Alternative trading strategies

Jenny Lowe shows how a range of derivative-based instruments can improve your trading strategies

 Alternative trading strategies


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Falling share prices around the world can make anyone think twice about their financial plans. But while the dramatic price swings may have scared some investors, others have taken heed of Warren Buffett’s advice and are being ‘greedy when others are fearful’.

Alternative trading strategies, such as financial spread betting and using contracts for difference (CFDs) and covered warrants, enable investors to access a wide range of markets. By using such techniques and products, the investor can adopt a range of strategies, and hedge or speculate on a growing number of markets and asset classes, including indices, commodities, foreign exchange and equities, to name but a few.

Using leverage

It is fair to say that the days of leveraged trading being reserved for the use of institutional investors are long gone. There are, of course, critics of the use of instruments such as spread betting and CFDs. They argue that there is something wrong with a product that does not involve investment in the underlying share, believing it to be more of a gamble than an investment. But supporters of spread betting point to the flexibility that it offers investors by allowing them to go short or long of a particular asset and to gain exposure to a wide range of assets and markets.

Financial spread betting was first introduced into the UK in 1974, when IG Index was created to enable investors to trade the price of gold without incurring hefty premiums through the exchange controls applied if the metal itself was bought.

Having originally been used almost exclusively by City professionals, institutional investors and other ‘high-rollers’, spread betting is now beginning to reach even the smallest investors and is being used effectively as a hedging tool against falling markets.

Taking control of your portfolio

Albert Maasland, head of Saxo Bank’s London office, observes, ‘Over the past
12 months, we have seen more and more individuals taking responsibility for part of their investment activities. I think a lot of people traditionally passed money to third parties to manage on their behalf and have been disappointed with the returns.’

Like any other financial instrument, spread betting has its own particular advantages and disadvantages. The proceeds, if you have made a profit, are free of capital gains tax (CGT), you can gear your potential profit, there is the option of making money by going short and you have access to a number of different markets, including foreign exchange deals.

On the other hand, unless the investor places a guaranteed stop-loss with the bet, you can incur very large losses should markets move against your position. Placing a stop-loss means that the bet automatically closes when losses hit a certain specified level.

So, for example, say you want to bet on the FTSE 100, which is currently trading at 4,450. You are given a spread of 4,440 to 4,451. Now, if you believe that the FTSE 100 will end the day higher than 4,451 you would place an ‘up’ or ‘buy’ bet and place a certain amount, say £5, per point. If you are right, and the FTSE 100 rises to 4,500, you would make a profit of £245 (4,500 minus 4,451 = 49 points). However, should the market fall to 4,430 you would have lost £105 (4,451 minus 4,430 = 21 points).

Limiting the downside

But there are ways to limit the losses and allow you to get a good night’s sleep. Joshua Raymond, market strategist at City Index, explains, ‘There are several risk management tools available to traders to reduce their losses, one of which is the guaranteed stop-loss. This is the most popular tool, and it allows investors to place an automatic order so that if the market goes against them, the system will automatically close up the position.

‘So, for example, if I had bought at 180p and I want to make sure that I only lose if
the market goes down to 150p, I can put a stop-loss in at that level and be safe in the knowledge that if the market goes against me my loss will be limited.’

Having put something in place to protect your losses, you can also do this to lock in gains, with a tool that is referred to as a ‘limit to order’. Raymond continues, ‘Obviously, investors are not going to be able to be at their computer for the entire time, so there
is the option to set a profit target and the system will then automatically close out the trade when that profit is reached. The aim is to give investors as much flexibility as they need to manage their trades without being worried or having to be at their computer
the whole time.’

There are many similarities between financial spread betting and CFDs, as neither attract stamp duty and both offer a method of investment that is based on derivatives.
But unlike CFDs, an investor using financial spread betting does not have to pay any commission. This is because financial spread betting firms swallow the commission by charging a slightly wider bid-offer spread than is the actual market quote.

However, investors should not be put off CFDs by the prospect of having to pay a commission fee because they are actually very low, typically in the range of 0.1 per cent to 0.25 per cent. Any gains from CFD trading may also be subject to capital gains tax, whereas this does not apply to the proceeds of spread betting.

At the margins
CFDs allow investors to take long or short positions, and, unlike futures contracts, have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis, with margins typically ranging from one to 30 per cent of the notional value for CFDs on leading equities.

Therefore, CFDs are essentially a form of margin trading. The advantage of trading on margin is that it can give you a much greater interest in the underlying investment. For example, if you think a share is going to rise, and you have £1,000 to invest, you could buy stock of that amount. If you guess right, and the shares rise by, say, 20 per cent, you have made £200, minus dealing charges.

If, however, instead of buying shares with that £1,000, you open a CFD, you could gain 20 or 30 times more exposure to the upside, giving profits of £4,000 to £6,000, depending on the margin set by the CFD provider. But, you must realise that you also risk magnifying losses twenty- or thirtyfold if you get it wrong and the price of the underlying share moves against you.

CFDs linked to many FTSE 100 shares trade at margins of five or ten per cent. Therefore, rather than using your investment to buy 100 per cent of a block of stock, you effectively put down five per cent and buy a contract to buy or sell a further 95 per cent of a much larger holding.

‘Let’s say you want to buy £10,000 worth of a stock, which will cost you £10,000,’ explains Saxo bank’s Albert Maasland. ‘With a margin product, which CFDs and spread betting both are, you will only have to put up a percentage of the total value of that stock. So let’s say that’s ten per cent. If the stock is trading at £1 and you want to buy 10,000 units, you will have to put up just £100, as opposed to £10,000 if you went down the shares route.’

CFDs and pensions
An added benefit of CFD trading is that it is possible to invest in them within a pension, which makes them tax free. However, only a small number of companies providing self-invested personal pension (SIPP) wrappers will accept CFDs, and those that do have strict scrutiny and monitoring requirements before allowing an investor to proceed.

CMC Markets, for example, offers investors with a SIPP the option to invest, with limited risk, in CFDs as part of their pension portfolio. The CMC Markets Trader SIPP Account comes with SIPP-specific design features, including a ‘no-slip price guarantee’. This means that any stop order will always be executed at the price an investor requests,
and under absolutely no circumstances can an account ever go into deficit.

‘We offer a watertight account guarantee that those investing in CFDs within a SIPP with CMC Markets will not go into deficit no matter how much markets move against them, and they will not see calls made on their other investments within their pension portfolio,’ enthuses Andrew Jones, head of SIPPs at CMC Markets.

Seeking cover
Of course, if all of this sounds too much of a gamble, there is the alternative of trading through covered warrants. These are derivatives issued by financial institutions
that give the holder the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a specified price on or before a predetermined date in the future.

Covered warrants offer investors an opportunity to make significant profits, and
the gearing means that they are potentially more rewarding than ordinary share dealing. However, as with both spread betting and CFDs, this also means that the risks and potential losses are greater – although they do offer protection on the downside.

Similar to CFDs, covered warrants provide an investor with the same level of exposure as buying ordinary shares but at a fraction of the cost of the underlying asset. Also similar to CFDs, investors using covered warrants don’t have to pay stamp duty, but are subject to capital gains tax.

Vince Stanzione, an active trader in these instruments who runs the www.fintrader.net website, explains, ‘Covered warrants are issued and backed by the issuer, which is normally a major financial institution, the main ones being SG Warrants and RBS Markets.

‘The investor buys and sells the covered warrant via a stockbroker, either by phone
or online anytime during normal market hours, and each warrant has a bid and offer price just like an ordinary share. Covered warrants are listed on the London Stock Exchange and each warrant has a unique ticker code.’

Puts and calls
There are two types of covered warrants, a put and a call, and you will normally have a selection of expiry dates and strike prices. A put warrant is bought if you think the price of the underlying asset is going to go down. So, for example, if you are looking to invest in gold and you think the price will fall, you buy a put warrant and as the price of gold goes down the put warrant becomes more valuable.

Stanzione clarifies, ‘When looking at a warrant, as well as puts and calls you will see a selection of strike prices, such as 700, 800, 900 and 1000. You will also see different expiration dates, such as June 2009, September 2009 and March 2010.

‘The more time a covered warrant has until expiration then the more the warrant will cost. Also, the further out of the money the strike price is, the more volatile and speculative the covered warrant is.’

However, with covered warrants, the good news is that the worst that can happen is that a covered warrant expires at zero, so you cannot lose more than the price you paid for your warrant plus your dealing commission. You can also sell the warrant before expiry to a bank at profit or a loss.

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