Cover story
Trading
derivatives
Professional investors use
derivatives for a variety of
reasons, whether it is to hedge
against a market crash in an absolute
return fund, boost the dividend in an
income product or even to super-size
gains if they have a strong conviction
in the direction of an instrument.
Managers who engage in practices
such as short selling will have a level
of insight into the market that retail
investors can only dream about, yet
as AJ Bell’s head of active portfolios
Ryan Hughes points out, even they
can get it wrong.
“Going short, or betting that a
stock will fall, is a very dangerous
strategy that should be used with
caution, with many professional
investors failing to get it right,” he
says. “The risk here is that you have
the potential for unlimited losses as
the share price can keep climbing
and climbing. Done well, it
can bring useful
diversification
to a portfolio,
but
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done badly, it can have damaging
consequences.”
Investors do not need to look too
far into the past to see where this can
go wrong. Electric car manufacturer
Tesla regularly tops the list of most
shorted stocks in the US due to issues
such as a weak balance sheet and
failure to turn a full-year profit. Yet
it spiked by close to 40 per cent in
a matter of days in early February,
leading to total year-to-date losses of
$8.31bn for traders short on the stock.
Following a surge in the number
of sites offering retail investors the
opportunity to spread bet and trade
contracts for difference (CFDs), the
FCA forced these providers to reveal
what proportion of clients end up
losing money. Figures of about 70 per
cent seem to be the average.
A key aspect of this type of trading is
leverage. Which brings us on to
our next point.
Levering
up
Gearing, levering up, or simply
borrowing money, is one of the
strongest weapons in the investment
trust arsenal and is one of the key
reasons why they outperform.
However, Annabel Brodie-Smith,
communications director at the
AIC, says retail investors should not
attempt this at a personal level.
“Gearing amplifies performance
in both directions, so when an
investment company’s portfolio is
performing well, it will boost returns,
but when the portfolio is going
through more difficult times, it will
accentuate losses,” she explains.
Hughes adds: “Gearing is very
different to retail investors borrowing
to invest, not least because the lender
is likely to be able to call in the debt
with little notice, potentially causing
issues if your investments have fallen.”
This brings us back to spread betting.
Retail investors on these sites can lever
up by 5x on individual shares and 20x
on indices – which, in an industry
where 70 per cent of customers
lose money, is a recipe for disaster.
Stories of people losing hundreds of
thousands of pounds are widespread.
strategy for professional investors,”
he says. “However, retail investors
need to have a good understanding of
the costs involved as it is often much
more expensive than people realise.
Additionally, get your currency position
Three years after the referendum
wrong and you may undo any of the
on Brexit, sterling can still move
good you did through stock selection.”
violently on a statement from
Again, leverage often plays a part: you
the prime minister about trade
can trade 30x your original investment
talks. While you may be tempted to
in currencies, but it is not just retail
play these swings with dreams of
investors who have been wiped out in
emulating George Soros, Hughes says this area. In 2015 the sudden removal of
the reality is less glamorous.
a cap on the Swiss franc pushed broker
“Investing in different currencies,
Alpari (UK) into insolvency when its
either actively or to hedge, is a common clients couldn’t cover their losses.
Betting on
currency
movements
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