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Resident trader
Trading CFDs in a gapping market
Will Kraa, August 27, 2007
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| "He lost a lot of money on the market. The plastic funnel keeps him from licking his wounds." |
Today I was talking to someone about CFDs and what might happen if there was a large adverse move in the price of a CFD so that it gapped through the stop set for the trade. It is quite likely that this is something that has recently happened to some traders. The question is: what would happen if the loss were larger than the amount of money in the account? The CFD dealer would be seeking compensation and there would be a request for payment.
Some people think that since the CFD dealer would close the positions if necessary – it is unlikely you’d lose more than the amount in the account. Mostly, this would be true since CFD providers would first issue a margin call and, if that wasn’t met, would close positions as required to free up enough margin to cover open trades.
There are possible situations where this procedure might not be followed and then losses could exceed the value of the account. So this time instead of doing a real trade it might be instructive to do a ‘hypothetical’ trade.
We’ll go back to early 2003 when AMP had dropped steeply in price after bad news eroded confidence in the way the company was run. By March, it seemed the low had been reached and there was a small bounce in price in the middle of the month. For the rest of the month the price traded sideways and on 16 April the price gapped up to make a new high. There is a good trading method that trades such price break-outs and so a strategy could involve opening a CFD trade at $5.05 the next day. A stop could be placed under the last low at $4.59 for a risk per trade of 46 cents.
Using proper risk management, assuming an account value of $25,000 and risking 3% of the account per trade, the amount to be risked would be $750 and the number of shares to be bought would be 1630 for a trade value of $8231.50. This would require a margin of $412, assuming a 5% margin requirement.
With $25,000 in the account the temptation would be to open a larger trade seeing so much more margin is available. Often in promoting CFD trading the emphasis is on the possibility of using the leverage to open a much larger trade than would otherwise be possible. I have seen advertisements saying $300 would enable a $10,000 position to be taken and accounts can be opened for as little as $1000. This may lead some to overlook the risk inherent in using so much leverage.
So let’s say this trader had been mesmerised by the great opportunities for instant wealth now so readily available by trading this relatively new product. He might have done some successful trades in the past and is now confident of his skill and is ready for the big money. (Notice I said ‘he’ – naturally no female trader would be silly enough to do such a thing!). And of course if you buy, say, 20,000 shares, your account would increase by $200 for every cent rise in price – which is a very great attraction for those wishing for big profits. Just think of it: if this company just went back to trading at its former price of over $10, it would amount to profit of some $100,000. Not a bad return even if it took a couple of years to get there. And of course the margin required for this great anticipated return is only $5,050, well below the $25,000 available for trading.
So our adventurous trader decides that buying 20,000 shares at $5.05 is the way to go since it is just such a great opportunity for a real boost to the household budget, who knows, even a rather upmarket car or doing away with the mortgage is in sight! (I like the way the market gurus and get rich promoters always pose beside cars such as Ferraris and the like.)
The market opens on 17 April and the trade for 20,000 AMP at $5.05 is done. During the day the price falls a little and then goes up and over the next few days generally moves up nicely until by 30 April it is steady at $5.58. By now the account is fatter thanks to an open profit of $10,600 and the trader goes to bed happy with himself for being such a clever trader. Already he has made twice the amount required for the initial margin for the trade and he is well on the way to making some serious money. With this profit there is now enough in the account for some more good-sized trades.
The next morning as the market opens there is shock in store as AMP goes into a trading halt and announcements regarding writedowns and demergers are made. Then after some worrying days AMP starts to trade again but at $2.00 lower than the closing price before the halt. Now there are emails from the CFD company calling for substantial deposits of funds to be made to the account to meet not just margin calls but to make good a deficit in the account. It is likely there may even be a phone call.
Then reality dawns as the loss is calculated. As the market opens the marked to market value of the contract is 20,000 x $3.54 = $70,800 which is $30,200 less than the contract opening value of $101,000. The CFD company closes the trade since not only is there simply no margin left to cover the trade, there is a serious deficit.
So now the situation is that the account total when the trade was taken was $25,000; there has been interest to pay (the CFD provider did not charge commission at that time) and now there is the difference between the opening and closing of the AMP contract to pay. Remember – Contracts For Difference. The difference here is a loss of $30,200, leaving a deficit of more than $5,200 to pay. This amount is owing to the CFD company -the same as any other debt - and must be paid.
We are assuming that the trader didn’t have any other unprofitable trades while the AMP trade was in progress since such trades would most likely have been liquidated by now to help cover the outstanding margin required. If there were any such losses they would by now have been added to the amount owing.
He has lost his entire trading account and ended up with a debt to cover. Fortunately the debt is not excessive for most people and can most likely be paid by credit card. If the trade had been larger the debt would of course be larger too. But of course a loss of over $30,000 is a serious one especially if that is all the spare cash that was available.
So what has gone wrong in this case? In the first place the moving average on the chart shows that AMP was still in a long-term downtrend and the bounce in price does not mean that the long-term downtrend is over. You might remember in a previous article I mentioned Stan Weinstein’s advice never to go long a stock that’s trading below a declining 30-week moving average. AMP was certainly doing just that and therefore a long trade at this stage was risky in any case. This would have been all the more reason to be very careful in risk management.
But the most serious problem with this trade is the initial risk taken for the trade. If this trade had been unprofitable at the start and therefore had to be closed at the initial stop, the amount lost would have been 20,000 times 46 cents or $9,200. This initial risk was 37% of the account when the trade was opened. Such a high level of risk does give the potential to make a very large profit but also carried with it the possibility of a very large loss. This trade was quite possible and to those who know little about risk management it might seem attractive but it is far too risky.
Using a rule of risking no more than 3% would have meant that just 1630 shares should have been bought. Then the dramatic drop in price of two dollars would have meant a loss of about $2500, an amount that would have been easily covered by the free equity in the account.
Risk is a serious issue for traders and investors to consider at all times. Greater risk can lead to larger profits but also larger losses. It is therefore imperative that the amount of risk is in keeping with the ability of the trader to sustain losses. If the risk per trade is over 5% of the account, it is too large and can too easily result in catastrophic losses. At 5%, the balance between profit and drawdowns is probably optimal, but it is likely to lead to losses that most people would find too much to bear. A trading system with risk per trade in the range of 0.5% to 2% is suitable for most traders and will be most likely to lead to steady profits, while perhaps not spectacular, are sustainable. I use 3% in my CFD accounts usually but do have other funds to replenish the accounts if that should ever be necessary. I do not put the majority of my capital in CFD accounts. Since I do have other funds available I have at times used a higher percentage in my CFD accounts but I have learned that the drawdowns can be severe.
If you are new to trading I would suggest that you need to find out what size loss you can be comfortable with. Risk management strategies are useless unless stops are used and implemented. If a loss equivalent to 2% of your account is something that terrifies you then you cannot use that percentage. The losses will too large for your comfort and you will not be able to take them readily and you will tend to ignore your stops. It would then be best to use a lower percentage so that the loss is one you can tolerate. This will mean smaller profits but will get you in the habit of being able to keep to your rules and trade well. As confidence builds you will be able to increase the percentage gradually and so become more profitable.
The lesson to be learned is that too high a level of risk can lead to serious losses, and it’s possible to lose more than just the amount in the account. This also illustrates that when the money to be made from a trade is the main thing kept in view the outcome can be disastrous. Risking too much on each trade may for a time lead to large profits if luck is with you - but will inevitably bring disaster in the end.
So what about the recent market volatility and its effect on CFD traders? If the stocks you held in CFD trades on average fell in line with the overall market there would have been a substantial loss. Let’s say you had an equal number of stocks that can be had on 5% margin and those that have a 10% margin requirement. The average margin for all your trades would then be 7.5% and that would give a 13 to 1 leverage (100%/7.5%). So if the market dropped 3% you would lose 13 x 3% which is 39%, a very substantial loss and this would have led to a margin call if you were fully margined.
But if you were fully margined you are doing some very risky trading indeed. In my opinion it is not safe to use more than 60 to 70% of the margin available to you as a maximum. So that means at least 30 to 40% of your account is left as free equity at all times to cover adverse price movements.
In that case a 3% drop in the whole market would translate to a drop of about 25% (60% of 39%) in your account, assuming the long contracts you held fell in line with the overall market. That would also mean that a sharp drop in the market would not lead to a margin call. I did not get any margin calls during the recent volatility.
And I would suggest that it would be prudent to exit CFD trades when this sort of thing takes place, unless you have short trades to offset your long ones. Currently I have most of the capital in my CFD accounts as free equity until I can get some idea of what the market is likely to do. I am doing some trades but they are short term (not intraday) with close stops, careful risk management and exited as soon as there is a weakening of the short-term trend.
Calculations for the "hypothetical trade"
Opening price $5.05, initial stop at $4.59, risk per share $0.46
Risk for a trade of 20,000 AMP is 20,000 x $0.46 = $9,600.
Account size $25,000, initial risk for this trade is $9,600 divided by $25,000 = 0.368 or 37% (Far too high!)
Opening value of the contract is 20,000 x $5.05 = $101,000
Closing value of the contract is 20,000 x $3.54 = $70,800
Difference is $101,000 - $70,800 = $30,200.
Interest is about $250.
Owing to CFD provider $30,200 + $250 - $25,000 = $5,450.
Please note this is a hypothetical trade to illustrate what could happen. It is not a trade I have done and this sort of thing has not happened to me.
More articles from this week's CompareShares newsletter:
Markets: Trouble in China has investors guessing
Self-managed super: Old strategies are now even better
Sustainable investing: Climate change and consumers: hot air or real deal?
Fundamental analysis: Chief ratios for stock hunters - part 2
Resident Trader: Trading CFDs in a gapping market
Smart Investing: Experience tunes in to the market blues
Analyst report: Retail in a tailspin?
US markets: Long valuation waves and market fear
Sub-prime: Sub-prime what?
Ask the expert: Uncovering the average forex trader
Stock of the week: Mincor shares suffer from nickel freefall
CFDs: Pyramiding provides windfall to CFD traders
CompareShares Reader: Cloud gazing or tea leaves?
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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