• Pace yourself and start small...
• Understand the dangers...
• Guarantee your losses... and more...
   

From the overworked laptop of Julie Brownlee

Dear Investment Academy Reader,

Spread trading can be fun, fast paced and a great way to boost your profits. But it can also be dangerous for the unwary trader. For novices, the jargon can seem baffling at first. But don’t let that put you off! Here’s how to get yourself spread trading...

What you need to know to get going

There’s never been an easier time to get into spread trading. All you need is an internet connection (but don’t stress if you don’t, you can use the phone) and an account with a spread trading company, such as Global Trader, and off you go. However, while setting up an account’s simple, cutting through the jargon that accompanies trading can make it slightly intimidating. But don’t worry. Here’s the Investment Academy guide to everything you need to know to get started.

First steps

Once you decide to place you initial trade, you’ll have to decide whether to go “long” or go “short”. Going long means trading that the price will go up, while short means you think it’ll fall. This shows one of the main advantages of spread trading – it’s easy for ordinary investors to profit from both rising and falling markets.

When you decide to trade, you’ll be doing it on a specific instrument, such as a stock or an index like the JSE Top 40. Let’s take telecommunications giant MTN as an example. You think its share price will go up, so you want to go long on the stock. You do this by trading a certain amount of money per “point” that it'll rise in value. The size of a point varies depending on the asset. With a share it might be equivalent to a cent of the share price. So if you go long MTN at R10 a point, for every 1c that MTN rises, you’ll earn R10. Conversely, for every 1c it drops, you’ll lose R10.

When you place your trade, your provider will quote two different prices – the “bid” and the “offer” (or ask) price. The difference between them is the “spread”.

So MTN may trade on a spread of 10,000c-10,010c. If you place a long trade, it’ll be at the offer price of 10,010c, while a short trade will be at the bid price of 10,000c. When you come to close your trade – which you can do at any time – it’ll be at the other price. So if MTN rises from 10,000c-10,010c to 10,100c-10,110c, you’ll open your long at 10,010c and close it at 10,100c for a total gain of 90c – even though the underlying share has risen 100c. The difference between the two prices is where the spread trading company makes its profit.

Know your risks

As you can see from the example above, you can make a lot of money from a relatively small spread trade, but you can also lose a lot. Even if you had just bet R10 a point on a long trade on MTN, if the share fell by 100c, you’d end up losing R110. So a crucial part of successful spread trading is managing your risks and taking precautions to prevent big losses.

Some of this will be forced by your spread trading provider. After all, they don’t want customers running up bigger losses than they can pay. So when you place your trade, you have to pay a deposit to your provider, which is called the margin. This varies in size depending on how volatile or risky the asset you’re trading on is. For a share like MTN, it’ll typically be about 10% of your position, while trades on smaller, volatile shares may require a much larger deposit.

In our MTN example, if you trade R10 a point with the shares trading at 10,000c-10,010c and a 10% margin requirement, you’d have to handover R100.10 in margin (10% of R10 x 10,010c = R100.10). This reflects the fact that your total exposure is the same as if you owned R1,001 worth of shares (10,010 x R10).

In effect you’re putting up a small portion of the money yourself and borrowing the rest from the firm. Of course, this still leaves the spread trading company with the risk that you account will exceed the margin you have left with them. So, if your losses are getting so big that they threaten to exceed the margin you’ve made available, the spread trading company will demand you increase the size of it – otherwise called a margin call. If you don’t come up with the money, they’ll close out of your position at the current market price.

Don’t run your losses

While margin protects your provider from you running up losses, it doesn’t protect you much. If you rely on hitting your margin limit as a way to close out trades that go the wrong way, you’ll go broke fast. To limit your losses, make use of a “stop loss”, which is an instruction to your provider to close out your trade once the market price rises above, or falls below, a certain level. In the MTN example, you might set a stop loss at 9,900c. If the price goes below this, your position is automatically closed.

Note that a stop loss doesn’t guarantee the provider will be able to close your position exactly at that level. If the market “gaps” (prices rise or fall sharply), your loss will be greater. Many providers offer “guaranteed stop loss orders”, which are guaranteed to close at that level and provide an absolute maximum potential loss. This extra protection comes at a price, usually through a wider spread.

That’s a very quick fly through spread trading! In your next dose of Friday’s Investment Academy, we’ll be looking at spread trading forex.

Until then, happy trading!

Julie Brownlee
For the Investment Academy team