Leverage. Chapter 1 LEVERAGE. In this chapter, you will be able to:

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1 Chapter 1 Leverage In this chapter, you will be able to: Understand how traders magnify their profits with leverage Understand how to profit from the market when it is declining by short selling Identify the advantages and disadvantage of Contract for Differences (CFD) as a leveraged product LEVERAGE I was only 22 years young when I started trading. I was trading with barely $14,000 that I accumulated from years of savings, income from national service, and some bits of realized profit from investments in local companies, based on strong fundamentals. To many people, $14,000 is not a great sum of capital to be active in the market. As of the moment I am typing this, $14,000 would only allow me to buy 3000 shares of Starhub (at $4.28), or 1000 shares of Keppel Corp (at $10.54), and not even a 1000 shares of DBS (at $16.40). Therefore, the golden question: where did you get the capital to start trading so young? has never failed to be put across to me. 1

2 High Probability Trading You may have come across plenty of advertisements that look dubious and fishy, such as Secrets to making HUGE PROFITS in the stock market or How I turned $200 into $20,000 in a month! Let me be honest with you. They could be true; however, this big secret to making magnified profit is no secret at all. It is leverage. WHAT IS LEVERAGE? Leverage is a facility that enables you to gain large exposure in a financial market while only tying up a relatively small amount of capital. When you invest in a leveraged product, the provider will ask you to put up a sum representing just a fraction of the total value of your position. Effectively, the provider is lending you the balance. Your profit or loss is based on the full position, however. So the amount you gain or lose might seem very high in relation to the sum you ve invested. It could even be much greater than your initial outlay. Most amateur traders (buy and hold traders, etc.) trade using cash, meaning that if they want to buy $10,000 worth of stocks, they must have $10,000 in cash in their trading account. Professional traders trade using leverage, meaning that if they want to buy $10,000 worth of stock, they only need $1,000 (approximately) in cash in their trading account (i.e. they only need a small percentage of the amount that they want to trade). This is called a leverage of 10:1, or a margin size of 10%. 2

3 Leverage WAIT, SO WHY DO 95% OF US LOSE MONEY IN THE MARKET? If you have not heard by now, most people who trade or invest lose money. Most surveys estimate that 80 to 95 percent of traders have lost or are losing in the market. These statistics are dismal for someone who wants to venture into trading. Fortunately, many of the losers have common traits that contribute to their losses, and they can serve to help others become successful. Some of the most common reasons traders and investors lose money are: trading without a plan, poor money management, and lack of risk management. All of these strategies will be shared in my book, but I believe many people have overlooked another key reason why most of us lose money. According to statistics provided by MSN Money in 2012, only 10% of traders in the market have ever opened a short position. If you are wondering what a short is at this moment, you have probably fallen into the 90% of traders, who have contributed to the reason why 95% of traders and investors lose money. In finance short selling (also known as shorting or going short) is the practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them ( covering ). In the event of an interim price decline, the short seller will profit, since the cost of (re)purchase will be less than the proceeds which were received upon the initial (short) sale. Conversely, the short position will be closed out at a loss in the event that the price of a shorted instrument should rise prior to repurchase. 3

4 High Probability Trading Figure 1.1 Profiting from the long side: buy low and sell high. Figure 1.2 Profiting from the short side: sell high and buy low to cover. During the month of August 2012, the Singapore Straits Times Index retraced heavily by over 200 points (7%). 4

5 Leverage Figure 1.3 August 2014 Performance of Straits Times Index It may seem that there is absolutely no way to make money when the market is in such a bearish situation. Yet take a look at my accumulated trading record for that month. You will notice that I was still able to profit by $5,700, as most of the positions I took were shorts. Figure 1.4 My Trading Plan for August

6 High Probability Trading Therefore, you can profit from the market by buying (longing) stocks and selling at a higher price, or selling (shorting) stocks and buying back at a lower price. In my own opinion, this is one of the biggest reasons why many traders and investors lose money because they do not utilize the market opportunities of both bullish and bearish markets to make money. On this note, Contract for Differences will be essential to our trading as they are one of the most useful leveraged products available, and allow us to open overnight short positions that cannot be executed with conventional cash accounts. Hot Tip: Stocks fall three times faster than they rise. Fear is stronger than greed. Panic causes traders and investors to sell even more quickly than optimism entices them to buy. By selling short, you will make more money faster. CONTRACT FOR DIFFERENCE (CFD) A Contract for Difference (CFD) is a leveraged product that allows us to gain the same amount of market exposure by depositing just a small fraction of the total value of our trade. It is a rapidly growing market that is attracting an increasing number of retail traders from around the world. A CFD is simply an agreement between two parties (you and your broker) to exchange the difference between the opening price and the closing price of a contract. If there is a profit between the opening and closing price, this amount of profit will be credited into your account. If there is a loss, this amount will be deducted from your account. Similar to holdings shares, there is no expiry date in CFDs. You can carry a 6

7 Leverage position as long as you like, but there must be enough money in your account to support that position. CFD are traded almost the same way as trading shares. The price of the CFD on a particular stock counter will be the market price of the stock as quoted by the stock exchange. However, unlike shares, which are traded in a minimum size of 1,000 shares per lot in Singapore, the quantity of CFDs is not fixed. This means you can buy in quantities of 10s, 50s, or even 888s. WHY USE CFDS? There are many reasons why CFDs are an attractive financial instrument for traders. Below, I compare them with a conventional cash account that most of us would open to trade or invest or money in the market. Cash Trade (Typical Brokerage) 1. High Commission (Minimum CFD Trade Low Commission (Min. $10 $25, or 0.275%) or 0.08%) 2. No fixed quantity for purchase Minimum purchase: 1000 shares (1 lot) 3. Full payment of market value A fraction of market value (10%-30% usually) 4. - Higher Return on Capital 5. Does not allow overnight short positions Allows overnight short positions 7

8 High Probability Trading 1. LOWER COMMISSION COST A typical brokerage firm in Singapore will charge a minimum of $25 or 0.275% for online trading of local equities. There are also additional costs, such as the Singapore Stocks Exchange s clearing fee. By trading the same equity using CFDs, it will cost you a minimum of $10 or 0.08% with a typical CFD brokerage in Singapore. This is a saving of more than 60%! Example: Buying 20,000 shares (20 lots) of Sheng Siong, trading at $0.50. Cash Trade (Typical Brokerage) CFD Trade 1. 20,000 x $0.50 x 0.275% = $ ,000 x $0.50 x 0.08% = $8 (Use $10 as minimum is $10) 2. FLEXIBILE CONTRACT SIZES There is no fixed contract size: CFD brokerages allow their clients to trade in any size. You can trade any quantity, however small, as long as your margin deposit can cover it. For example, you could buy 888 shares of Sheng Shiong with CFD trading, instead of the standard 1,000 with a cash account. 3. PAYMENT FOR FRACTION OF MARKET VALUE The key feature of CFD trading is that it allows us to gain large exposure in a financial market while only tying up a relatively small amount of our capital. From the below example, we would only have to come up with $1,000 to own 20,000 shares of Sheng Siong using CFD, when the market value is $10,000. Example: Buying 20,000 shares (20 lots) of Sheng Siong, trading at $0.50. Margin for Sheng Siong is 10%, that of the typical CFD brokerage. 8

9 Leverage 4. HIGHER RETURNS ON CAPITAL Cash Trade (Typical Brokerage) CFD Trade 2. 20,000 x $0.50 = $10,000 20,000 x $0.50 x 10% = $1,000 As demonstrated in the above example, CFD allows you to make higher returns on your capital due to leveraging. Example: Profit from 20,000 shares of Sheng Shiong from $0.50 to $0.60 Cash Trade (Typical Brokerage) 2. Capital = $10,000 ($ $0.50) x 20,000 = $2,000 Returns on Capital = $2,000 / $10,000 = 20% CFD Trade Capital = $1,000 ($ $0.50) x 20,000 = $2,000 Returns on Capital = $2,000 / $1,000 = 200% 5. SHORT THE MARKET The ability to short sell when the market is down is perhaps the biggest attraction and advantage of CFD. When you trade shares, you are unable to sell without first owning the stock. For CFD trading, there is no such restriction. There is also no restriction on the period you can carry your short position. You can continue to hold on to your short position for as long as you have a big enough deposit to maintain it. In other words, you could open a short position today and buy back six weeks later to close the position. 9

10 High Probability Trading 6. CFDS FOR HEDGING CFD can be used for hedging a portfolio of stocks, or an individual stock. There are a number of ways to hedge with CFDs. We can hedge with an index or we can hedge with individual stocks that are already in our portfolio. DISADVANTAGES OF CFDS While the advantages of CFD trading are several, there are also many disadvantages. Disadvantages are primarily a result of the high-risk nature of CFD. 1. LEVERAGING CAN MAGNIFY YOUR LOSS The lure of making higher returns on capital can be very tempting due to our human emotion of greed. However, our losses can also be magnified with leverage. If we can win a marginal amount of profit from a small amount of capital, we can also lose a marginal amount of capital. Leverage works both ways. 2. INTEREST COSTS As we are buying with our margin, we will need to borrow to carry our position. In CFD, you will incurred an Overnight Funding charge. This borrowing cost in the long run can add up to a substantial amount. The longer you hold a long position, the higher the interest charges. However, the borrowing costs can be very insignificant compared to the total cost of your trading. The typical CFD brokerage charges overnight funding at 2.5% P.A. Yes, it is 2.5% per year. 10

11 Leverage Example: Buy 20,000 shares (20 lots) of Sheng Siong, trading at $ ,000 x $0.50 x 2.5% / 365 days = $0.68 per day. As the additional cost of borrowing CFDs is less than a dollar a day, it is safe to say that a CFD position is guaranteed to incur a lower cost than a cash position if it is closed within 7 weeks. 3. CHEAP COST AND LOW CAPITAL CAN LEAD TO OVERTRADING Overtrading can lead to losses and it can even become an addiction. Therefore, it is important to reduce the frequency of your trading by only trading the highest probability trades that will lead to profits. IMPORTANCE OF RISK MANAZGEMENT With leverage involved, the risk in trading CFD is much higher. Profits, as well as losses, could be magnified to substantially massive figures. A huge loss could lead to the destruction and demise of a trader. As CFDs allow a trader to hold a position far bigger than his or her capital, a trader can incur a huge loss when the trade turns against them. Therefore, risk management is a very important aspect of CFD trading. Traders need to limit and control their losses for every trade. I will elaborate on risk and money management in high probability trading in further chapters of this book. 11

12 High Probability Trading SUMMARY This chapter introduced Contract for Differences (CFD) as a leveraged product. Secrets to how traders make large scale of profit with minimum capital and short time period are also explained. We have also explored the possibility of why and how vast majority of the investors and traders loses money. The chapter is concluded with a defined comparison of the advantages and disadvantages of CFD trading to cash trading with a conventional brokerage account. 12