Aaron Lynch |
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The leverage question is one that inevitably strikes all traders at some stage in their trading. Most traders logically start with shares, most likely, ones you acquire then throw into the bottom draw. Interest is further sparked when a profit or a loss is returned on these shares and the thought, maybe I could do better if I was more active in my approach!
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For most the journey ends there, however, an increasing amount of everyday share holders are attracted by a more active approach and getting away from shares due to the limitations of large capital outlays and sometimes modest returns on their investment. That being said the next question is often the hardest to answer, as it takes in a steeper learning curve and a greater time commitment.
Which leveraged product should I trade? Options, Futures or Contracts for Difference? There are, of course some other vehicles like Warrants and Foreign Exchange, however, in the scope of this article I wanted to examine a share trader's progression to leverage, so it is most likely it will come in the form of the first three.
There is considerable study required to start trading these various tools actively as each has their own advantages and disadvantages. A case study is the easiest way to describe the difference between options, individual shares futures and contracts for difference. In this case we will use the major Australian bank, CBA (Commonwealth Bank). Let's assume that we are bullish on the share. We could attempt to go out and purchase, for example, 1000 shares at the approximate price of $32 per share. The $32 000 outlay is one that is beyond most traders when they begin, as their capital base prevents this.
This is where leverage becomes attractive; an account of $5000 would allow a trader to control 1000 shares without having to physically purchase them. The table below shows the three forms of leverage and the relevant bid/ask prices and cost to open the position, when the underlying market was trading at $32. We will assume that we can get filled in the middle of the spread, for our case study. A very important point to remember is that the margin or cost of your contract is not the risk in the trade.
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Instrument
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Bid
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Ask
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Contracts
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Margin/Cost
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Option
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0.48
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0.52
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1
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$500
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Individual Share Future
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$32.28
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$32.32
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1
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$900
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Contract For Difference
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$31.96
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$32.06
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1
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$3200
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These tools have different qualities associated with risk management; they also have different characteristics of returning a profit. We will look at the major differences in turn; however, we need to make a few assumptions regarding the movement of the underlying share price. For our case study we will factor an entry price into the leveraged products at an underlying price of $32, with the bullish sentiment continuing over the next five trading days and exit being triggered at $33. For the initial order using share futures and contracts for difference, we will use a trailing stop loss of 30 cents behind the close of each day we are in the trade.
All great traders look at risk first and foremost. The risk associated with these three trades, assuming our 30 cents trailing stop, is in the table below. The risk in both dollar amounts and percentage assume that there is sufficient liquidity and volume at our stop loss price. In a large share like CBA, in most normal market conditions, it is a fair assumption.
Another very valid point is that the call option provides a guaranteed up front risk, as the maximum we can lose is the premium paid for the option in this example, $500.
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Instrument
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Contracts
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Shares Controlled
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Account Size
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Risk $
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Risk %
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Option
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1
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1000
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$5000
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$500
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10%
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Individual Share Future
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1
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1000
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$5000
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$300
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6%
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Contracts For Difference
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1
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1000
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$5000
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$300
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6%
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With the study of risk completed the focus of the trader now turns to reward. As Safety in the Market students we always have an exit strategy in mind to lock in profits. This then enables us to measure the risk and reward scenario. There is a difference in these leveraged tools regarding how much we may make given that the market moves in our favour.
When the share price moves 1 cent the share future and contract for difference will generally move at the same rate. This is described as having a delta of 1. Options' trading tends to be a little different, with the options that we would use in ABC trading having a delta of around 0.5, when you enter the trade. It is important to note that the delta of the option will increase as the share price starts to move in the direction of the trade. The potential reward for this case study is in the table below assuming that the CBA share has moved from $32 to $33.
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Instrument
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Entry
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Exit
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Profit
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Reward Vs Risk
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Option
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$0.50
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1.25
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$750
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1.5 to 1*
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Individual Share Future
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$32.30
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$33.30
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$1000
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3.3 to 1
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Contracts For Difference
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$32.01
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33.01
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$1000
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3.3 to 1
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*I am assuming that we will allow the option to expire worthless without trying to retrieve any time value if the share price moves against us.
Looking at leveraged markets can be difficult to ascertain where you should start, based on the table above it may look like options are not the way to go. You must factor in that there is a limited risk component built into options and this is very attractive to traders. The downside of options is, that they can be a little complicated with the factors of time decay and volatility.
ISF's and CFD's do not have time decay in the same way as options and the volatility component is measured in a different way, as it is factored into the spread when you trade.
Two final points we will look at is the issue of paying (or receiving) interest with CFD's and also looking at the slippage that can be involved in these markets. When you go “long” in a CFD you will be charged a daily interest rate that is based around the standard cash rates, however, the exact amount varies between the CFD providers. This needs to be factored into the example we have used. We also must look at slippage in all markets, the ISF and CFD markets can have wide spreads and may make it difficult to execute at the exact price you wish. A factor of 5% slippage would be a good place to start your analysis with.
The table below looks at the overall effect of the move in CBA with slippage and interest accounted for, with the interest charges averaged for each day, as they will fluctuate with the movement of the share price.
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Instrument
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Underlying Move
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Slippage
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Interest
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Overall Return
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Option
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$1.00
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N/A
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N/A
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$750
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Individual Share Future
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$1.00
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$0.05
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N/A
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$950
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Contracts For Difference
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$1.00
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$0.05
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$8.00 per day
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$910
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An in depth case study of the benefits of these three markets is conducted at our Interactive Trading Workshops held regularly around the Australia. Investigating the different leveraged tools in this way is a great start to work out which instruments will suit you. I have often found that traders will form a niche view of where they want to trade and what focuses their interest.
Trading in leveraged markets can generate fantastic returns but remember that trade and risk management is critical to protect your capital.
Good Trading
Aaron Lynch