Golden Rules of Investing

Lesson:
Innovation:
How tradings becoming easier
In association with

GOLDEN RULES OF INVESTING: LESSON 10

DOMINIC PICARDA

ASSOCIATE editor investors chronicle

Lesson 10
INNOVATION
How investings becoming easier
hort-term trading has grown enormously in popularity in recent years. Once the preserve of private investors who were wealthy and sophisticated enough to be able to access the futures and options arena, today it is possible to trade the worlds financial markets with just a few hundred pounds in an account. Although by tradition a publication for longer-term investors, Investors Chronicle has fully embraced the trading revolution of the last decade and more. As well as promoting technical analysis the inspiration behind many short-term trading ideas the IC has regularly recommended specific strategies and kept readers up to date with the latest innovations in the trading industry.

Dominic Picarda Dominic Picarda is an Associate Editor at Investors Chronicle and is in charge of its trading coverage. As well as writing the Trader column every week in the IC, he also writes regular trading tips for the Money section of the weekend Financial Times.

Of course, while we believe that owning shares and other assets should play a part in almost everybodys long-term financial planning, wed never say the same about trading. For all its benefits, short-term trading is fraught with risk and requires discipline and skills that require time and effort to acquire. In this supplement, well explore some of the most basic but essential aspects of trading today. As well as comparing it with mainstream investment, we will explore the vital question of whether trading is suitable for you. We will also consider key themes such as the use of leverage, how to plan and monitor your trades, the mentality needed for trading and the possibilities offered by mobile trading.

GOLDEN RULES OF INVESTING: LESSON 10

90%
Y

an estimate of how many traders end up losing money

TRADING vS INVESTING
ouve watched the FTSE 100 rising relentless over recent days. Although youre bullish about the long term, you reckon the index is due a significant sell-off over the next few days. So, you sell it short and watch your prediction come right as the market falls 5 per cent over 10 days. Your return, however, is 50 per cent. Welcome to the world of trading. If youre reading this booklet, youre probably already an investor of some description. Perhaps youve established yourself as a buy-and-hold investor in shares and fancy some of the excitement and rewards that short-term speculation can deliver. But, before you take the plunge, you need to understand the nature of trading and how it differs from long-term investing. Just because youve made money from buying shares or funds, doesnt mean youll automatically make a good trader. The skills involved are very different and have to be learned, usually the hard way. And whereas the average person who invests in a UK stock market tracker over many years can make great returns without trying, the average trader loses money over time. When investing, timing hardly matters. You can buy a share, watch it halve over six months, and then see it

Markets can remain irrational for much longer then you can remain solvent.
John Maynard Keynes, lifelong economist and sometime trader

rocket 10-fold over the next five years. The passage of time can turn bad decisions into great ones. As a trader, you should never take this approach. The name of the game is to get in and out at the right time at the best possible moments. And when you make a mistake, you need to admit it and cut your losses immediately. You dont have to choose between investing and trading. In fact, you should do both. The bulk of your wealth should be put into conventional investments for the long haul, such as shares, bonds, property and so on. The last few per cent the bit you can afford to lose without causing yourself any hardship is your trading pot. Start off small and learn the ropes. In fact, you might even want to start out your trading career using a virtual account, containing only pretend money. That way, you can get a feel for how the markets move in realtime without risking even a penny of your hard-earned cash. Above all, ask yourself why you want to trade. If youre a get-rich-quick type or have an addictive personality, put this guide down and stick to the long-term stuff. But if your answer is that you are fascinated by financial markets and want the satisfaction that comes from predicting the next move, read on.

GOLDEN RULES OF INVESTING: LESSON 10

proportion of monthly volumes placed via mobile at market leader ig index

5%

G N I D A R T LE I B O M

to d one of these apps Having downloade reals in nd s ha ice ur pr yo in low is fol g n he future of tradin your phone, you ca your re speculation is as well as monitor literally. More and mo time, buy and sell, done top e sk uv de yo py at wh lum k gh positions and chec being done not throu en op tial es. ten on po ph n even research s but through smart in the past. You ca t or laptop computer tha u s yo ice g pr hin the ryt of do almost eve calling up charts by s de tra Nowadays, you can d an ough a good mobile you follow. can from your PC thr rything eve do to le ab be g was seen as a bit soon you should tially, mobile tradin Ini e lied it bil mo a trading firms supp out trading from of a gimmick, and The great thing ab sit than to re g mo vin le ha litt m uld do es you fro thinking clients wo phone is that it fre have been ds. y rio the pe t d Bu de s. ten ice ex pr for use it for tracking in front of a screen e, with out the ength of the uptak your homework ab surprised by the str Once youve done ing a u yo ort , rep PC ur tly yo en m rec fro trade read-betting firm sp e on market you want to bile ur mo yo m via trades placed to buy and sell fro fivefold increase in can execute orders the at be to you happen nths. handset wherever you within 10 mo e got reception. So uv yo bile as g lon so time e advantage of mo . So, how best to tak ding opportunities the se su mi to t no neednt miss any tra nt ding? It is importa tra r ing be sie ea m ch fro that comes become that mu increased freedom Mobile trading has ans , es me on is ph Th t. art se sm nd of of age deal from your ha to le ab thanks to the coming ne do o als ve t would not ha iquitous iPhone, bu t trading when you no such as Apples ub is le lity og ibi Go ss m po uter. One ch as those fro so from your comp android models su rtain erry. Spread betting age alerts when ce ckB ss Bla me as t ll tex we e as eiv rec to and HTC, of e e tag tim van w. are met. ww s have taken ad charting conditions and other trading firm re. these devices to of y excellent service he ilit an ab d ers se off rea u totrade.e the vastly inc s. ion cat pli g ap launch special tradin

GOLDEN RULES OF INVESTING: LESSON 10

13
IN

the number of active spread-bettors who changed providers last year

Which kind of trading is right for you?

aving decided that you want to trade financial markets, youve got to pick what trading instrument youre going to use. And youre spoilt for choice these days: spread bets, contracts-fordifference, futures, options, covered warrants, accelerated trackers, geared ETFs, fixed-odds bets... Your choice of trading instrument will depend mainly on how much risk and return you want to seek, what

markets you want to trade, how long you want to trade for, and what your tax priorities are. Despite all the different names, the various instruments all have common features. They all involve leverage, are designed for shorter-term holding periods, allow you to make money from price falls as easily as from price rises, and trade a wide array of markets from one single account. The main reason for trading is

Maximum risk known up front

Spread bets CFDs Covered Warra nts Fixed-odds bets

Capital gains tax on profits Eligible for use in Sipps Currency risk

GOLDEN RULES OF INVESTING: LESSON 10

number of active UK spread bettors

83,000
WHATS WHAT
Futures, CFDS, and spread bets are all essentially the same product, with a CFD being little more than a mini-futures contract and a spread bet being a mini-CFD. If you buy an asset via one of these instruments and its price goes up or down, your profit or loss is basically the difference between the starting and ending price, multiplied by your position size. The same is true for a short position, where you gain if the price falls and lose if it rises. Covered warrants take a bit more thought than the more straightforward instruments mentioned above. They are specially designed products made out of traded options. But you have to take more into account than simply whether you expect the asset youre trading to go up or down. Specifically, you have to consider the amount of time left until the fixed date when the covered warrant is due to expire, as well as likely volatility in the market. RBS and SG are the two big issuers of UK covered warrants.

leverage, the ability to turn small moves in the market into much bigger returns. You have to want to use leverage if you want to trade. There is no point doing so if you dont. As to how much leverage you want to use and the type of leverage this depends on your goals and your appetite for risk see our diagram on page 8 for more. One key difference between the various trading instruments is taxability. Profits on all instruments that are classified as investments could be liable to capital gains tax, whereas profits on those that are classified as betting are entirely free from tax of any kind. The main tax-free trading instruments are spread bets and fixed-odds financial bets. Although their status might appear to give them an unbeatable advantage over taxable rival products, there are good reasons why you might want to trade taxable instruments. For example, if you make losses on CFDs, futures and the like which many traders do you may be able to write those losses off against other capital gains you have made elsewhere. Trading products generally offer a good way to spice up returns within a wider portfolio of investments or to lay off the risks in such a portfolio. If your portfolio is a self-invested personal pension (Sipp), however, the rules prevent you from using gambling products such as spread bets. By contrast, covered warrants or CFDs would be allowed subject to your Sipp providers willingness and own rules on this.

GOLDEN RULES OF INVESTING: LESSON 10

7.2
Geared exchangetraded fund (ETF)

the average leverage on FTSE 100 covered warrants

Typical leverage available from:

2x - 3x

2x - 10x
FTSE 100 Covered Warrant

Fixed-odds financial bet

3x - 20x

5x - 50x
Spread bet or CFD

10x - 500x
Foreign exchange trading

everage is what makes trading worthwhile. Its the force that turns small changes in a price into a much bigger return. It has created many millionaires and even more paupers. So what is leverage and how can it be used to make you rich rather than poor? Leverage also known as gearing simply means borrowing money to finance your trading. By using more of the trading firms money and less of your own, you generate much bigger returns either positive or negative. A diagram

Leverage: friend and foe

of how this process works is show below. Of course, we use leverage commonly in everyday life, perhaps without realising it. For example, you might buy a house for 200,000 by putting down a 20,000 deposit. The houses value then goes up to 250,000, making a handsome return on your original equity. The golden rule of using leverage in trading is to use only as much as you can responsibly take

THE POWER OF LEVERAGE Your stake = 10

Trading firm puts up = 90 Price changes = 10% 10/10 = 100%

GOLDEN RULES OF INVESTING: LESSON 10

the leverage you can get trading currencies

on. Just because a lot of leverage is available doesnt mean you should use it. A good rule of thumb is that the total value of each position you take should never be more than what youd take when buying actual shares. Lets say youd normally buy 10,000 of shares at a time. So, when trading, you should stick to a similar total position size. The problems arise when you use the 10,000 in your trading account to take out a position worth 100,000. If what youre speculating on then moves 20 per cent against you, youve now lost 10,000 more than you started out with. However, you do not necessarily have to use borrowed money in order to achieve leverage. Some instruments have built-in gearing, such that you can get exaggerated returns without the risk of losing more than your starting stake. Covered warrants are one example of this, as are fixed-odds financial bets. With both of these instruments, you are quoted at the outset a multiplied return that you will achieve if the price youre trading does what you think it will. For example, you might be quoted 10x gearing on a covered warrant, implying a

500 1
-totenfold increase in the warrant for each 1 per cent move in the asset that it is based upon. Or, you might be quoted a 1,000 per cent return on a fixed-odds bet, which implies the same sort of thing. However, the maximum loss on either of these two instruments is either what you paid for the warrant or the stake you placed on the fixedodds bet. So you can sleep easy in your bed knowing that even were the market youre trading to move dramatically against you overnight, your liability is completely capped. Aside from the risk of making outsized losses as a result of using leverage, you also need to bear in mind the ongoing cost of using it. When doing a spread bet or CFD trade, there is a daily financing charge on the value of your position. If it is a buy trade, your trading firm will debit interest from your account based on the total value of your position. In the case of a sell trade, you might receive a credit. The typical cost of running a long position is based on the inter-bank interest rate plus a couple of percentage points. In the current environment of ultra-low interest rates, this means the cost of holding a position overnight could be as little as 0.008 per cent of its total value. So, if you were placing a buy bet on the FTSE 100 worth 50,000, you would pay just 4 a day to keep it open. Nevertheless, it pays to keep an eye on financing costs, especially if you are in a trade where the price is just going sideways.

Give me a lever long enough and I will move the world

Archimedes

GOLDEN RULES OF INVESTING: LESSON 10

KEEP TRACK OF YOUR TRADING

28%
R

the applicable rate of capital gains tax on CFD profits

ecord-keeping will never be the most glamorous of tasks, to say the least. But, as a trader, you should always keep detailed records of your activities, starting from before you enter a position right up to when youre totting up your profits and losses to put on your tax return. Not only will you will save yourself time later on by doing all this, but you may also be able to become a better trader in the process. Especially if you become a very frequent trader, you may have very many transactions to report at the end of the tax-year. It is, of course, one of the advantages of spread betting and fixed-odds financial betting that you wont have to make any mention of your profits or losses when it comes to filling out your declaration to HMRC. Fortunately, virtually every trading firm makes this fairly easy, by allowing you to download precise records of the trades youve done in the form of an excel spreadsheet from the trading platform. You should always do this regularly, as well as getting your spreadsheet to give running measurements of your performance, including things such as volatility and time. Keeping a record of what trades youre planning to do and why is also an essential part of the process.

There is the plain fool who does the wrong thing at all times anywhere, but there is the Wall Street fool who thinks he must trade all the time.
Jesse Livermore

Writing out the logic for intended positions will help you hold yourself to account. Sometimes jotting down your idea can confirm whether it is valid or not. And, later, you will have something to come back to in order to help understand your thinking at the time, which should encourage you to repeat good trades and avoid mistakes. An example of how a basic trading log might look is shown to the right. Developing a standardised template like this means you can quickly and conveniently insert your ideas as they come to you. It is also wise to take a screen shot of the chart that inspired your thinking, as this will make it easier to reference later on. Theres no single correct way to draw up a plan like this. The most important things to note are your logic for entering the position, your entry level and targets, and the other things that youre going to be watching for during the trade. Conducting post-mortem after each position comparing the outcome of your trade with your expectations is an integral part of the process. It is just as necessary after a winning trade as a losing one. Be as honest as you can when appraising your results for example, if the successes are down to good luck more than judgement.

10

GOLDEN RULES OF INVESTING: LESSON 10

the applicable rate of capital gains tax on spread betting profits

Tradingplan
Market: Nasdaq 100 Price now: 1638 Date: 24 August 2009 Idea behind trade Nasdaq is in a strong uptrend and its occasional dips tend to end around the 34-day exponential moving average. Strategy Go long when Nasdaq pulls back to the 34-day exponential average currently 1591) Trade size: 10-a-point Entry target: 34-day EMA Exit target: 120 points Stop loss: 40 points Reward/risk: 3:1

0%
1900 1800 1700 1600 1500 1400

Jun Jul Aug Sep Oct Nov Dec

Key chart levels

Support 1591 - 34-day exponential moving average 1546 - 55-day exponential moving average 1600 50% Fib retracement Resistance 1713 lateral resistance dating from 2006-2009 period 1740 61.8% Fib retracement of bear market 1764 Raff Regression channel line

e Analysis Post-Trad ember at triggered 3 Sept

Order to go long ptember. ts at 1741 23 Se 1591. Took profi

11

GOLDEN RULES OF INVESTING: LESSON 10

months is the average time for a losing novice trader to wipe out his account

Trading Psychology
he key to becoming a successful trader isnt about being able to read intricate meanings in price charts or coming up with high-tech automated strategies. Its about mastering yourself, your own emotions and your own psyche. Once youve learned how you tick and how to control your reactions in a market situation, you stand a much better chance of becoming a profitable speculator. The biggest emotional challenge you will face as a trader is how to cope with losses. Doing a series of losing trades doesnt just shrink the funds in your account, it can also severely affect your confidence. You may find yourself asking yourself whether you are really cut out for playing the markets. Even worse, you might end up making even bigger losses if you react desperately in an attempt to regain money and pride. In the first place, you must accept that losses are an occupational hazard of trading. Even the worlds best traders regularly make losses. If they are small enough in relation to your wins, you can still make a profit even if more of your trades end up in the red than in the black. Taking a short break from the markets is often a good idea when youre having a bad run. There is

12

GOLDEN RULES OF INVESTING: LESSON 10

proportion of winning trades needed to break even with a 3/1 reward/risk

no disgrace in making a tactical retreat. Learning to admit when you are wrong is a key element in keeping your losses small. Too many traders hang on to losing positions in the vain hope that they will eventually come right. The usual result of such stubbornness is much bigger than necessary losses are incurred. Taking a quick, early loss and moving on to the next trade is the best policy. Aside from encouraging you to take silly risks in a bid to rebuild your account balance, the other effect that a losing streak can have on you is to leave you paralysed with fear. Your analysis identifies a decent trading opportunity but you are just unable to pull the trigger, and end up missing out on a profit. Or, when you do manage to enter a position, you close it as soon as youve registered a tiny profit, because youre so desperate to prove you can win something. There is a wealth of literature out there to help you understand how your trading brain works. As well as all the books on charting and stop-losses, make sure you read one of these. Brett Steenbargers The Daily Trading Coach is especially helpful. Maintaining a log of your trading is absolutely critical element within developing the right mentality to the markets. Unless youve got a record of why you made past decisions good and bad you will not be able to analyse your behaviour objectively at a later date, almost certainly condemning you to make further and unnecessary mistakes.

33%

just gambling in disguise?

Theres a widespread belief that trading and gambling are one and the same thing. And thats not entirely untrue: many people do trade as if they were indeed at a casino or betting shop. This perception is encouraged by the name of the most popular variety of retail trading: spread betting, even though the latter is really just a junior form of futures or CFD trading. So what are the differences between trading and gambling? Financial markets arent entirely random. Spins of a roulette wheel are down to pure chance. There is no way to predict outcomes successfully. However, many traders particularly within hedge funds find money-making strategies that rely on patterns repeating themselves in financial markets. Your losses arent your trading firms gains. When you place a wager at a betting shop or a casino, your wins are the houses losses, while your losses are their gains. Therefore, the house has a vested interested in your losing. But your losses are generally not a source of profits for trading firms. Trading firms will lend you money, gambling ones wont. Because gambling is a leisure activity, official gambling companies do not generally lend their punters the means to place wagers. By contrast, trading relies on the trading firm putting up money towards their customers positions.

13

GOLDEN RULES OF INVESTING: LESSON 10

Q&A: David Jone s

Chief Market St
IC: There are loads of spread-betting firms out there, why should traders choose IG Index? DJ: As part of IG Group, were a secure company, listed on the London Stock Exchange with an 1.8bn market value. We offer great resources to traders, research facilities, edu cation including seminars, as well as our highly regarded trading platform. IC: How should a novice trader approac h spread betting? DJ: My advice is to view it as a marathon, not a sprint. Managing your trading account conservatively is key. Think carefully about how much of your wealth you commit to your trading account. Too many newcomers end up put ting a big chunk of their resources on sure things that turn out to be nothing of the sort! At the same time, som e traders open an account and spend months doing nothing. Youve actual ly got to do some spread betting to learn how it works! IC: What are the main mistakes you see new traders making? DJ: Aside from trading too large, they can

rategist, IG Index
spread themselves ove r too many markets. Especially if tradin g short term, its best to follow a han dful of prices and really get to know them. Likewise, dont get sucked into the latest hot stories and when things go wrong, dont allow a short-term trade to become a long-term one. Often, you re best off taking a small and early loss. IC: How much do you need to become a spread-bettor? DJ: We allow people to bet at just 10p a point for the firs t six weeks, equivalent to a total pos ition size worth just 500 for the FTSE 100. Even our full-sized positions can work out being very small, as you can trade currencies from just 50p a point, as well as certain shares and the Dow Jones from just 1 a point.

DAVID JONES

E NOW David Jones explain s to Dominic Picard a how to think like and how to avoid fall a winning trader ing into the psycholog ical traps in a short available online now podcast . Download: investors chronicle/podcasts

PODCAST AVAILABL

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