A painful lesson on vagaries of the bourse

Thread Rating:
  • 0 Vote(s) - 0 Average
  • 1
  • 2
  • 3
  • 4
  • 5
The Straits Times
Nov 6, 2011
A painful lesson on vagaries of the bourse

Know the risks - or playing CFDs with a small outlay may land you with big losses

By Aaron Low

When I first learnt about Contracts for Difference (CFDs) last year, it seemed to me then that it was exactly the kind of investment tool I needed.

First, I did not need to stump up a huge amount to buy the expensive stocks I wanted, such as banking stocks and big blue chip firms.

Second, I liked the idea that I could go 'short' on stocks, which is to sell them, something that I could not really do on the open market easily.

Costs were also relatively low, so I could make frequent trades without running up huge transaction costs.

Lurking in practically all the information I read on CFDs was the quiet warning that CFDs were a risky business, largely because leverage cuts both ways, in that you can profit handsomely with only a small outlay but can end up losing big too.

Then, there was the issue of counterparty risk, which means that if my chosen CFD provider did not have the financial strength and goes bust, my investments in CFDs would essentially be worthless.

As such, I put in a small amount initially, to the tune of about $1,000.

I started off badly at first, losing about $150 in the first week of trading.

I realised I was reacting too quickly to small market movements, closing and opening new positions almost on a daily basis.

This meant that I was making multiple transactions, incurring transaction costs that ate into my capital.

I went back to do more research and look for strategies on the best way to use CFDs.

Armed with more knowledge, I went back into the market again, making bigger but more targeted buys.

Slowly but surely, I started to recoup my losses, riding on strong speculation into silver, and turned in a profit. At one point, my initial capital had tripled.

It was an amazing feeling. I was actually making real money trading, like the traders on Wall Street.

But it all came crashing down one fine day in August.

I took a gamble on commodity player Noble, buying a CFD comprising several thousand Noble shares valued at about $1.58 on Aug 8.

Markets at that time were getting jittery over the health of European banks due to the region's sovereign debt crisis.

I had believed, rather naively, that European policymakers would not let their banks implode, and would not repeat the mistakes of the 2008 financial crisis.

And if markets could see that Europe was getting its act together, Noble's price, which had seemed oversold at that point, would surely rise again, I reasoned.

But when the markets opened on Aug 10, Noble and the rest of the markets crashed.

Noble fell 11 cents that day, from $1.58 to $1.47, or about 6.9 per cent of its share price.

Eleven cents seem a pittance but due to the thousands of lots I bought, along with the leverage I had used, I was immediately hit with a huge loss that day.

All the profits I had made over the previous five months, plus some of my original capital, were wiped out in one day, over a period of several hours.

I could have held onto the position as I still had funds left to absorb further losses without risking a margin call - this is when my broker would tell me to top up my funds or risk having my position automatically closed due to a lack of funds.

But with a trembling hand, I decided to close all my positions that day, preferring to keep what was left of my capital and learning a valuable lesson about risk and the vagaries of the stock market.

Noble's share price continued to plunge hitting a low of $1.21 on Oct 3.

If I had tried to wait it out, I would have been deeper in the red. It was only in recent weeks that the firm's share price recovered. Noble was trading at about $1.56 on Friday.

It was not a lot of money I had lost, fortunately. But it was a shock to see how fast the markets could move, taking out unprepared investors such as myself.

Having an extra tool such as CFDs in an investor's toolbox, even if risky, is not a bad thing. But what is important is how one uses it; whether one understands the risks involved, not unlike like how we would treat fire.

I still use CFDs, although a lot more sparingly. I use them now to hedge against stocks I actually own.

This means that if I had bought 2,000 shares of a company, depending on where I think the market is going, I may use CFDs to short the stock to protect myself from falling prices.

So for me, the main lesson I had learnt from the use of CFDs is this: Know thy risk.


My Value Investing Blog: http://sgmusicwhiz.blogspot.com/

Forum Jump:

Users browsing this thread: 1 Guest(s)