How to stay in the game

When trading it’s natural to focus on profits and profits alone. But don’t be fooled when T.V. adverts tell you that that’s what the best traders do. They don’t! If you watch the financial news channels then you may hear talk of ‘love for the game.’ If you want to stay in the game, then preservation of capital becomes more important than accumulation. After all, if you manage risk effectively, you increase the scope of opportunity to make a profit. If you don’t, well, you only have one chance to lose everything. Get good at the game, and the money will follow.

We haven’t just written this special report because the markets are volatile. The concept of protecting your capital is every bit as important as growing it. This isn’t rocket science either – risk management needn’t involve any fancy financial engineering as we’ll see. Risk can be managed both before you even enter a trade and when you’re in the thick of it.

UK 100 vs. 5 sectors over 5 years

The above normalized chart shows the 5-yr performance of a few sectors compared to the UK 100 . Miners and oil & gas producers consistently underperformed the wider market, despite being some of the most heavily traded stocks! On the other hand, the less sexy telecoms, healthcare and consumer goods outperformed the UK 100 with consumer goods in particular continuing to strengthen through the second half of 2015 on a buoyant housing market and with defensives such as tobacco riding out market downturns impressively, even as the UK 100 declined.

A little research here can greatly reduce the risk of big losses before you’ve even entered a trade. We have this information at our fingertips and, as our client, so do you.

Check the wider market fundamentals

When preparing to enter a trade, it’s important to look at what the wider market fundamentals are saying as these affect the index. For example, much of the UK 100 ’s volatility of late can be attributed to China and the oil price. Some stocks tend to move very much in line with the UK 100 and it’s no coincidence that such stocks have been as volatile as (if not more than) the index itself. Have a look at what’s outperforming and what’s underperforming sector-wise, then look again within the sectors – there will be underperformers and outperformers there too. This is especially evident in the mining sector where commodities such as gold often benefit in times of heightened market volatility.

UK 100 sectors in 2015 and into 2016

The table above summarises the 2015 performance of four UK 100 sectors and their constituents. The outperforming Household Goods & Home Construction sector was itself outperformed by most of its constituents, while both Mining and Oil & Gas were underperformed by the majority of theirs, BG Group (BG.) being the notable exception, due as it is to be bought by Royal Dutch Shell (RDSB). Note precious metals miners Randgold Resources (RRS) and Fresnillo (FRES), benefitting from safe haven demand for gold in H2 2015 and into Q1 of 2016. Remember also that 2016 has only just begun!

Diversification

Diversity in a portfolio is key to hedging against the risk of unexpected market swings. If an investor goes overweight healthcare and airlines in their portfolio, what happens when all the M&A hype that’s buoyed pharmaceuticals for the past few years dies down, the sector becomes embroiled in scandal and Russia and OPEC conveniently broker a deal that leads to a modest recovery in the oil price?   ‘If only I’d bought that oil major!’ he or she may exclaim. That’s an imaginary situation by the way, but it’s possible.

Hedging using CFDs

CFDs provide a way to hedge that’s straightforward and cost effective; replicating the act of buying and selling the shares you’re familiar with while encompassing the concept of leverage that makes options and futures so useful.

The investor using CFDs benefits/suffers to the same extent as the traditional investor but has the advantage of not having to part with the full amount at the outset. He/she also saves on stamp duty as there is no physical purchase. Best of all, the CFD trader can take a positive or negative view.

For example, while traditional Barclays (BARC) shares require the full amount be paid up front (e.g. £10,000 outlay for 5,988 shares at 167p), an identical trade using CFDs involves an initial outlay of just £500 (BARC CFDs require a 5% deposit). The outlay is lower but the risk and reward are the same as if £10,000 of shares were held.

If you’re holding traditional shares – say £10,000 worth of J Sainsbury (SBRY) - and see the market start to come off, then you can take £10,000 worth of short exposure to SBRY using CFDs. You would require a £500 deposit to do so. If the shares fell 20% you would stand to make £2,000, offsetting the loss on your traditional shares (CFD leverage magnifies the return on your small deposit). If the shares gained 20%, however, you would of course be liable for the £2,000 loss, but that would be offset by the profit in your share portfolio.

J Sainsbury (SBRY), daily chart (source: IT Finance, 4 Feb)

Lower dealing costs mean that it’s more cost effective to enter and exit positions multiple times using CFDs which in turn makes them ideal for hedging against short term market volatility. The chart above illustrates just a few instances of heightened volatility in the SBRY share price. We can’t predict the future, so when a major break below support happens, the ability to hedge your portfolio is invaluable. CFDs are flexible enough to allow the investor to hedge short term adverse moves multiple times, bringing relative peace of mind.

For a more detailed rundown of CFDs, their mechanics, associated costs and some trading scenarios click here.

Going short the index

An alternative hedging strategy is to go short the wider index. If you’re already holding a diverse portfolio whose performance more or less tracks that of its parent index – say the UK 100 – then shorting the index using CFDs may be more straightforward than hedging your positions separately. Using this approach, you’re able to hedge your entire portfolio in just one trade, saving a lot of dealing costs in the process.

Trading the index: An example

If you believe the UK flagship index may fall to January lows 5598 and beyond, this implies at least 250pts downside from here. Going short the UK 100 index with one CFD contract (at £10 per point) would require a £230 deposit and net you £2,500 profit if called correctly – offsetting the losses in your share portfolio. If the index rose by 250pts, however, you would of course lose that £2,500 with that loss again offset by profits in your share portfolio. In both instances, though, the trade has insulated you from market volatility.

You can limit your potential loss with the use of a stop loss. For example, you might decide to go short at £10 per point using a 100pt stop loss. If you call the direction wrong and the index rises by 100pts, you would be stopped out with a £1,000 loss on that trade, with your shares continuing to post gains beyond.

Of course it is completely up to you A) how much you go into the index (2/4/6/10/20/50/100/1000 pounds per point) B) whether you go LONG (think the index will go up) or SHORT (think the index will go down) and C) how far you place your stop loss away if at all (limiting your potential loss).

Averaging in

The above table illustrates how a 5/10/20% fall in price requires a bigger percentage recovery in order to achieve breakeven. While buying more as the price falls may seem counterintuitive, this is actually the practice of the contrarian trader. Contrarians buy when everyone else is selling and sell when everyone else is buying.

‘Doubling down’ or ‘averaging in’ are thus valid strategies, widely used by speculators and can prove highly successful in mitigating losses too. If the price of a held security moves down, the investor may purchase more shares at lower prices. This acts to lower the average price paid per unit – hence ‘averaging in’ – and therefore lowers the amount (in percentage terms) the price needs to recover to breakeven.

Averaging in:  An example

Dave is holding 1000 shares in the blue chip company XYZ PLC (XYZ) that he purchased for £10 each. His exposure is £10,000.

An unexpected market downturn causes the XYZ share price to fall by 50% to £5.

Dave now buys 1000 more XYZ shares at the new price of £5. Since Dave now holds 1000 shares at £10 and 1000 shares at £5, the average price he paid for his shares is now (£10,000+£5,000)/(2,000 shares) = £7.50/share

His exposure has increased to £15,000.

Importantly, a 50% fall in the XYZ share price meant that a subsequent 100% recovery would be needed for Dave to break even at the original price of £10.

Dave thought this unlikely to happen, but his analysis suggested that the market should nonetheless improve in the coming days. He bought more at £5 because that lowered the average price per share to £7.50, a more realistic 50% above the new price of £5. If shares go back up to £7.50, then Dave has broken even. Phew!

If shares do indeed go on to recover to £10, then Dave stands to make back his original £10,000 investment and see his second tranche of shares return £5,000 in profit.

In the event that the share price continues to fall, however, the now greater exposure will cause losses to increase. However, Dave protects himself by placing a stop loss 10% below the price at which he averaged in. This limits any potential loss on his second position to £500 should the price continue to fall.

Investing in safe havens

Gold is a traditional go-to when equity markets are tanking, and has regained its poise in early 2016 due to uncertainty about US monetary policy and supply having peaked. In an environment where US interest rates are set to stay low for longer, gold becomes more attractive due to a weaker US Dollar. There are several ways to invest in the yellow metal, both directly and indirectly:

Bullion: Physical gold, which is usually priced a little above the spot price and must be stored.

Gold ETFs: An accessible way to invest in funds that track the gold price.

Gold mining stocks: Miners are a popular way for investors to speculate indirectly on the gold price.

CFDs / spread betting: Gold, ETFs and equities are just some of hundreds of markets that can be traded on CFD and spread betting platforms.

Using Stop Losses

Always be prudent to consider what you could lose on the trade before deciding whether it is worthwhile in the first place. You should always ask yourself the following when preparing to enter a position:

1. What’s the worst case scenario?
2. Just how far will I let the price move against me before calling it a day?

The idea of taking a loss is difficult to swallow, but if you’ve managed risk effectively enough then it’s perfectly feasible to bank a profit with just one good trade out of three. How? The answer is known as ‘risk/reward’ (which is actually calculated by dividing the reward by the risk).

Risk/Reward

In setting up a trade, the investor will compare the expected profit with the potential loss. The higher the number the better; if the potential profit is twice the potential loss then a 50% success rate will still make money. If it’s 3 times, then a mere 33% success rate is all that’s needed, and so on.

On its own, the use of stop losses and profit limits is possibly the simplest form of risk management. Placing a stop loss at a level at which you are happy to put your hands up and say ‘I’m out’ will protect you from the sorts of losses you may be absolutely UNcomfortable with!

Before taking a position in the markets, be sure to contact Accendo for…

• Updates - How do things look in terms of investor sentiment?
  • What’s going on in the markets and round the world?
  • News and broker updates emerge daily affecting prices.
• How to use CFDs and Spread Bets to maximise your profit potential.
• How to use the tools available to minimise the risk involved

At Accendo Markets we don’t tell you what to do. It’s your call whether you buy or sell. Our aim is to provide the help you need highlighting opportunities which may be profitable to you, the trader, and assist you in making trading decisions which can benefit from the use of leveraged instruments.

Our unique and award-winning service provides you with the help and tools you need to make appropriate trading decisions in the financial markets, both to grow and protect your capital.