TD Direct Investing A Guide to Financial Spread Trading

Transcription

1 TD Direct Investing A Guide to Financial Spread Trading

2 Introduction This Financial Spread Trade/Trading (FST) eguide will help you to understand the background and principles of Financial Spread Trading. Financial Spread Trading is a derivative product, in other words a financial instrument that derives its value from an underlying asset, index or interest rate. During the past decade specialist providers have made FST popular with individual traders. They are regulated financial products in the UK and the Republic of Ireland. As well as FST there are four other main types of derivatives that are available to the individual investor to trade. Before you read on you should note the Risks highlighted below. This eguide is intended for educational purposes only and as such should not be treated as investment advice or a solicitation to make an investment decision based on the content of this eguide. Investors should be aware that the value of an investment can go down as well as up. You may not get back all the money that you invest. Please remember that financial spread trading is designed for active traders. Financial Spread Trading involves leveraged transactions, which means that you only deposit a fraction of the full value of the deal. Consequently profits or losses can quickly and substantially exceed your initial deposit and will require you to make further, possibly intraday, payments. Financial Spread Trading should only be considered if you have significant investing experience and knowledge, a thorough understanding of the risks involved and if you are dealing with money that you can afford to lose. If you have any doubt over the suitability of a particular investment for you then you should seek independent financial advice. The tax treatment of Financial Spread Trading depends on the individual circumstances of each client and Taxation Law and may be subject to change in the future. The information within this eguide is based on our understanding at the time of writing. Version 0.1 February

3 Introduction You need to be aware that FST is aimed at experienced traders rather than long-term investors or beginners. It is a very highrisk financial instrument that in many cases will be unsuitable for many traders. If you don t fully understand the intricacies of FST, do not contemplate trading before conducting further research, and/or taking advice from a financial advisor. It is crucial that you fully understand the product and associated risks before starting your financial trading journey. The UK Gambling Commission found that 15% of spread betters developed serious gambling addiction problems compared to just 1% involved in other gambling practices.* Never underestimate the emotions involved in trading you must understand how much you are prepared to lose, how much you can afford to lose and what your investment limits are. If you don t fully understand the intricacies of FST, do not contemplate trading before conducting further research, and/or taking advice from a financial advisor. *Source Money Advice Service 3

4 What is Financial Spread Trading (FST)? FSTs are manufactured as a way of dealing the price movements of assets such as stocks, bonds, currencies, indices and commodities without ever owning the underlying asset. They are synthetic financial instruments that are always manufactured by the FST provider and are traded directly with them. They replicate the price movements of the underlying asset and are quoted in a similar way to it. However, there is no central exchange where they are listed and traded. Instead they are made and offered by the specialist FST provider that you choose to deal with. This is known as over the counter trading (OTC). For that reason your account will be normally owned and operated by an FST provider, even when they are offered by a well-known brokerage such as TD Direct Investing. FSTs can experience rapid price movements. They are specialised instruments made and offered by the provider; your access to FST is through a specialist account using a dedicated dealing platform that has sophisticated order types for risk management and comprehensive tools and research. There are usually demonstration facilities as well as live accounts. 4

5 What is Financial Spread Trading (FST)? Experienced traders use FST to maximise their trading capital. This is because they only pay an initial deposit for the full value of the deal, which is known as trading on Margin, or leverage. This method of funding substantially increases your buying power. In most cases, FST also offers the ability of shorting in other words, they have the potential to profit from falling market prices as well as from market price rises. FST offers a very wide range of global markets and instruments. They have simple and relatively low trading costs as the price charged is the bid/offer spread. Subject to individual circumstances and applicable tax laws, these instruments can also offer tax-efficiency. Like other derivatives they are exempt from Stamp Duty, but there is a further tax advantage: FSTs are defined by HMRC as betting and therefore any profits are not subject to Capital Gains Tax (and losses cannot be offset against CGT). FST offers a very wide range of global markets and instruments. The benefits and potential rewards from trading FST come with a high degree of risk. FSTs require only a small initial percentage of the trade value as deposit, which magnifies the volatility of the underlying asset. This means that if markets move against you, losses can quickly exceed your initial deposit and require you to make further payments. These are known as Margin calls and may be made to you at any time, including intraday while the markets are open. If a margin call is not satisfied your position will be closed, crystallising a loss which you will be required to pay. This eguide will explain the risks involved in more detail. It is important that you understand and are comfortable with the risks involved before opening an account and starting to trade FST. To help you understand whether FSTs are right for you, you will always be required to pass what is known as an Appropriateness Test as part of the FST account opening process. This is a regulatory requirement designed to ensure that only experienced traders who understand the product and the risks are allowed to trade these instruments. 5

6 Key Information Although much of the industry refers to the product Financial Spread Trading, from a regulatory standpoint Financial Spread Betting is the official name given to this instrument, which is regulated in the UK and Republic of Ireland. In the UK they are regulated by the FCA (Financial Conduct Authority) and have the protection of the Financial Services Compensation Scheme (FSCS). FST originated in the gaming industry as spread betting. There are other forms of spread betting, such as sports betting. Those are gambling products rather than financial services products and are therefore not detailed in this eguide. There are also forms of Financial Spread Trading known as Binary Bets (or Binaries). While they may be offered by some providers, they are not regulated by the FCA and so again are not covered in this eguide. This eguide will discuss only those forms of Financial Spread Trading that are regulated in the UK by the FCA, where regulatory protection is given to the individual investor. They are treated as gambling products rather than investing in other parts of the world and for this reason some providers, and the regulator, call this instrument Financial Spread Betting. You should understand the nature of FST and the Terms of Service that will apply to you before opening a FST account. How FSTs are treated by the regulators is one major reason why they have a different identity to other available derivatives. They have separate trading accounts and trading platforms and their trades are not co-mingled with the other types of derivative available. FST originated in the gaming industry as spread betting. 6

7 Financial Spread Trading (FST) in more detail Financial Spread Trading (FST) has become a popular type of derivative offered in the UK because of its accessibility. Financial Spread Trading speculates on the variable price movements of underlying financial instruments. A FST is effectively an agreement made between you and the provider where you exchange the difference in value of a particular market or instrument, between the time at which the FST is opened and the time at which it is closed. In other words, when you open a new FST position you are entering into a contract directly with the FST provider to speculate on the difference between the opening and closing prices, which will either be in your favour you win and make a profit or you lose and suffer a loss. The size of the result depends on the amount of movement and the size of the trade. You are therefore speculating on the price movements of financial instruments such as shares and indices without owning the underlying asset. FSTs are not traded on an Exchange; they are always manufactured, quoted and traded OTC directly with the provider. 7

8 The bid/offer spread FSTs are made by the provider and quoted on thousands of different UK, European, US and Asian stocks, indices, sectors, commodities and currencies. Each FST is usually equivalent in value to one share or one point. A FST always has a quoted bid/ offer price spread, (hence the term Spread Trading ), which works in a similar way to the bid/offer spread on equity markets. The offer is the higher price at which you buy the position, the bid is the lower price at which you sell and the difference between the two is the provider s gross profit margin. This bid/offer price set by the provider therefore represents the cost you will pay to open a position and then to close it. It will reflect the bid/offer spread of the underlying asset but with FST it also contains the provider s profit margin and any related charges made to cover their risks. The spread makes instrument pricing easy to understand and compare across different providers. Unlike with equities and other derivatives there are no other trade transactional charges or commissions involved. There can be other costs involved and these are mentioned later. The width of the bid/offer spread helps create a competitive marketplace because providers need to offer as narrow a spread as they can to be competitive. It also means that providers derive their income in part from the bid/offer spread rather than simply relying on you making a loss against them on the trade. With FSTs you can, unlike on equity markets, deal in either direction. When opening a position you undertake to buy or sell a FST on a cost per point basis, deciding either that the market will rise (go long), or fall (go short). If you predict correctly and the market moves in your favour, you will make a profit. That profit will be your FST size multiplied by each point that the market has moved in your favour. If you are wrong you will make a loss of your FST size multiplied by each point that the market moved against you. 8

9 The bid/offer spread As with share trading, you decide how long you want to keep your position open and real-time prices constantly show your exact position and valuation. Rolling Daily FSTs do not have an expiry date, so you may decide to trade intra-day, overnight (subject to additional financing charges) or for longer as part of a hedging strategy. Because you are trading on Margin, your initial deposit required to open the FST is substantially less than the full opening value, typically 5%. There are also Quarterly FSTs aimed at slightly longer-term strategies - these do have an expiry date, generally after three, six or nine months. Unlike Rolling Daily trades these do not have a separate overnight financing charge. Instead, the cost of financing is again included as a slightly wider bid/offer spread. Because you are trading on Margin, your initial deposit required to open the FST is substantially less than the full opening value, typically 5%. 9

10 Trading on Margin When you buy shares on the stock market, you are normally required to pay for them in full. Your brokerage will quote you the price and you must pay for them by settlement day. So if you bought 10,000 worth of shares you will need to pay for the full 10,000 value. However, because FST is margined, you pay for them in a different way. In this example you might only be expected to pay 5% of the value of the shares as an initial deposit, i.e This deposit has given you exposure to the price movement of 10,000 worth of shares for initially just 500, which is known as leverage. If you think the shares will rise in value, your opening position will be to go long. If on the other hand you believe that the shares will fall in value, your opening position would be a sell and you will go short. Leverage magnifies your profits, but it can also equally magnify your losses. Let s assume that your FST position was a buy that was anticipating a rise in value and that you are correct. With the value of the shares increasing by 10% they are now worth 11,000 and you decide to close the deal by selling. If you had bought the actual shares, you would have made a 10% profit ( 1,000). However, since you bought the FST instead and only had to set aside 500 to make the trade, you made a 200% profit ( 1,000) when you sold. However, the same principle can work against you in reverse. In this example, if the shares had declined 10% in value instead, your loss on your initial FST deposit would have been 1,000, or 200%. This outlines two key points. The first is the power and risks involved with using margin trading, particularly when markets are volatile as price fluctuations up or down can be large and extremely rapid. Leverage magnifies the profit or loss and for this reason you should monitor your positions closely. It is good practice to deposit more than the initial margin requirement to allow for any margin calls should the market go against your initial position, including intraday. However, it also illustrates that losses could be far more than your initial deposit. Because of this it is essential that you plan measures to control the size of loss if the market moves against you by employing various forms of risk management tools, which are explained below. 10

11 Margin Calls Although you have only been required to put up an initial margin deposit, you should ensure that you have sufficient cash in your account to cover any potential loss positions as these can happen suddenly including intraday. If price movements mean that your potential loss is likely to exceed the initial deposit you made then the FST provider will contact you at short notice to top up your account with further cash so that your position can remain open. This is known as a margin call and how this call is made will differ between providers, though it is usually electronic. You should be fully aware of the procedures used before placing a trade, as markets can move quickly and funds may be required immediately. Alternatively, the position will be closed out by the provider and this will crystallise your loss. Besides margin calls, most FST providers also operate automated maximum limits to ensure your account balance remains in credit with them. Typically, a maximum limit is set at 80% of your initial deposit made, but these limits vary with provider and are designed to protect both parties. 11

12 Risk management tools and order types Financial Spread Trading platforms usually offer a range of order types when opening a position that can be used to help you reduce the size of financial losses, particularly when you may be unable to monitor your position. They are best seen as risk management tools. Stop Loss This is an order that closes out your position if it is going against you once a certain chosen price has been breached. It is good practice to set one every time you open a position. You can also add one to an existing open position and it can be adjusted or cancelled by you as prices change. Stop Losses are particularly beneficial where a position is left unmonitored because the Stop Loss will be triggered if the CFD trades at the price set. However, it will not account for those instances where a market price gaps (jumps from one level to another without trading in between), which can happen under unusually volatile conditions or overnight. When the market recommences trading it is at a price below the stop loss level set. If this happens, the stop loss would not be effective and instead your position would close at the next available price and your loss could be bigger than anticipated and crucially, could be bigger than your initial deposit. This is why Guaranteed Stop Losses (explained on the following page) act as a Gapping/slippage tool. Automatic Stop Loss It is now commonplace that all trades opened will contain an automatic stop loss, a compulsory feature of the trade. If a provider does not do this then it is good practice to set one every time you open a position. Whether compulsory or optional they will have some capacity to be adjusted to suit the individual trade. Stop Losses are particularly beneficial where a position is left unmonitored because the Stop Loss will be triggered if the FST trades at the price set. However, it will not account for those instances where a market price gaps (jumps from one level to another without trading in between), which can happen under volatile conditions or overnight. In the Spread Trading world this is known as slippage. If this happens, your position would close at the next available price and your loss could therefore be bigger than anticipated and larger than your initial deposit. 12

13 Risk management tools and order types Guaranteed Stop Loss This order type works like a Stop Loss but crucially also gives complete protection against market gapping/slippage in return for an additional payment and therefore brings additional peace of mind. View these as an insurance policy. Some derivative accounts offered are only available with Guaranteed Stop Losses made compulsory for every trade - though investors should remember that derivatives are still only suitable for experienced traders. A Guaranteed Stop loss will still only limit the size of your losses, not prevent them. Trailing Stop Loss These act in a similar way to a Stop Loss but move in tandem with the market price to protect profits as prices move up and down. The trailing stop allows investors to set a pip distance between the current price, and the point at which they intend to exit the trade. If the current price should fall by that number of pips, the position will automatically be sold. If the current price rises, the percentage level will be recalculated from the new high. Using a trailing stop is an excellent method for potentially minimising loss, whilst locking in profits in the event that the markets move against a position. Limit Orders These can enable you to take profit or make a purchase automatically if an order reaches a target market price. You can usually set these as being Good for the Day (GFD), Good until Cancelled (GTC) and some providers allow you to name an exact date the order is valid until. Buy Stop This has the opposite effect to a limit order. Placing this opens a position at the point you set, anticipating a price rise when your position is long. Sell Stop This will open a position at the point you set, anticipating a price fall when your position is short. 13

14 Market Choices FST offers thousands of diverse trading choices on Equities, Indices, Sectors, Commodities and Currencies. There is usually a Market Information Sheet from the FST provider that shows availability, the details about the instrument and the initial margin requirement. In addition, many markets are available 24 hours per day, with providers often open for business from Sunday night right through to Friday night. Unlike shares and other derivatives, trading is usually performed in a single base currency (usually Sterling) chosen when the account is opened. US Dollar or Euro can sometimes be specified. There are no foreign exchange conversions because your position is based on a points movement of the underlying asset, not the value of the underlying asset itself. FSTs can be traded on a wide range of global Equity markets including those from the UK, US, Europe and Asia. As well as trading the underlying equity, some investors use a spread trade with a technique called hedging *. This is where a FST short position is taken out with the intention of offsetting any potential short-term losses incurred by the long-term ownership of the underlying equity. This way the investor does not need to sell the underlying shareholding, so ownership and shareholder rights are protected and Capital Gains Tax on share profits is not crystallised. Indices are a popular way to trade an entire market rather than an individual share. Most global markets are available, popular examples include the FTSE in the UK, the Dow Jones, NASDAQ and S&P in the USA, or the Japanese Nikkei and Chinese Hang Seng. Sector FSTs work in a similar way, where you can take positions on individual market sectors such as Banks, Pharmaceuticals or Technology. Commodity FST gives direct exposure to commodity markets, ranging from oil and energies to base and precious metals to a wide range of agricultural products. Currency FST allows you to speculate on the movements of currency pairs in Foreign Exchange Markets. Popular examples include the US Dollar, Euro, UK Sterling and Japanese Yen and Swiss Franc, but there are many others. Most FSTs will allow trading in both directions, i.e. both long and short positions. This is subject to any requirements that may be set from time to time that may restrict short positions by a regulator in times of particular economic crisis. These restrictions will be clearly shown while in force. *Hedging can be a complex technique and you must understand it fully before using it. 14

15 Costs to look out for As with any financial instrument, it is important to understand all the costs involved and what you will be expected to pay, along with the Margin requirement. The Bid/Offer Spread Just like equity share trading, a bid/offer price is made by the FST provider on each instrument offered. As we have seen, this will contain the majority of any charges such as currency exchange, the bid/offer spread of the underlying asset, market and risk costs and the provider s revenue all rolled up into a single charge. There are no separate transactional commissions per trade and the spread varies by FST provider and the nature of the underlying asset. This has the advantage of being straighforward to understand and compare, though remember that any position opened must first overcome the bid/offer spread before it could move into profit. Occasionally there may be promotional offers made by providers to attract clients based on there being no spread (a so-called frictionless trade ). This may look attractive but remember that this will mean that the provider will only make money if you lose. Taxation Another reason for the popularity of Financial Spread Trading is their tax treatment**. Unlike equities, FSTs do not currently incur UK Stamp Duty on buys. This is because as derivatives they are synthetic and you do not own the underlying shares. In addition, any profits you make on FST are not subject to Capital Gains Tax because they are classed as a bet by HMRC, though any losses cannot be offset against capital gains for CGT purposes. Unlike equities, FSTs do not currently incur UK Stamp Duty on buys. **tax treatment depends on the individual circumstances of each client and maybe subject to change in the future. It is recommended that specific tax advice, where required, is obtained from HMRC or a qualified tax adviser. 15

16 Costs to look out for Overnight Financing Because FSTs are traded on margin, when you buy a FST there will be a financing charge made because you are effectively borrowing money to finance the purchase overnight. This will appear as a daily debit on your account. The opposite occurs when you sell a FST short; in this instance you are loaning money, so any interest is payable to you and will appear as a credit. Usually overnight financing applies to any positions remaining open after PM. These charges are usually based on LIBOR*** and applied to the full value of your position, not the margin amount. Because they are accrued daily they are only charged if your position remains open overnight. Be aware that these costs can quickly build on positions kept open for long periods. This is why many providers also offer Quarterly FSTs for medium-term positions where the overnight financing is built in the spread. This may be more cost-effective under these circumstances. ***London Inter-Bank Offered Rate. Dividends Generally, an equity-based FST will seek to replicate any dividend payments that occur on the underlying share on its exdividend date. If you hold a long FST position then a payment representing the dividend will be credited to your account. Conversely, it will be debited from an open short position. Dividends are paid net of tax and the effect on the underlying price is reflective of this. Guaranteed Stop losses As explained above, these usually incur an additional insurance premium to pay for the guarantee against the risk of market gapping. 16

17 Choosing a Provider There are a large number of FST providers in UK, so it is worth reflecting on how to choose one. Naturally, you will want your provider to offer competitive costs (through tight spreads) and attractive margin limits as well as the markets/instruments on which you wish to trade. The providers might be FST or derivatives specialists or they in turn may operate the service on behalf of well-known equity brokerages. FST is also offered by some Bookmakers. It is wise to check that the provider is regulated by the FCA and that your money is protected through the Financial Services Compensation Scheme (FSCS). When choosing a provider you should also consider the stability, security, speed of execution and ease of use of the internet based trading platform. You may also want a mobile trading option to be able to deal on the go. Customer service, reputation and the financial strength of the provider should not be ignored. The tools and educational materials offered to help you make decisions are important too: such features as real-time pricing, stop-losses, sophisticated charting, analysis and market news are all essential ways of helping you make informed trading decisions to manage your risks. Many providers offer online educational programmes, tutorials and seminars. Some offer telephone access as well as online trading. One reason to opt for a brokerage service such as that provided by TD Direct Investing is because the broker has researched and chosen to partner with a specialist who is a tried and trusted FST provider who continuously monitor their standards and reputation. You may also want a mobile trading option to be able to deal on the go. 17

18 Trading Strategies We have seen that FST offers the potential for high rewards but also carries a similar high level of risk, where financial losses can build up quickly and soon exceed the amount of you initial investment. For these reasons it is always wise to familiarise yourself with FST before placing a live trade, which is why demonstration accounts with virtual money are a useful way of learning the ropes and developing trading strategies. This is also why the Appropriateness Test is designed to ensure that FST is only used by experienced equity traders. A demonstration account can familiarise you with the basics such as charting, opening and closing a trade, placing stop losses and limits, instruments/markets and navigation. These are essential prerequisites but a demonstration account cannot replicate the emotion of trading with your own capital and you should recognise this and develop trading strategies that help control emotions. It is good practice to only ever trade FST with money that you can afford to lose and be aware that unlike equities, losses can potentially be unlimited and mount up quickly. Successful FST traders are disciplined in their approach and aware of the psychology and emotion that can influence their trading decisions. Never underestimate the emotions that can be involved with this level of risk and reward. Experienced traders do not usually trade up to their Margin Limit and ensure that their open positions are covered either by Stop Losses or Guaranteed Stop Losses. They use tools and research to help form their judgement rather than trading purely on gut feeling and they monitor their open positions closely. They will close a position and take a smaller loss rather than bet the farm on a single trade and have losses escalate beyond their resources. Many successful traders use small stake sizes and only risk 1-2% of their available capital on any one position. Capital preservation is as important as making profits. 18

19 In summary In summary, it is worth restating that Financial Spread Trading can offer individual experienced investors considerable trading opportunities. The rewards can be substantial but so are the risks involved. These are high-risk instruments that are not suitable for most investors. Only experienced traders will pass the Appropriateness Test, which is designed to demonstrate that they not only understand these instruments and their risks but are comfortable with them. FST offers a number of benefits such as market access, directional trading, leverage, favourable taxation and low costs. The FST providers invariably offer demonstration accounts and it is wise to familiarise yourself with their technology and tools first. Many also provide trader education and in-depth information that is designed to make you a more effective trader. This eguide has outlined some of the principles and risks of Financial Spread Trading. While the underlying principles are relatively straightforward for those that have experience in equity trading, these are high-risk instruments not suitable for everyone. If you would like to continue your Financial Spread Trading fact-finding journey, please visit for more information. 19

20 Legal Disclosure Brokerage Services provided by TD Direct Investing (Europe) Limited (a subsidiary of The Toronto-Dominion Bank). Incorporated in England and Wales under registration number Registered office: Exchange Court, Duncombe Street, Leeds, LS1 4AX, United Kingdom. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London, E14 5HS, United Kingdom (Financial Services Register Firm Reference Number ), member of the London Stock Exchange and the ICAP Securities and Derivatives Exchange. VAT Registration No Banking Services provided by TD Bank N.V. Incorporated in the Netherlands and registered as a branch in England and Wales under branch registration number BR Authorised by the Dutch Central Bank (De Nederlandsche Bank DNB Institution Number 481) and subject to limited regulation by the Financial Conduct Authority and Prudential Regulation Authority (Financial Services Register Firm Reference Number ). Details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request 20