Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders Read online

  There are also many useful resources on the website fo r this book:

  systematicmoney.org/lever aged-trading These include spreadsheets that you can use to help implement all the trading systems i n this book.

  ¹ If you aren’t familiar with some or all of these products, don’t panic. I explain them later in the book.

  ² A hedge fund is a type of investment fund where leverage is usually used.

  ³ A stop loss closes your trade when the price reaches a predetermined point. I explain stop losses in more detail later in the book.

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  74 I don’t cover options or binary options. These are fundamentally different products, and I would need to write at least one more book to explain them properly. I would advise beginner traders to avoid options. I would advise absolutely everyone to avoid binary options, which are incredibly expensive and dangerous.

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  75 You will probably have heard the term ‘Forex’ used to describe foreign exchange trading, often pronounced ‘Four-Ex’ (which makes it sound like an Australian beer). I prefer the acronym ‘FX’, pronounced ‘Eff-Ex’, which is used by professional traders. It’s also quicker to type.

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  76 I also discussed the idea of Semi-Automatic Trading in Systematic Trading , but there is much more detail in this book.

  Introduction

  Anyone who is contemplating risking some, or all, of their bank balance in trading needs to be aware of one imp ortant fact: The majority of traders lose money.

  There is plenty of evidence to support this depressing statistic.

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  77 For example, a US study in 1999 found that only 12% of traders were consistently profitable, whilst another in 2003 found that around two-thirds of day traders lost money. Before 2010, US

  brokerage firms did not have to report on customer profitability.

  You can see why they wanted to keep these figures under wraps; an analysis of this data in 2011 showed that only 25% of their customers wer e in profit.

  Traders in other countries are just as unsuccessful as those in the US. French financial regulators found that 89% of customers trading foreign exchange and CFDs lost money. Meanwhile the Polish regulatory body estimated that 80% of traders were losers.

  In Taiwan, researchers calculated that only 13% of accounts were profitable in any given year, and only 2% were able to outperform the market c onsistently.

  What about the UK? One of the quotes at the start of this book is from a UK broker: “81% of retail investor accounts lose money...”. This figure is typical in the UK FX, spread betting and C FD industry.

  The mistakes that losing traders make

  Perhaps the stark statistics above don’t faze you. You firmly believe that you will be in the minority of successful traders, due to your superior skill, high IQ or work ethic. I’m afraid I have to debunk your illusion. You will mostly be competing with traders with equal or superior levels of ability, intelligence and commitment. And, in any case, there is no guarantee that

  being a better, smarter or harder working trader will automatically lead to pr ofitability.

  So how can you avoid joining the ranks of money-losi ng traders?

  Importantly, all the research I’ve quoted above is based on studies of amateur traders, not professionals. Nowadays I only trade my own money, but in the past I have worked as a trader for an investment bank, and as a portfolio manager for a hedge fund managing billions of dollars. In my experience, professional 20

  traders don’t make the same mistakes as amateur traders. 78

  Amateur traders should learn from the professionals and avoid three key errors:

  Overconfidence: overestimating how successful you will be at trading.

  Over-betting: taking on to o much risk.

  Overtrading: trading too frequently.

  Let’s look at th ese in turn.

  1. Overconfidence

  It is very easy to become a trader. You just need a computer or smartphone, and some money (and with leveraged trading you hardly need any money at all). If it is very easy to become a trader, then surely it is very easy to become a successful trader? It is not. The markets are very hard to predict and even the best traders can’t predict them perfectly (or even well).

  Do not listen to the trading gurus who tell you that returns of 50%, 100%, 200% or more each year are possible if you buy their exclusive system or sign up to their virtual private trading room. Some professional trading funds, usually labelled with the moniker ‘top hedge fund’, will have the occasional stellar year: that’s just the way luck works. But over longer time periods, where their performance is more likely to be skill than luck, even the best hedge funds make relatively modest average returns of about 15% a year.

  Small retail traders do have some advantages over large funds, but these are massively outweighed by other factors. These funds trade dozens or hundreds of financial instruments, employ many highly-qualified experts, and invest millions of dollars in technology. Do you really think you can do significa ntly better?

  Whether you’re new to trading in the financial markets, or you consider yourself an expert, it’s important that you have realistic expectations of what is possible.

  Overconfidence is problematic enough, but it also encourages traders to make two other types of error: over-betting and overtrading.

  1. Over-betting

  It is more fun to trade with the hope of making big bucks from a small stake, than to earn pedestrian returns barely better than you could get from a b ank account.

  For this reason, people are drawn to the very riskiest kinds of trading – like penny stocks or obscure cryptocurrencies that can go up 100% or more in a few days. Massive risk means you have a chance of a massive reward, but it also introduces the possibility of massive losses. The trader who loses 20% in a bad year has to make 25% before they are even. But a trader who loses 90% of their capital faces the near impossible task of increasing their account ten-fold to get back to square one.

  Most amateur traders take too much risk and this is why most of them lose money.

  1. Overtrading

  Brokers constantly encourage their customers to trade more often.

  They provide fancy trading apps and pretty websites with nice charts. Many brokers have relationships with celebrity trading gurus who claim to be offering an educational service. Their real business is encouraging novices to trade more, so they can collect a cut of the brokerage commission which i s generated.

  Whilst writing this chapter I examined the accounts of a large UK

  CFD and spread betting provider. They made an average of $1,379

  in revenue per customer. Revenue for a brokerage company is a cost for their customers. The customers had an average of $500 on deposit with the brokers at the end of the year. Running a brokerage firm is clearly more lucrative than being a client.

  According to an old story, a naive client visiting New York and admiring the boats of bankers and br okers asked:

  “Where are the custome rs’ yachts?”

  Every time you trade you remove some money from your account and hand it to your broker.

  Limit your trading to the absolute minimum. Do not assume you will make sufficient profits to cover costs which are inflated by overtrading.

  Those are the mistakes that traders often make. Leverage will just make things worse. Le t’s see why.

  Why leverage is dangerous

  Leverage magnifies the three mistakes that retail traders typ ically make:

  Overconfidence : If you overestimate your ability to predict the markets, you’re likely to use more leverage. If you can easily make 10% a year, then why not use ten times more leverage and make 100% a year? But leverage magnifies your mistakes as well as your profits. If you’re not as good as you thought, or if you get unlucky, then you’ll lose a lot of money v ery quickly.

  Over-betting : It’s risky to trade Bitcoin, the cryptocurrency whose value collapsed by
half in a little over two weeks at the beginning of 2018. But trading Bitcoin with added leverage is terrifyingly dangerous. Even relatively pedestrian assets like US

  government bonds can become risky if you use the maximum leverage allowed by m any brokers.

  Overtrading : Leverage also increases your trading costs, so if you are overtrading your account you will be more severely punished. Suppose you have $1,000 and decide to buy gold. You pay $10 in costs for a $1,000 trade. Using leverage from a particularly generous broker you could buy 50 times more gold: $50,000. This will incur 50 times more in costs: $500. Your trading costs as a proportion of your account value have gone up fiftyfold: from 1% ($10 ÷ $1000) to 50% ($500 ÷ $1,000). You have burned up half your account just p aying costs.

  Easy access for amateur investors to huge amounts of leverage is superficially attractive, but incredibly dangerous if used recklessly.

  Why you should use a system when you start trading A trading system can help you avoid the fundamental errors made by most amateur traders: overconfidence, over-betting and overtrading. The systems I show you in this book are all carefully calibrated to use the correct amount of leverage, and with a trading frequency that’s crafted to suit the products you’re likely to be trading. They are based on realistic expectations of typical future performance, rather than wildly 20

  optimistic p redictions. 79

  When you are an experienced trader you will want to start making changes to these systems, or even start making your own calls on the market. I explain in the final chapter how you can do this, whilst still ensuring you’re safe from repeating the typical mistakes of amat eur traders.

  How is this book different from other trading books?

  There are thousands of books on trading listed on amazon.com .

  Most of them will make promises about the untold wealth you can have if you’ll just follow the author’s advice. The writers appear to know what they are talking about: you can find many of

  them posing on Instagram or other social media in their palatial homes or private jets, surrounded by attractive people, and waving large wads of d ollar bills.

  Sadly, most of these images are a facade. Most celebrity

  ‘traders’ don’t make huge fortunes from trading, although some make a good living from selling trading courses and books, and from kickbacks paid by brokers when they introduce new customers.

  The houses, jets and attractive people are usually rented for the day. You can buy a briefcase worth of fake money on eBay for a fraction of its face value. Truly successful traders usually keep very l ow profiles.

  I take a different approach. Here is what someone wrote when reviewing my first book:

  “It’s not often you come across a trading book that promises you nothing in terms of riches, trading from a hammock on a beach with your laptop or becoming a billionaire hedge fund yet delivers you most of the successful components to give you a trading edge over many other market participants.”

  Review of Systematic Trading , on amazon.com Just as in Systematic Trading , there is no secret recipe in this book that will allow you to make easy money in the market. I offer no guarantee of profits and you should not expect to make huge returns. Instead I offer a more realistic promise: if you follow my advice you will avoid making the errors that nearly every amateur t rader makes.

  Not everyone agrees with this approach. Here is a less complimentary book review:

  “I agree that the general principles set forth here are valid and useful. This work is marred, however, by an exceedingly pessimistic view of the kind of Sharpe ratios a skillful system developer can achieve...”

  Review of Systematic Trading , on amazon.com (The Sharpe ratio, as you will discover later, is a measure of the profitability of a trad ing system.) I respectfully disagree. Some people can indeed make very good money from trading. However, much of that is down to luck rather than skill, and few people will trade for long enough to know the difference. It is safer to be pessimistic: assume you don’t possess special trading skills and that you may well be unlucky.

  Consider a trader who is overly optimistic and trades accordingly, using too much leverage and trading too frequently.

  If they have been overconfident about their abilities, or if they are just unlucky, they’ll end up with huge losses.

  In contrast, a trader who is pessimistic about their likely performance will limit their trading and won’t use too much leverage. If things turn out even worse than expected, then at least they will have limited their likely losses. However, if things go well they will be pleasantly surprised. They should bank the unexpected gain with cool detachment. The trader will not dwell on the missed opportunity of additional profits if they’d only taken more risk or traded more often.

  So, this is not a book for fantasists. It’s for realists who think that avoiding mistakes is paramount: controlling your risks and tr ading costs.

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  77 Sources: ‘Report of the Day Trading Project Group’, North American Securities Administrators Association (1999), www.nasaa.org/wp-content/uploads/2011/08/

  NASAA Day Trading_Report.pdf ; Douglas J. Jordan and J. David Diltz, ‘The profitability of day traders’, Financial Analysts Journal (2003); www.financemagnates.com ; ‘Study of investment performance of individuals trading in CFDs and forex in France’

  Autorité des marchés financiers 2014; KNF report on trading in the over-the-counter markets, quoted in www.financemagnates.com/

  forex/brokers/knf-survey-polish-forex-market-shows-roulette-table-concept-80-lose-money ; Brad Barber, Yi-Tsung Lee, Yu-Jane Lian, Terrance Odean, ‘The cross-section of speculator skill: Evidence from day trading’, Journal of Financial Markets (2014).

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  78 Maybe that should be: most professional traders don’t make the same mistakes as amateurs. Hubris can affect even highly intelligent professionals and the very smartest traders are most at risk of believing themselves to be invincible. Take the hedge fund Long Term Capital Management (LTCM). LTCM employed star traders who’d worked at Salomon Brothers and several brilliant professors, including two Nobel Prize winners. They ran strategies with vast amounts of leverage and for a few years were incredibly profitable. Then, in September 1998, it all went horribly wrong, and the fund lost 90% of its capital within a matter of weeks. Nearly $5bn evaporated into thin air. There are plenty of other famous examples of professionals blowing up, but the vast majority of professional traders behave in a far more sensible way than the average amateur.

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  79 Having realistic expectations about performance also means that you shouldn’t expect to make a consistent profit every year, never mind the ‘guaranteed’ daily or weekly returns promised by certain online trading gurus.

  Part One: Fundamentals

  Chapter One

  Types of Leveraged Trading Product

  In this book, I cover several different kinds of leveraged products: FX, margin trading of stocks, CFDs, spread bets and futures. In this chapter, I explain how they work and the important differences between them. There is some technical detail, but this is necessary if you’re going to trade safely wi th leverage.

  Introduction to leveraged trading

  Before I discuss specific products, I am going to explain the concept of leverage in some detail and introduce certain key features of leveraged trading. Once you understand the general ideas, you will able to grasp the finer details of each product more easily.

  What is leverage?

  Leverage, or gearing as it sometimes called, is the use of borrowed money to make a bet on the price of an asset. The simplest kind of leveraged trade is where we borrow money to buy an asset, hoping that the price will go up (trading jargon for betting on a price rise is going long ).

  House mortgages

  This is like buying a house with a mortgage. If I buy a house that costs $500,000 and it goes up by 10% in price over the next year, then I will make $50,000. If I am renting the house out, then
I’ll also make a rental return. If you can earn $20,000 in rent after paying agent’s fees and maintenance, then the total profit will be a handsome $70,000. In percentage terms, that works out to 14%: 10% from the property going up in price, and a 4% r ental yield.

  But most people don’t buy houses outright, as only the very wealthy have that kind of spare cash. Instead, I would probably raise a deposit of $100,000 and get a mortgage for $400,000.

  Sadly, the bank is unlikely to give me the loan for free, I will have to pay some interest. With a 4% interest rate it will cost 20

  me $16,000 to service the loan for a year. ¹70

  The figures involved are summarised in the foll owing table.

  Notice that I have earned money from two sources: (i) the difference between rent and interest payments , and (ii) a leveraged ga in in price .

  Even if prices are unchanged, I make profits because my rent ($20,000) is greater than the mortgage payment ($16,000). This difference between what I earn from owning an asset (for a house, rent) and what I pay to fund the purchase (mortgage interest) is kno wn as carry .

  This example is a positive carry trade . If the rent was lower than the mortgage, then it would be a negative carry trade . ¹¹

  Similarly, certain assets will earn a return when we buy them.

  Shares in companies pay dividends – a share of the firm’s profits. Bonds pay a regular interest coupon. This return may be more than the interest we pay when borrowing (positive carry), or less than the interest (nega tive carry).

  I have also profited from a leveraged increase in price. In the original example (with no mortgage) I earned $50,000 on a $500,000 investment from the price increase: 10%. With a mortgage, after the house increases in value by 10% I still make $50,000, but this is now a 50% return on my $100,000 deposit.

  That is a five-fold improvement.

  Leveraged trading works in a similar way, but the deposit is known as margin (hence , margin trading is another term used for leverage d trading).