Know when to fold 'em

Jeffrey Hutton | 03 May 2012

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Jeffrey Hutton is a Morningstar contributor.

 

When it comes to trading contracts for difference - or CFDs - Kenny Rogers was right. You have to know when to fold 'em.

"You have to know how much you're prepared to risk," says Ashley Jessen, sales and marketing manager for Capital CFDs.

Jessen was one of the first people to set up a CFD trading account when they were first introduced in Australia in 2002.

That same year, he quit his job as a stockmarket guru at a financial education company to trade CFDs full time out of an office in Bondi Junction that he shared with other traders.

CFDs offer broad exposure to an asset without having to stump up all the money up front.

Want exposure to $10,000 of BHP Billiton (BHP) shares? Pay the margin, which can be as low as a few per cent of the total, and the trader taps into the share's commensurate gains and losses.

"CFDs are an excellent trading product, but it is wise for all traders to understand all the potential risks associated with trading a leveraged product," says Jessen, who co-wrote the 2009 book CFDs Made Simple.

In the years before the global financial crisis, traders piled into CFDs. But as equity markets stumbled, interest in CFDs slowed.

The number of CFD traders more than tripled from 9000 to 31,000 between 2005 and 2007, according to the publication Investment Trends. In the 12 months to the end of 2011, their number rose by 2000 to 41,000.

"People got excited during the boom years," Jessen says. "The CFD doesn't say you have to trade at 50 times leverage."

"This is about controlling leverage."

Jessen says novice traders should limit their leverage to between one and three times their margin payment, Jessen says. Pros might consider multiples of between seven and 10 times their margin.

Michael McCarthy, chief marketing strategist for CMC Markets, agrees that interest in CFDs has slowed.

On his company's website, a client can get exposure to BHP shares for a margin payment of as little as 5 per cent of the value. He says clients need to be aware of the risks linked to high levels of leverage.

"Leverage is the biggest issue that clients need to decide on," McCarthy says. "It's a basic economic principle - there's greater reward, but there's also greater risk."

Jessen recommends limiting losses to about 1 per cent of holdings. So, on an account worth $20,000, the loss an investor should be willing to accept on a given trade should be no more than $200.

Set the amount you are willing to see a particular share fall and divide that into the $200 and that determines how many shares of a given equity you should buy.

If you can't stomach anything more than a $2 slide in BHP stock, then you shouldn't buy more than 100 shares.

CFDs are handy tools to act as a hedge, experts say. One emerging trend is going long on the local sharemarket but offsetting that with CFDs that short the S&P 500 in the US.

A steady drip of bad economic news out of China has in part hurt BHP shares. Investors who are worried that more bad news is on the way could buy CFDs for BHP and safeguard their positions, Jessen says.

"CFDs are the most efficient tool to hedge a portfolio," Jessen says.

"You could be long 1000 shares of BHP and you can short 1000 shares in BHP through CFDs and you would be perfectly hedged."

Hedging is key because it's tough to recover from steep losses. A 25 per cent fall in the value of an asset requires a 33 per cent gain just to recover, Jessen points out.

CFD trading is not for beginners, Jessen says. But getting a mentor could be a good way to get across detail fast.

Online discussion forums such as the ASX's TopStocks could yield some potential gurus. A potential mentor, who mirrors your values doesn't have to be a successful investor themselves, just mindful of how they could have done better.

"You want to find someone who walks the same walk as you," Jessen says.

"You want someone who has made plenty of mistakes."


 

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