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Australian market has always been fertile ground for those who have
wanted to experiment with the launch of new derivative products.
However, many of these have been less than stellar in there penetration
of the market, few have found acceptance among traders. The overcrowded
derivatives market has seen the coming and going of share ratio’s, the
limpness of single share futures and the failure currency and index
warrants to grab either the hearts or wallets of traders. Recent times
have seen the introduction into the domestic market of spread betting on
financial instruments. A distinctly English phenomenon spread betting
had its origins in sport betting and has quickly spread to cover most
financial instruments. Within the context of the domestic market spread
betting is offered by IG Index (www.igindex.com.au)
Groups such as IG Index offer spread betting over currencies, indices,
commodities and interest rate instruments. It is even possible to bet on
a downturn in the housing market via the UK National House Price
Survey. You can even bet on the change in house prices across varying
regional areas. Trade Example The structure of a spread bet is
quite simple and can best be explained with reference to an example.
Assume that we have a positive view on BHP and believe that in the
coming months it will move higher. We have a choice of instruments that
will allow you to trade this view and we choose to use a spread-betting
tool. The price quotations for spread bets are similar in theme to the
quotes for other derivatives. You have a series of expiry months, which
have different bid/offer quotes. As you would expect the quotes with the
shortest time to expiry have the lowest bid/offer spread. The
difference in spreads
across the various time frames is a reflection of interest costs or
holding costs. In this respect a spread bet is somewhat similar to an
option or futures contract where the cost of carrying a position is
reflected in the pricing. If the share were to pay a dividend during
this period then the prices would also reflect this cash based
transaction. It is important to note that the prices do not reflect any
bias by the quotation provider, they are calculated mechanically in much
the same way forward futures prices are calculated. In this example
let’s assume that we wanted to take a longer-term position so we opt for
the June bet. The next point we need to decide is the amount of our
bet, unlike other derivatives which have a fixed dollar value for each
tick a spread bet allows you to set your own dollar weighting. And as we
will see this decision is crucial to the management of the trade.
Imagine that we decide to risk $50 per point. So we have decide to buy June BHP at $50.00 per point, this means that for every point BHP moves we either make or lose $50.00. Based upon these prices we control $63,656 worth of BHP ($50.00 per point x $1273.12).
Like other derivatives when we engage this position we are charged a margin. This margin reflects our bet size multiplied by a deposit factor that it set by IG Index. The deposit factors for all instruments are available in their Product Disclosure documents.
Assume that our view proved to be correct and in the coming month BHP moves up and we opt to sell our BHP at the prevailing bid price of 1452.26. Our sale proceeds are $72,613 ($50.00 per point x 1452.26), this gives us a total profit on the trade of $8,957.
However it is always important to consider the worse case scenario of BHP suffering a strong reversal. If BHP had fell to 1150.00 and we opted to cut our losses we would have lost $6,156 on the trade.
This highlights the need for caution when dealing with any leverage instrument. The tendency of traders when they enter a leverage market is to take on as much risk as they can possibly fund. In most situations this is far too much risk and doesn’t reflect prudent trade management.
Position Sizing
Consider our earlier example of BHP, this example showed how quickly losses could accumulate with a large bet size. As mentioned earlier there is a tendency among traders to use all the available leverage and as a result suffer from a catastrophic loss. Since we can determine the size of our bet as being anywhere from $5 to $100 per point we need a mechanism of determining the appropriate bet size for our risk profile.
This is quite a simple endevour and is based upon our risk amount and the distance to our initial stop. For example assume that our initial risk is $1,000 and that we are using a 2 ATR stop valued at $0.45 or 45 points, you need to remember that bets are defined as points.
Based upon these figures our appropriate bet size is $1,000/45 = $22.22, Since we can only bet in round numbers we round this down to $22.00. Thus, if our position was to drop 45 points and we had bet $22.00 then our maximum loss would be $990 ($22 x 45 points = $990), slightly lower than our anticipated $1,000 because of our rounding down.
If we had a wider stop we would have had a lower bet size. If for example we were setting our bet size based upon a technical feature that was 65 points away our bet size would be $15.38 or $15.00 rounded down ($1,000/65 = $15.38)
Setting a smaller bet size gives the position room to move and allows the trade to develop. You can see that the size of the bet and the level of your initial risk are intertwined. If in our original BHP example we had an initial risk of $1,000 and a bet size of $50 then BHP would only have needed to move 20 points or $0.20 to trigger our stop. When you consider that at the time of writing the ATR(15) of BHP was 20.10, unless we were extraordinarily gifted in our timing of our entry or more likely very lucky our chances of surviving more than one day are extremely low. As you can see ego based bet sizing is very expensive, it much more prudent to base the bet sizing on some form of risk assessment rather than what you think you can tolerate.
We can back up this initial form of risk management by using a controlled risk stop. The controlled risk guarantees that irrespective of the market action on the day your stop is triggered the only loss you will suffer is that defined by your stop. For example if we had a position in AMP at 700 and a controlled risk stop set at 600 and the market opened at 500. Our stopped would be triggered and honoured at 600, so our loss is limited to our predetermined figure.
The capacity to set a guaranteed stop is one of the major advantages that the new firms providing spread betting and CFD trading have introduced in Australia. Overnight we have gone from a situation where brokers are reluctant to manage stops and traders are even more reluctant to take stops when they occur; to a situation where positions cannot be opened without a stop in place. This stop is then honoured by the provider irrespective of the prevailing market price.
Naturally the spread betting firm charges a margin for this facility but when compared to the slippage that can be encountered in highly leverage positions the cost is quite small.
Comparison
The question needs to be asked under what circumstances would you use a spread betting tool instead of simply going long the underlying or using an exchange traded option.
To answer this question you first need to be aware of both your motivations for trading and your experience. Often traders try and answer this question by simply asking which one will make me the most money. This unfortunately in one of those nebulous how long is a piece of string questions.
My feeling is that traders should not dabble in derivatives until they have had some experience at trading the underlying instrument. Trading the underlying will enable you to fine-tune both your methodology and your psychology in an environment that lacks much of the sudden death nature of derivative trading.
If you are at a time in your trading career where you feel confident with derivative’s then we need to break down the pro’s and con’s of spread betting versus other derivatives. The main competitor to spread betting are exchange-traded options, we can ignore single share futures because they are simply a non-event.
ETO Advantages
Imagine that we decide to risk $50 per point. So we have decide to buy June BHP at $50.00 per point, this means that for every point BHP moves we either make or lose $50.00. Based upon these prices we control $63,656 worth of BHP ($50.00 per point x $1273.12).
Like other derivatives when we engage this position we are charged a margin. This margin reflects our bet size multiplied by a deposit factor that it set by IG Index. The deposit factors for all instruments are available in their Product Disclosure documents.
Assume that our view proved to be correct and in the coming month BHP moves up and we opt to sell our BHP at the prevailing bid price of 1452.26. Our sale proceeds are $72,613 ($50.00 per point x 1452.26), this gives us a total profit on the trade of $8,957.
However it is always important to consider the worse case scenario of BHP suffering a strong reversal. If BHP had fell to 1150.00 and we opted to cut our losses we would have lost $6,156 on the trade.
This highlights the need for caution when dealing with any leverage instrument. The tendency of traders when they enter a leverage market is to take on as much risk as they can possibly fund. In most situations this is far too much risk and doesn’t reflect prudent trade management.
Position Sizing
Consider our earlier example of BHP, this example showed how quickly losses could accumulate with a large bet size. As mentioned earlier there is a tendency among traders to use all the available leverage and as a result suffer from a catastrophic loss. Since we can determine the size of our bet as being anywhere from $5 to $100 per point we need a mechanism of determining the appropriate bet size for our risk profile.
This is quite a simple endevour and is based upon our risk amount and the distance to our initial stop. For example assume that our initial risk is $1,000 and that we are using a 2 ATR stop valued at $0.45 or 45 points, you need to remember that bets are defined as points.
Based upon these figures our appropriate bet size is $1,000/45 = $22.22, Since we can only bet in round numbers we round this down to $22.00. Thus, if our position was to drop 45 points and we had bet $22.00 then our maximum loss would be $990 ($22 x 45 points = $990), slightly lower than our anticipated $1,000 because of our rounding down.
If we had a wider stop we would have had a lower bet size. If for example we were setting our bet size based upon a technical feature that was 65 points away our bet size would be $15.38 or $15.00 rounded down ($1,000/65 = $15.38)
Setting a smaller bet size gives the position room to move and allows the trade to develop. You can see that the size of the bet and the level of your initial risk are intertwined. If in our original BHP example we had an initial risk of $1,000 and a bet size of $50 then BHP would only have needed to move 20 points or $0.20 to trigger our stop. When you consider that at the time of writing the ATR(15) of BHP was 20.10, unless we were extraordinarily gifted in our timing of our entry or more likely very lucky our chances of surviving more than one day are extremely low. As you can see ego based bet sizing is very expensive, it much more prudent to base the bet sizing on some form of risk assessment rather than what you think you can tolerate.
We can back up this initial form of risk management by using a controlled risk stop. The controlled risk guarantees that irrespective of the market action on the day your stop is triggered the only loss you will suffer is that defined by your stop. For example if we had a position in AMP at 700 and a controlled risk stop set at 600 and the market opened at 500. Our stopped would be triggered and honoured at 600, so our loss is limited to our predetermined figure.
The capacity to set a guaranteed stop is one of the major advantages that the new firms providing spread betting and CFD trading have introduced in Australia. Overnight we have gone from a situation where brokers are reluctant to manage stops and traders are even more reluctant to take stops when they occur; to a situation where positions cannot be opened without a stop in place. This stop is then honoured by the provider irrespective of the prevailing market price.
Naturally the spread betting firm charges a margin for this facility but when compared to the slippage that can be encountered in highly leverage positions the cost is quite small.
Comparison
The question needs to be asked under what circumstances would you use a spread betting tool instead of simply going long the underlying or using an exchange traded option.
To answer this question you first need to be aware of both your motivations for trading and your experience. Often traders try and answer this question by simply asking which one will make me the most money. This unfortunately in one of those nebulous how long is a piece of string questions.
My feeling is that traders should not dabble in derivatives until they have had some experience at trading the underlying instrument. Trading the underlying will enable you to fine-tune both your methodology and your psychology in an environment that lacks much of the sudden death nature of derivative trading.
If you are at a time in your trading career where you feel confident with derivative’s then we need to break down the pro’s and con’s of spread betting versus other derivatives. The main competitor to spread betting are exchange-traded options, we can ignore single share futures because they are simply a non-event.
ETO Advantages
- Can trade both time and volatility, you can also set in play strategies that allow you to trade range bound stocks. You are not limited to directional plays.
- Well accepted, ETO’s have a long history in Australia.
- Strong standardisation.
- Can
deal with a variety of providers, you can also exit a position by
dealing with another trader as opposed to dealing with the same market
maker.
ETO Disadvantages
- Liquidity in individual positions can be an issue.
- On-line platforms immature, this means you may have to talk to a broker. Whilst this might not seem terribly onerous it does introduce problems for those who have brokers who are keen to give advice.
- The setting of stops is extremely problematic with most brokers unwilling to handle stops. This can lead to an open ended liability with written positions.
- Dealing with market makers can be an interesting experience.
- To the retail client it can seem as if the spreads are made up on the spot by the market maker.
- Whilst
there are some 50+ stocks which have ETO’s in reality trading is
confined to around 10 stocks, 4 of which are banks so the range of
stocks is very poor.
Spread Betting Advantages
- Available on a wide range of markets covering equities, indices, commodities and interest rate vehicles.
- Can set level of gearing, there is no fixed tick weighting which may preclude traders from trading derivatives such as futures contracts.
- Stops are mandatory in controlled risk accounts and are guaranteed.
- Strong liquidity; transparent quotes so you are able to deal at the price you see on the screen. There is no need to chase the market maker around trying to get filled.
- Mature on-line platform allowing the dealing in a variety of instruments from a single platform.
Spread Betting Disadvantages
- New to the Australian market.
- The possibility to set your own level of gearing will cause problems for undisciplined traders.
- You do have to deal with one party. You cannot open a trade with one provider and then arrange to close it with another.
I
feel the most interesting feature of spread betting is that it is a
derivative that appears to be gaining wide acceptance. If the experience
in the UK is a guide then products such as spread betting and CFD’s are
likely to gain a foothold in the local market. In the UK turnover from
spread betting is approximately ₤230 million per annum, this is a
sizeable figure when you consider that turnover is measured in
commission or spread not the actually dollar value of trades
