Undoubtedly, spread trading being a leveraged trading product means that you can make much bigger returns than you could normally make by buying and holding traditional shares. A 10% move in a market could well translate into a 100% gain, thanks to the leveraged buying power of this trading instrument. However, losses can accumulate just as fast if you’re not careful which is why you need to have risk control.
Note that leverage by itself is not dangerous – it only becomes dangerous if it is abused and in this respect bad money management and overconfidence are a no-no when dealing with leveraged instruments. If you are too confident in your market view, you might end up staking too much money on a single trade or continue holding the position even when the market continues to move against you.
For instance, let’s suppose the price of Barclays stock is at 250p. Dave is convinced the price will rise to 300p in the next few weeks so he buys at £100 a point opening his spread bet at 250p. At £100 a point, Dave’s position is equivalent to holding 10,000 Barclays shares which equates to a market exposure of £25,000 (at 250p), even though his trading capital consists of just £3,500. However, the price of Barclays shares goes in the opposite direction and falls 15p to 235p – reducing the present value of Dave’s position by 15 x £100 or £1,500. (this leaves Dave with just £2,000).
However, Dave chooses to keep the position open, hoping things will turn round. The following day, Barclays suffers another 20p drop (20 x £100, another £2,000 loss) and suddenly Dave is wiped out with the provider automatically closing the trade as Dave has gone below the minimum required to hold the position.
Dave made two mistakes here:
– He took on a much bigger trade than was prudent by the size of his trading account, such that a 14% drop in the price of Barclays stock was enough to wipe him out.
– When things moved against him, he kept holding the position only for his losses to increase and eventually being forced to close his position due to insufficient margin funds.
Apart from betting a smaller amount per point – say £10 a point – Dave should have used a stop loss order to protect his position from continuing to accumulate losses. A good policy is not to risk in excess of 2% to 5% of your trading capital on any one trade.
Likewise it is important that you have appropriate profit targets when planning a trade – this can be as important as cutting losses short. Most traders tend to close their profitable trades too early and this is particularly common amongst traders who have incurred substantial losses in the past and thus look to close a trade as soon as its showing a profit. But the reality is that you have to let your profits – this is the only way to offset any losses you have incurred on your losing trades. Thus profit targets should ideally be 2 or 3 times the potential loss if you happen to be wrong on a trade. So if you bought at 100p, you might decide to place a stop order at 95p and have a price target at 115p. To exit your trade once your profit target is reached, you setup a limit order matching that price level.