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These are grim times for the UK economy, but don’t let the volatile times pour cold water on your money making ambitions. Alex Poole turns to the world of leveraging for some good cheer

Have you made any New Year’s resolutions yet? If not then good for you, and you’re certainly not alone. Like all self-respecting investors, you’ve stubbornly decided to stick with all the bad habits you enjoy and resolved only to keep channelling your energy on the one thing that really matters – increasing the value of your portfolio. This year, though, there’s something of a distraction, a complex economic picture that even the most hype-proof investor can’t ignore. Even as you skip scornfully past that newspaper article on ‘ten steps to a better a you’ and turn straight to the financial pages instead, you’ll be confronted by a slew of articles expressing concern about health of economy and financial markets – from the credit crunch to retail sales figures and the state of the housing market.

So just what do these tales of woe mean for investors? Of course, the volatile economic picture means that all the usual investment best practice is as important as ever.

Thorough research and careful stock-picking are essential (see Shares’ tips for 2008 in the 19 December issue or visit www.sharesmagazine.co.uk), and new investors in particular should ensure they don’t follow the banks’ poor example, and be sure to reduce any non-mortgaged debt before putting money into investments that have an element of risk.

However, many investors may be looking ahead to 2008 with some definite New Year cheer. This is because they see an opportunity to make profits while volatility reigns supreme – by trading leveraged products rather than owning the underlying shares. Products such as spread betting, CFDs and options (see sidebar) have increased hugely in popularity over the last few years, and it’s not hard to see why. What leveraged products do is give investors more power in the market through trading on margin, and without a crowbar in sight or the need to break a sweat – OK, well maybe some sweat is allowed, especially just before the market swings back in your favour with only minutes left on your trade!

Another reason that these products have become so popular is that they are low cost in comparison with traditional sharedealing. The ability to trade on margin with a small stake means that investors can gain exposure to markets very cheaply. With spread betting, for example, there are no dealing costs and the only ‘price’ is that of the spread. It’s possible to trade from as little as £1 a point, and there is no Capital Gains Tax (CGT), income tax or stamp duty payable. CFDs are also free from stamp duty, and will generally incur very minimal commissions, with some instruments available to trade commission free, depending on the provider.

The sheer scope of the markets and instruments available to trade is also remarkable, and a clear benefit for any investor. It’s possible to trade equities, CFDs, currencies, indices, and commodities – and a whole lot more. Of course, many of these products also provide access to global markets. What this kind of choice means is that you can easily diversify your trading – for example, an investor who is worried by the volatility of UK equities could trade in a rising commodity market such as oil, a traditional haven such as gold, or even access other markets around the world that might be enjoying different economic conditions to those in the US or UK.

As well as the cost advantages and choice on offer, leveraged products also score a big win with anyone looking to make profits in a volatile market (hands up, anyone?) by offering the ability to go short. Mick Mills, risk manager at TradIndex, agrees that shorting is a major boon for traders: ‘The fact that these leveraged products can be used for shorting – as we have seen is specific market sectors such as retail and banking – is clearly a benefit. Clients can quickly “turn and burn” trades for a profit as opposed to holding long-term investments as they would with traditional sharedealing.’

Mills also points out that despite this contrast, leveraged products and sharedealing are not mutually exclusive: ‘They can also be used to complement traditional sharedealing as part of a broader strategy, for example to hedge against a share portfolio.’

TradIndex offers spread betting on a range of markets and instruments, from equities through to indices, commodities and currencies. The site and trading platform have recently been revamped, and new clients get a free copy of The Beginner's Guide to Financial Spread Betting. Visit www.tradindex.com for more information.

Risky business

If the advantages of trading with leveraged products are clear, then so, unsurprisingly, are the risks. It’s often said that ‘with power comes responsibility’, and in the trader’s case this means that with the power of leverage comes the responsibility to manage risk effectively. If an investor uses leverage and the trade moves against them, the loss is much greater than it would have been if the investment had not been leveraged – in other words, leverage magnifies both gains losses. A key difference with traditional sharedealing and other non-leveraged investments is that you can lose more than the initial investment, so it pays to employ risk-management tools such as stop losses, and research markets thoroughly to be aware of the possible trading ranges of the any instruments you plan to invest in.

Indices, for example, frequently post three-digit moves – it may seem like easy money when your £5-a-point buy on the Dow makes you a nice £200 profit as the index ticks up by 40 points, but it’s much less fun when a 200-point plunge leaves you facing a margin call of £1,000 on the same £5 bet.

The issue of risk is certainly one that David Jones, chief market strategist at IG Index, is keen to emphasise in the current market conditions. ‘There is much more volatility [currently in the market], so consideration of managing risk is paramount, and the use of stop losses is crucial.’

‘This year was the worst start ever for the Dow, and a timely example of this volatility and risk. Indices such as the Dow and FTSE can easily swing more than 100 points daily.’

Keep your options open

Of course, indices are known for their volatility anyway and spread betting on them is often favoured by experienced traders for precisely this reason – it’s a rollercoaster ride that’s not for the fainthearted. If this includes you, you’ll be pleased to hear Jones add that there are other leveraged products that might be more suitable. ‘Something people may want to consider is options trading,’ he says. ‘These are still geared products, and offer more leverage than traditional sharedealing, but losses are more easily quantified, and a good way to manage risk.’ Options allow you to gain exposure to larger amounts of shares for less initial cash outlay than would be possible when trading the actual shares by buying or selling the shares at a fixed price by an appointed time. If the market moves in your favour, you gain; if you get it wrong, all you lose is the price you paid for the option (see sidebar).

Spread betting on individual equities is also a very popular market, and is clearly a more natural fit for investors more used to traditional sharedealing – especially if they’ve already put time and effort to company research and analysis, so they can use the clout of a leveraged product to back their existing judgement in the market. IG Index, which scooped this year’s Shares Award for Best Spread Betting Provider, offers investors access to more than 7,000 shares, as well as a range indices, currencies and commodities. Clients also get TradeSense, a six-week course for investors who wish to learn more about spread betting. For more information, visit www.igindex.co.uk.

In the mix

Paul Howard, head of product development at TDWaterhouse, echoes the comments of Mills and Jones in his enthusiasm for the benefits of leveraged products, while also stressing that investors should be mindful of the risks and take care to use such products as part of an investment mix that suits them best.

‘Leveraged products such as CFDs and spread betting can hold great advantages over traditional sharedealing,’ says Howard. ‘Trading on margin with a small stake and the ability to go short, for example, can be a very good way to invest. We do see a lot of customers going short with our CFDs, which is a valid strategy, but of course this may not be for everyone.’

‘It’s important to remember that leveraged products such as CFDs are all part of the product mix for investors. At TDW, we’re a one-stop shop, so clients who understand the risks involved with leveraged products can take out a CFD, but they can also use us to take out bonds and gilts, or invest in funds. Investors today are very sophisticated, and will mix products according to their needs. For example, they may prefer a safer, more traditional investment vehicle when saving for a child’s university fund, but have another pot of savings with which they’ll take more risk, and leveraged products would be ideal for this.’

TDWaterhouse offers online trading in ‘the full range of asset classes available to retail investors’. For more information visit www.tdwaterhouse.co.uk.

Stay cool

James Hughes, market analyst at CMC Markets, also agrees with his counterparts about the benefits of leveraged products, but strikes a cautionary note about the rigour and psychology any trader will need to be successful. ‘The main difference between spread betting and sharedealing is that spread betting is far cheaper and more cost effective for clients,’ says Hughes. ‘The fact that investors can go short is also crucial – when you think about the current market volatility, the ability to go short on shares you don’t own is a massive plus point.’

On the market volatility, Hughes also feels that the more successful traders will be those who learn to keep their cool and take a rigorous approach to assessing the market – be that through fundamentals or technicals – rather than let themselves be consumed by the ‘melodrama’ and hype generated by endless headline news about the credit crunch and other factors affecting the market.

Hughes also emphasises the importance of a reliable trading platform, ‘With everything else to worry about, you need a hassle-free platform that can cope with the surges in demand we’ve seen recently with the market volatility.’

CMC Markets offers spread betting and CFDs on a huge range of markets, as well as free seminars and a demo account to help you get started. Visit www.cmcmarkets.co.uk for more information.

Conclusion

Leveraged products are powerful investment tools, with many advantages over non-leveraged investments. The ability to go short, in particular, is a key benefit while the market is so volatile. It’s clear that if you can manage your risks, research the market instruments you plan to invest in thoroughly and choose your products carefully, you’ll have a far better chance of success. That’s quite a commitment, but one that could be highly profitable. Perhaps there’s a New Year’s resolution worth making after all.

WHAT ARE LEVERAGED PRODUCTS

Leveraged products allow investors to trade on margin, providing them with exposure to underlying markets while only requiring them to deposit a small fraction of the total value of the trade. While commissions and costs will vary according to provider and type of product, dealing costs are generally far lower than with traditional sharedealing. Most leveraged products are commission free, and they also have significant tax advantages. There is no stamp duty to pay, and spread betting is free of Capital Gains Tax. Note though that tax laws can change and it’s wise to seek independent financial advice on tax matters relating to trading, especially if the profits form a large portion of your income.

It’s also important to remember that leverage involves risk and magnifies losses as well as profits – it’s therefore possible to lose more than your initial stake, so a risk management strategy is essential. What all this adds up to is that leveraged products are a cheap way to gain exposure to a broad range of markets and give the average private investor real trading power through gearing. What’s more, different types of leveraged product have their own special advantages. Spread betting, CFDs and options trading are the main types of leveraged product, so let’s look at each of these in turn.

Spread betting

This is essentially a way for investors to trade a financial market by speculating on the direction it will take without having to physically own the product in that market (such as a share or commodity).

If a trader thinks a market will rise, he ‘buys’ the market (known as ‘going long’), or if he feels it will fall, he ‘sells’ the market (known as ‘going short’). This ability to short the market is a major benefit of spread betting and other leveraged products, as it means traders can make profits even in volatile and falling markets, such as those we have seen in recent months.

Spread bets are quoted using a ‘bid’ and ‘offer’ price. The bid price is always quoted first, and the spread is the difference between the two prices. A trader going short would sell at the bid price, while a trader going long would buy at the offer price. As we’ve mentioned, the ability to go short is a key benefit of spread betting, so let’s take a short trade as example to illustrate our point.

As the market opens, a trader thinks the share price of J Sainsbury (SBRY) may fall after The Times reports that the company is understood to have missed internal sales and profit targets in the run-up to Christmas. He logs on to his online account with a spread betting provider and finds that SBRY is quoted as follows:

Bid 400.25

Offer 400.75

As he plans to go short, he takes the Bid price, staking £10 per point. Our trader is proved right as the market reacts to the news and the share price falls, closing down (‘off’) 40 points at 360p, leaving our trader sitting on a tidy tax-free profit of £400.

Spread betting gives traders access to a vast range of markets instruments, from equities as outlined in the example above, though to global indices, currencies and commodities.

CFDs

Like spread betting, a CFD – or contract for difference – enables you to trade on a financial instrument without having to physically own it. In essence, a CFD contract is an agreement between two parties, agreeing to settle at the close of the contract at the difference between its opening price and closing price, multiplied by the number of shares specified in the contract.

Let’s take an example. In January you agree to buy 1,000 Vodafone (VOD) shares at £2.00 (a total value of £2,000). You lodge a 10% margin deposit of £200. In April, the price of Vodafone shares moves to £3.00, and you agree to sell at this level – a total value of £3,000. You generate a gross profit of £1,000 (ie. £3,000 less £2,000) and your deposit is returned.

There is no stamp duty on CFDs and, like spread betting, investors can trade on a wide range of markets and instruments, from shares to commodities and indices. CFD traders can also go short, as with spread betting. However, a small commission may be payable on some CFD markets.

Options

One of the greatest benefits of trading options is the leverage that they provide, allowing you to gain exposure to larger amounts of shares for less initial cash outlay than would be possible when trading the actual shares. The way that they work is that if you buy an equity option, for example, you get the right – without the obligation –to buy (a ‘put’ option) or sell (a ‘call’ option) the underlying shares at a fixed price by an appointed time.

If the market moves in your favour, you gain; if you get it wrong, all you lose is the price you paid for the option. For this reason, losses are easy to quantify, though of course with the high gearing offered by many options contracts, these losses could still be very large. As with CFDs and spread betting, you can also make a profit in a rising or falling market.

Another reason that options having been growing in popularity recently is that as they are available in many different permeations, and are therefore useful tools to include as part of any specific investment strategy. One such strategy that many options providers are seeing is clients using the products for hedging. For example, buying a put option in a stock you hold, or in the index on which it is listed, can protect a portfolio from volatility. Key terms here are a ‘covered call’ where the trader owns the underlying assets, or an ‘uncovered’ call, where the trader does not own the underlying asset.