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Leveraged Investing: CFD vs Pivot

leveraged investing image

If you’ve ever bought property, you’ve already experienced a leveraged financial investment. You use your money (a deposit) to buy something worth more (a property) and pay interest. You take the view that the property will increase in value, and that the overall return will outweigh the ongoing costs.

In the same way, you can use leverage in other financial investments.

Leverage can make a big difference to investment returns. If you buy $100,000 of shares and those shares go up by 10%, you make $10,000 on your money. Do so with $10,000 of your money and $90,000 of borrowed funds, and the $10,000 profit means a 100% return. More leverage means greater potential returns – so long as you get the investing right. Otherwise it can be a shortcut to greater losses.

‘Getting it right’ means making the right investment call (to go long or short) on the right investment, at the right time. And then taking profits by exiting the position at the right time.

That’s a lot of calls to get right. Even if you chose the right investment and called the direction right, you could find yourself wiped out, especially with leverage. How?

Where CFDs stop

When a CFD provider advances funds that let you risk their money as well as yours, they do so with conditions. Of course, they want their money back. So if you’ve started to lose some of your money and it looks like you might be on the way to losing theirs, they’ll stop you before you have a chance to lose more.

In this case stopping you means just that: ‘stopping out’ your position. They unwind the trade; ensuring that you make a loss on the trade, even if it would eventually have come good at some later date. The trouble is, if you’re not in the market, you can’t profit from it.

Let’s take a typical Australian stock such as BHP. A normal day’s price movement can be potentially 2.7% up or down. For over a third of all two-week periods over the past 20 years, the interim price will at some stage have been 5% or more below the daily finishing price. Which means that if you plan to hold a 20:1 leveraged (5% deposit) CFD position for a fortnight, and have borrowed $95 to fund your $100 long or short position, you’re running a greater than one-in-three risk that your position will be stopped out – to protect the lender.

In the illustration below, the CFD customer has taken a long position in BHP, believing that the share price is due to rise. This is an excellent call, with the stock gaining up to 7% over a three-week period. Accordingly they took a $100,000 position, with a 5% deposit. Stop-out will occur where the customer’s equity has been reduced to 25% of its initial value – i.e., when 1.25% of the initial 5% deposit remains.

In this case, the price fell before it rallied, and the CFD provider watched the customer’s equity fall from $5000 to $1250 before stopping out the position, some time on the second day. The investor never had a chance to see the position turn around.

This problem is sometimes known as ‘path dependency’. Whether you make a profit depends not just on where the price starts and finishes, but what path it takes between the start and finish points. Call the start and finishing points correctly and you will make money, but only if you’ve guessed the interim price path, too.

StopOut-chart

For a single stock with high leverage, the stop-out risk can be very high. On average over the past 15 years, a CFD customer using a 5% deposit to gain exposure to BHP upside and subject to a stop following 75% loss of deposit, would have been closed out on 50% of all 3-week holding periods. A further 10% would have made losses. In other words, out of every 100 CFD trades on this single stock, even with a 5% deposit, there’s only a 40% chance of surviving long enough to make a profit.

With the odds of a CFD customer making a profit in any 3-week period at 3:2 against, it’s hardly surprising that many CFD investors burn through their initial capital in a few months, then give up. Simple maths means that very few of them survive long enough to make money.

Stop-Out Risk – 5% CFD Deposit on BHP – 3 week hold (1999-2014)

StopOutRisk-chart

So, how can you win, with leverage, in the share-market? In short, to win, or finish first, you have to survive to the finish – and not be dependant on the path. So apply some of the same investment principles as with an unleveraged investment:

  1. Diversify – to reduce the volatility, compared to holding individual stocks;
  2. Diversify – to avoid having to pick individual winners – and hold the wider market.
  3. Hold your position for a longer period – which may provide a greater potential for the market going your way.
  4. Avoid path dependency – ensure you can survive the inevitable reversals that occur over any longer holding period.
  5. Consider investments with known risks – so that you either win, or only risk losing your initial investment – not the full extent of the exposure you’ve taken on.
STWReturns-chart

A shorter holding period can mean that returns tend to be much more volatile – whereas holding an equity investment for longer tends to narrow the range of returns experienced. The ratio of winning to losing periods doesn’t change much; but the extreme losses occur less often, as illustrated by the chart above, showing the range of returns experienced over the short and medium term from an investment in STW, the State Street S&P/ASX-200 Index Tracker Fund.

Investing in a diversified portfolio, through exposure to a stock market index rather than a single stock, or in an investment fund or company holding a range of assets, reduces your risks further.

Pivot: leveraged investment with known potential downside

With Pivot from Vestin, you enjoy the same power of a leveraged investment such as a CFD, but with a known potential downside. What happens to the price during the investment period doesn’t matter – only where it ends up relative to the start.

Any loss is limited to the initial capital outlay.

Conclusion – You have to be exceptionally diligent to make money out of CFDs. Pivot from Vestin gives you the power of leverage, plus the peace of mind of a known potential downside.