Last week we explained the concept of leverage and the benefits and drawbacks the use of leverage can have for the average active investor. This week we would like to focus on the use of CFDs as a leveraged instrument for increasing exposure to the stock market and share some stories and suggestions on how best to use leverage within your portfolio.
It is unfortunate but the great majority of investors that use leverage not only lose part of their capital, some lose the lot! This is not just anecdotal evidence but is factual when talking to brokers in the industry. I have personally had discussions with brokers, past and present, in Australia and overseas, who have confirmed that their average CFD account holder or futures account holder take nine months, on average, to wipe out their entire account. Some of the major reasons for this include:-
1. The leverage available with CFDs is too great. For the majority of CFD investors, leveraging a portfolio at 7 to 10 times its original starting capital is far too great. As in our example from last week, the temptation is to use the available leverage to take on position sizes that are way too big for the capital in the account. At 10 times leverage, a $100,000 face value position can be controlled with just $10,000. If the position drops in value by 15%, the investor has lost his $10,000 of capital PLUS an additional $5000.00 that needs to be provided to the CFD provider, that is, a 150% loss trade!
The GFC proves that the world’s financial fraternity as a whole cannot handle too much leverage!
2. Most CFD traders start with a small capital base and then leverage it up. CFDs and leverage have been a blessing to some investors who have the necessary skills to trade with leverage but it has also been a blessing to some of the CFD providers who have preyed on the ill-equipped CFD trader.
The information that I am about to share with you is probably not widely known by the bulk of CFD traders the world over. Most market maker CFD providers run what’s called an ‘A book’ and ‘B book’ operation by profiling their customers. The ‘A book’ comprises large net worth traders or institutions who are skilled enough to make money on a regular basis and the ‘B book’ comprises smaller traders who are ill-equipped to trade with leverage and hence have the odds stacked against them. Some estimate that the ‘A book’ holds around 20% of clients whilst the ‘B book’ holds the remaining 80%. Where this really gets interesting is that the CFD provider actually places the trades of the ‘A book’ client into the market and hence carries no risk, or hedges the positions through other instruments. However, the CFD provider takes risk with the ‘B book’ betting on the fact that these clients as a whole will lose money on a regular basis and hence does not place these trades into the market or hedge them.
The ‘B book’ scenario is similar to that of a casino as the CFD provider (the ‘house’) assesses that they have a positive edge in their favour through the lack of trading skills of this demographic of CFD trader. I am outlining this for one reason. The CFD providers realise that the bulk of CFD traders trade with no money management, no risk management, no researched exit strategy, little or no trading plan, do not have an EDGE and more importantly, do not have the psychological wherewithal to handle trading with large leverage. This turns a commissions and spreads business into a casino with a house edge which is extremely profitable on the back of losing traders.
I’m not saying that this is inherently wrong. It is just the way that it is. Much like a casino. The problem is that most human beings cannot help themselves and hence need rules to guide their behaviour whether it be via government laws or via the rules of a trading system.
3. The roller coaster ride of investing in the market becomes magnified with leverage. This magnification cripples many investors into making psychological trading errors of magnitude and these mistakes can be catastrophic to a portfolio on an ongoing basis.
4. The majority of investors don’t use a researched strategy with an edge, trading plan, money management and risk management techniques. This lack of rigour and lack of a tested rules-based process cripples traders. Trading with leverage requires the disciplined application of a strategy with clear and unambiguous rules-based calls to action.
5. The bulk of CFD investors continue to leverage their profits until an outlier event that their rules do not protect against wipes out the majority, if not all, of their capital base. A mistake that many CFD investors make is that they continue to leverage profits without taking them off the table. This leverage on leverage effect can create massive draw down and wipe-out in some instances. What is required is to regularly remove capital from a leveraged portfolio and invest it in other lower risk un-leveraged strategies. We all need to be able to sleep at night. As an investor your goal should be to get as much capital as possible invested in un-leveraged strategies. Leverage is merely a stepping stone to speeding up a wealth building process until a pre-defined level is reached.
A simple rule in a trading plan such as not allowing more than 25% of your entire investment base to be exposed to leveraged trading will go a long way to protecting a portfolio from wipe out. Apparently the entire Lehman Bros business was leveraged at 30x at the time of its collapse!
6. Similarly, another mistake leveraged CFD traders make is that they continue to trade with leverage in unfavourable markets trying to recoup losses.
Let’s look at an example.
At Share Wealth Systems we provide investors with SPA3 un-leveraged and SPA3CFD leveraged trading rules. When a client has a large capital base (in-excess of $150K) we suggest they only take part of their capital and invest it in SPA3CFD, that’s if they would like to trade with leverage. Our research and experience tells us that the draw down with SPA3CFD will be greater than SPA3 un-leveraged.
I will use the current Share Wealth Systems SPA3CFD public portfolio to explain draw down in a little more detail.
On 30 May 2008, $40K was injected into the SPA3CFD public portfolio and the portfolio was leveraged to 3.2x its original injection. The portfolio was started near the beginning of a SPA3 Low Risk market which allowed both stock and CFD positions in the portfolio. To explain this further, SPA3CFD is designed to increase exposure in a rising market, or SPA3 Low Risk market, and decrease exposure in a falling market or SPA3 High Risk market. The system mechanically triggers the Low and High Risk market periods which removes discretion from the CFD trader.
Only weeks after starting the portfolio the market changed direction and SPA3 triggered a High Risk market. From the $40K injection the portfolio quickly retraced to $28,357 on 12 June 2008, a 29.1% drawdown in less than 2 weeks! I can clearly remember one customer ringing me and mentioning that the CFD portfolio may “ruin our reputation.” At the time I re-enforced that we firmly believed that the portfolio would come out of draw down at some stage and that we would continue our daily processes and trust the SPA3CFD EDGE. For the next six months the portfolio did as it is was designed to do. It held it’s own and only went down marginally through one of the steepest market retracement periods in the last 30 years.
The blue line is the SPA3CFD equity curve and the black line is the ALL-ORDS Index.
On 13 February 2009 SPA3 triggered a Low Risk market which allowed the portfolio to once again gain exposure to a potentially rising market. CFD positions could now be added to the portfolio with the purpose of capitalising on new potential market gains. However, the market did not rise immediately and the portfolio reached its maximum draw down of 39.25% on 12 March 2009 before it started rising. Let us point out that this is deep draw down but it is to be expected with leverage in an adverse market. Remember that the portfolio is leveraged at 3.2x it collateral compared to some CFD portfolios that leverage as much as 7 to 10 times, or even more.
From the maximum draw down on 12 March 2009 the portfolio has now risen 348.9%, or from $24,319 to $109,166. The principles of SPA3 have allowed the SPA3CFD portfolio to let the leveraged profits run during the good times and protect the capital from wipe out during the bad. We trusted our EDGE and continued to stick to the rules as we know that over a large sample SPA3 is proven to out-perform the index. Based on research, SPA3CFD should return around double the annual compounded returns than SPA3. These are the odds and we know that they are in our favour hence we can leverage with confidence. It also helps us minimise or potentially eliminate trading errors.
If you are considering using leverage in your investing endeavours please establish a set of rules before you expose your capital. If you set exits and have a pre-established plan you will have a higher probability of success than if you don’t. And always remember to not put all your eggs in a leveraged basket.