihood of resulting in bank ruin. Many of these beginners are naive and don’t really know how financial markets work. They often assume positions based on nothing more than gut feeling. As the expression goes – “if you fail to prepare then you should prepare to fail”.
- There are many negative comments in forums and other pages on the internet
The argument: “Some internet posters report difficulties in selling positions, suspect price spikes, stop order slippage, price re-quotes, and many more problems.”
Some may be true, but remember one important thing. One unsatisfied client can make a lot of noise, whereas satisfied clients usually tend to keep quiet. Comments you may find may be skewed and exaggerated. While it is difficult to comment on individual cases without knowing the full details, it should be known that it is in the interests of the spread betting firms to treat their clients fairly and to make sure that they stay with them over the long run.
- Trading systems don’t work
The argument: “There are many trading systems based on technical analysis selling for huge prices and claiming huge profits but they don’t work.”
Trading systems are not sold or provided by spread betting companies but rather by external sources. Those systems don’t work and you will end spending your money and time. If the systems were really good, why would they sell it instead of profiting themselves from such a great strategy? Most trading systems are scams, looking for people who are desperate for profits. You will have to read books and maybe attend some seminars to build your own system. Any shortcut will lead you nowhere.
As a final comment, I must say that financial spread betting is an excellent way to trade the markets but one that needs a high degree of knowledge and dedication. Most people take shortcuts and end up losing money – contributing to a high percentage of losers. This results in disgruntled people making negative comments about financial spread betting and scaring newcomers. The problem is very often with the traders themselves and not because of an underlying problem with spread betting.
28 Oct 2011
Last week we started looking at options as another trading vehicle available to spread traders. In our introductory article we covered all the basics of trading options with spread betting and promised to analyse some possible strategies to implement in times volatility is huge. Today we will start with two basic strategies that can help you when volatility is high and you don’t know which way to go: the long straddle and the long strangle. And of course you could also profit from sideways markets by doing the opposite and selling a straddle or a strangle.
There are times under which markets are volatile as there are certain events, which you expect to come embraced in volatility. A corporate earnings announcement, a decision on interest rates, a GDP report announcement, are just some examples of situations in which volatility is expected to pick up making asset prices move very quickly. In such situations you are assured to see your portfolio value change rapidly but you still need to guess market direction before opening any position. That is the most difficult part of spread betting and at the same time the most important one.
But fortunately, even when you are not sure about the direction a market will move, you can still use your spread betting account to do some effective trading. By carefully selecting a pair of options you can set up a trap to get some juice from the market without needing to care about direction. One call and one put option is what you need to play with volatility. Today we will analyse two useful directionless strategies that just use one call and one put option.
Setting a Long Straddle
The first and simpler strategy is the straddle, also known as long straddle as it involves long positions.
The straddle is a neutral strategy in the sense direction does not matter. The only concern is with volatility and thus price movement. The strategy involves buying both a call and a put with the same strike price and expiry date. The strike should be near the underlying asset price, or saying other way, the options should be at-the-money or near it. To make a profit out of this strategy, one needs the market to move away from the options strike. The more it moves away from that price, the higher the profits will be. Unfortunately this is a costly strategy, meaning that you need a large movement in the underlying asset price in order to cover your initial cost.
In terms of risk, the maximum loss is equal to the options cost and the upside potential is virtually unlimited. There are two breakeven points, depending whether the underlying asset goes up or down. The upside breakeven is equal to the options strike plus the options cost. The downside breakeven is equal to the strike less the options cost.
A Straddle Example
Let’s assume you want to implement the straddle strategy on FTSE 100. In order to better simulate reality, we got real price data from IG Index a few days ago. The FTSE was trading at 5,560 at that time.
In order to build the strategy, you should choose some options that are at-the-money. In this case you can choose a daily call and a daily put, both with strike price of 5,560. Those options expire at the end of FTSE session – 16.30. You can try with different expiry dates.
For the sake of our example, the call was worth 21.05 and the put 19.55. The total cost to set up the strategy would be £40.60. Applying what you’ve learned before, in order to breakeven, you need FTSE to move above 5,600.6 or below 5419.4. That is a move of 0.75%, a really huge one. But in times the market is volatile as it currently is, it may worth implement such strategy. There are certain advantages deriving from a setup like this. First of all, you don’t need to guess direction as you have with normal spread trades. Secondly, you do have a maximum loss set up from the beginning. That is different from a stop loss in the sense that as long as the market goes up or down it does not matter the path it takes while a stop order will kick in when the market departs too much from the direction of your trade.
At maturity date, you basically need the market to rise or decrease more than 0.75% to make money. If that is not the case, you will lose a maximum of £40.60, the cost of the options.
Setting a Long Strangle
Let’s now look into a similar strategy – a long strangle. Like for the straddle case, this strategy is directionless, and you just have to care with volatility.
The strangle involves buying both a call and a put option with the same expiry date but with different strike prices. Usually, the options are out-of-the-money, reducing your initial outlay. The lower initial cost, means lower maximum loss but, at the same time, a reduced profit. You will need a higher price movement to breakeven, when comparing to the straddle.
In terms of risk, the maximum loss is equal to the cost of the options like in the straddle case, and the upside potential is also unlimited, although always less than in the straddle case. There are two breakeven points. The upper one is equal to the call strike plus the options cost and the lower is equal to the put strike less the options cost.
A Strangle Example
Let’s use the example above with FTSE 100 quoted at 5,560. We need two out-the-money options, one call and one put. Like in the above example, let’s pick daily options: a call with strike 5,600 and a put with strike 5,520.
Real data taken from IG Index values the call at 6.35 and the put at 6.95, for a total initial outlay of £13.30. In order to recover that expense, you need FTSE to go above the call strike plus that cost, or below the put strike less the cost. Basically FTSE should go above 5613.3 or below 5,506.7 – a movement of 0.96%.
The strangle costs you less but will require a much larger move in the underlying to make you money. That’s the cost of the extra protection. The more out-of-the-money the options were, the less they would cost, the higher the protection, and the larger the underlying would have to move for you to profit.
Putting It All Together
Let’s now look a the differences between the straddle and the strangle with the help of a simple graphic plotting the underlying price and profit.
It is clear from looking at the above chart that there is an exchange between potential profit and maximum loss. The strangle will protect you better in case volatility does not pick up, but at the expense of decreased profits for any given underlying price, when volatility does it job. The intersection of the lines with the x-axis also shows that you need a larger change for the strangle to breakeven.
The following table summarises all relevant data deriving from both strategies. The first part shows the initial parameters. The risk metrics follows, showing the key points that you should care with, and then there are some example values.
|Up % Breakeven||0.73%||0.96%|
|Down % Breakeven||-0.73%||-0.96%|
|Underlying % Change||Straddle P/L||Strangle P/L|
The straddle and the strangle are great strategies for spread betting traders when they don’t know the direction a market will take and are expecting a large volatility, but are too costly. In certain times, in which some volatility is expected but not huge movements, some other cheaper strategies may be preferred. Two of those are the short butterfly and the short condor that we will review in our next article.
07 Jun 2011
Financial spread betting is an efficient way of getting involved with financial markets since it avoids income tax, stamp duty, commission costs, position sizing difficulties, and only requires a margin of your total investment.
Spread betting is a levered product allowing you to just put aside 10, 5, or even just 1% of your total trade to execute it. When you buy FTSE 100 at £1 per point with the index trading at 6,000, you are trading a £6,000 position. To do that you may be required to have at least £60, just 1% of the total position. It means that you are levered and are borrowing money. Spread betting providers are not charities, so they charge you a financing cost every day, usually stated as LIBOR + some spread. It may be LIBOR + 2.5% for example, or +3%. Let’s assume that this charge is 5% at current rates and that FTSE closes at 6,050 in the day. You will be charged 6,050 X 5% / 365, or £0.83 in financing for the day.
Spread betting companies differ in the way they charge this financing cost and how they carry your position overnight. In technical terms, they differ in the way they rollover your position. There are three main rollover possibilities:
1) DAILY ROLLOVER WITH PRICE ADJUSTMENT: At the rollover time, which is defined by each provider, the company closes your position and re-opens a new one including a finance charge. Considering the above example in which FTSE is valued at 6,050 at the end of the day, your provider will close your position at 6,050 and charge you £0.83, but this value is not debited in your account. Instead the company opens a new position for you adjusted by this finance cost. Expressing £0.83 in terms of points would be to divide it by your £1 stake, that is 0.83 points. The new position is opened at 6,050.82. Next day, the same logic applies. Your position is closed every day and opened at a new price including a finance charge. This is what IG Index do (although they now offer daily traded funds that work similarly to what is stated in point 3)
2) DAILY CASH ADJUSTMENT & DAILY ROLLOVER: At the rollover time, your provider closes your position and re-opens a new one but debits the financing cost directly in your account. In the above example, your position is closed and re-opened at 6,050 and your account funds will reflect a cost of £0.83. This is what Finspreads and City Index do.
3) DAILY CASH ADJUSTMENT BUT NO ROLLOVER: The last possibility is keeping your position opened until you close it and debit your account for financing costs in a daily basis. This is what IG Index and Capital Spreads do and is certainly the best way to understand what really happens. IG Index calls this rollover method a “DFB” or “Daily Funding Bet”. If you hold positions for a few days, you can easily subtract close and open prices to exactly know your performance for that trade. In the other examples, you need to calculate daily profits and add them for all days. It is less intuitive.
No matter what method your provider chooses, the final result is always the same, so don’t worry much about that. The important is just to understand how things work.
08 Apr 2011
Spread betting is a risky game of trading in which you can lose more than you have in your account. That’s because of leverage. Every time you buy or sell a market, you just need a small fraction of your total trade – a margin, which can be as low as 1-2%. If the market goes against you quickly, then you could be in trouble. That’s what most people think – but are they correct?
Spread betting has in fact some risks, and losing more than what you have in your account is a real possibility, but depending on your provider and on the type of trades you carry, it can be a really low one. Before going broke, there is a margin call trigger, in which most providers will automatically start closing positions you have in your account until the margin is again satisfied. This is a safeguard against having to put more funds into the account.
You can also set up stop loss orders to avoid any margin call and close your positions earlier. Some companies like Capital Spreads always attach a stop to each position you hold. But, sometimes it may not be sufficient. There are certain situations in which every trader is trying to buy or sell and the market will gap, causing slippage, meaning your position will not close at the predefined price. To avoid this, most providers (such as IG Index) offer you guaranteed stop orders which the closing price, but they come at a cost.
Many people, especially those new to spread betting, are worried about the possibility of not being stopped at the specified stop price and having to put additional funds into their accounts. Although this is an understandable concern, in reality this occurs much less than one may think, especially when you stick to reasonably liquid markets. Guaranteed stop orders are expensive so you should evaluate when and if you really need them.
Let me give you an example of the cost involved with guaranteed stops. Capital Spreads charges a 1 point spread in FTSE 100 daily rollover, but adds 2 more for guaranteeing your stop and requires that stop to be placed at least 30 points away of current market price. For FTSE 100 shares they charge 0.1% in the spread and 0.5% additionally for the guaranteed stop. This certainly is a cost worth considering carefully. Besides paying more, you also have to place the order far from market prices. In certain cases they may require a 5% or even 10% distance that may be completely outside what you want to allocate to the particular trade. In such cases, guaranteeing your exit is useless.
Nevertheless, there are certain situations in which you may be better off paying the price for the peace of mind. Examples are:
- When you’re spread betting small caps. These shares can easily experience price gaps because of illiquidity and because they are not well covered by analysts. The problem is that your provider also knows that so will charge you more on those shares than in others. The greater the risk, the more expensive the insurance.
- When you’re spread betting shares of companies approaching an important event such as an earnings release. Such events can trigger fast price changes if there is unexpected news.
- When you’re spread betting shares of companies involved in M&A talks or rumours. Within seconds the price can move very fast or if it happens outside market hours, when the market opens you not even have a chance to trade at the desired price.
- When markets are highly volatile. Protect yourself when the market is highly volatile. Remember that you are not a gambler, and the aim is to minimise risk where possible and cost effective.
- When spread betting some commodities. Commodities can often have large swings in price, even after periods of low volitility.
- To have a good night’s sleep. Sometimes you just need to have a good night’s sleep without thinking what will happen to your money. Buy the guaranteed stop if it will buy you piece of mind.
In normal situations use stop orders, monitor them, and stick to more liquid trades. This way you avoid headaches and unnecessary commissions. Good luck trading!