Why do most Spreadbettors Lose?

This is a particularly expansive (as well as expensive for the poor punter!) subject with a multitude of potential answers that will be specific to each individual client’s circumstances and personality profile but, nevertheless, it is a very interesting subject that’s for sure, and certain common themes are recurrent, as we will explore in this feature piece. Being aware of these issues will enhance your chance of being successful.

Let us start with a simple statement of fact; and that is that spreadbetting is, quite simply, trading and trading is hard – we make no bones about this. An open industry secret is that of all novice futures, FX and stock day-traders, less than 10% are successful over the long haul based on anecdotal evidence. Think about that for a moment – less than 10% of traders make money and indeed the vast majority of these wipe themselves out within 12 months.

Our industry associates tell us that there is, however, a general ‘type’ of spreadbetting client account that has a chance of making money in the long haul and which invariably display the following simple traits:

(1) The initial funding of their account is of a sufficiently adequate amount to give the client a chance of making money (myth no. 1 explosion – in order to (a) make spreadbetting worthwhile given the effort required and (b) to have sufficient funds to carry a drawdown, which inevitably will occur, you should really not be considering trading with less than £1000 starting funds) and;

(2) Those accounts do NOT over-trade; i.e. they don’t over-leverage themselves and so experience big swings in P&L that in turn causes outsized psychological impacts that will likely negatively affect their trading further.

Time and again a new client gets the ‘keys’ to their account and then believes that they need to be all over the first thing they see moving. Add the typical leverage factors offered with many instruments into the mix (up to 100 times in the case of FX!) together with inexperience, and they would be rather more well advised to go down the casino with their money as they are basically playing the same type of ‘game’ that is primarily gambling. Spreadbetting can therefore be akin to betting, or it can be akin to a commercial enterprise where you consider the risks as a first base, and then look to let the rewards look after themselves.

As an active spreadbettor of over 15 years now, I have pretty much seen it all in the markets from 9/11 and its aftermath to the invasion of Iraq, Lehman’s collapse, the Great Financial Crisis of 2008-09 and also the millennium bubble (although, I doubt I’ve seen everything – one thing that I have learnt is that the market always, repeat always, has a new surprise around the corner for you!) and when I cast my mind back over my own losing periods I can put them into 3 distinct camps:

(1) Early stage “learning the ropes” period

This generally lasts (sorry to say this) on average around 18 months – 2 years. A punter really needs to see both sides of a bull and bear market in order to understand how markets work.

Given that the natural ingrained tendency of most traders, certainly retail (i.e. non-professional) traders, is to go “long” as opposed to going “short”; you truly need to experience how soul destroying, frustrating and wealth depleting a bear market is (unless you’re short of course!) in order to see just how detrimental to your wealth (and wellbeing if you are in over your head!) trading can be. It is worth pointing out that in the small cap, and in particular the AIM arena in the UK at present, that we are most certainly in a bear market (see chart below), and it is very noticeable to me in speaking to many punters in recent months how despondent and dejected they are with the market. Coming on top of a very difficult 2011, many popular sectors, specifically AIM Oil stocks, have had a similarly shocking 2012 so far. Lots of spreadbettors are certainly now familiar with how a bear market feels…

During the “learning the ropes” period you will likely deplete a material amount of capital and quite possibly wipe yourself out – in fact you may do this 2 or 3 times (I did!). This is to be accepted as par for the course and underscores the importance of only risking true risk capital (NOT the school fees!). Think back about the 10% success ratio of traders over the long haul – to expect that you can start spreadbetting and either make a living or, even more remotely, a fortune out of it with no prior experience, and in particular if there is not a preparedness to put meaningful amounts of time into the endeavour, is quite simply unrealistic if not outright madness.

(2) Stubborness
An unwillingness to accept that I was wrong has been a major undo-er of me on 2 occasions now. The first instance was in 1999 (and so should arguably be lumped with the learning the ropes issue) when the US technology boom was in full swing. As a Yorkshireman, I am loathe to overpay for anything and so I felt that the US tech market (Nasdaq) was way overvalued and due a fall. Trouble was, I shorted the market at 2800 in September 1999 and to my absolute horror it continued to rise inexorably day after day, taking my hard earned cash with it. To add fuel to the fire that was burning in my pocket, I continued to add to the position as the market ploughed ever onwards as I simply could not believe the valuations.

Finally, the pain was too much too bear as I continually funded margin call after margin call and my pockets were threadbare. I was eventually closed around 3300. This, painful as it was, turned out to be a blessing in disguise as the market continued on to ultimately peak at just under 5000 in April of 2000 as the chart below illustrates.

Was I right on the Nasdaq? Yes, it did subsequently fall to around 1000 in 2002 and only now, some 12 years later, is the index just getting back to the point where I put on my short. What was my lesson here? MONEY MANAGEMENT. Money management is your safety valve in the face of stubbornness. You may be right, but like comedy; timing is everything, and if it’s out, then it is better to take an annoying rather than a catastrophic loss, and more importantly be around to fight another day.

The other important lesson that I personally learnt is that no matter how much conviction one has in a position, always only trade a modest amount at the trade inception, i.e. don’t go “all in” right off the bat. This way, I can address the perennial controversial issue of ‘stops’ (which I don’t believe in per se). If I have only risked 3-5% of my trading pot and I really do believe in the underlying position, then a move of 20% against me will (a) not unduly hurt me and (b) gives me the opportunity to add modestly to my position again. If the position goes further against me after adding a second time, then the market is telling me that, although I may be fundamentally correct in my view, the weight of money pressing against me is simply too great, and it’s time to fold my cards rather than continue to swim against the shark infested tide. This, again, links with the simple point of reducing voluntarily the leverage you use on your account – just because it’s there, it doesn’t mean you have to use it.

‘Hooks’ of 5% margin on the miners by spreadbet and CFD firms just have me rolling my eyes – anybody who trades their account to the max on the basis of these margin rates is just asking for trouble.

To conclude point (2) it is important to ‘have the courage of your convictions’ in the market, i.e. to be able to pull the trigger on a trade, but it is equally important to know when to put up the white flag – trade modestly and with controlled leverage and you can take advantage of being a little bit too early to the trade by averaging in – but only average/scale once – if you are still offside and feel uneasy, then get out quick.

(3) Hubris

Perhaps the most annoying losing periods for me have come in later years when I have grown in confidence in my trading and been lucky enough to enjoy an extended
profitable run. This may seem counter-intuitive but, when you are making money, it is all too easy to fall into the trap of thinking that you can do no wrong and that you know better than “the market”. I typically follow a pattern of thinking that as my account is well padded with profits that the successful run will continue, and so I personally have a tendency to ‘over-trade’, i.e. place too may trades relative to the account size and also up my size after a good run. I am sure many readers can relate to this experience.

How do I counter hubris now? Again, it is linked with money management and that is for every 50% increase in my account, I take off the profit capital and so re-base back at the original account funding level. This helps me personally in 3 ways – firstly, psychologically I am in a better place as I am than playing partly (or wholly if a 100% return) with “the markets money”, and never underestimate the importance of psychological wellbeing and the right mindset when trading. Secondly, I am consciously scaling back my size and so also controlling the leverage in my account as I take funds out of the market, and thirdly I am aware that nothing lasts forever and so I am reducing further the impact of when the inevitable drawdown occurs.

Looking at individual instruments, the following are generally the major reasons for account failures by clients:

1. Equities trading

This is usually due to the lack of homework on the part of punters and, amazingly in more cases than you would image, simply blithely following bulletin board posts on popular stocks du jour. DO NOT follow anyone but yourself and ALWAYS do your homework.

When it comes to stocks outside the FTSE 350, my own personal rule of thumb is to margin myself at 50% on the position even if the margin rate with the spreadbet
firm is only 20%. I adjust my GNE and so give myself a large cushion should things go wrong. With AIM stocks, 70-80% margin is applied or I simply buy them for cash

– there are too many AIM horrors around for anyone to even contemplate trading these with margins of less than 30% – just look at the likes of Gulf Keystone where the stock can move 30% in a day – again, get on the wrong side of that and you are in a world of the brown stuff…

2. FX trading

This is extremely simple – lack of stop loss application coupled with over leverage. 100:1 leverage adverts should be ignored – you DO NOT want to be levered 100% – get yourself on the wrong side of an economic release with this type of margin trading and its lights out before you can say drat!

3. Indices

Trading indices, for me personally anyway, on a daily basis is a zero sum game – some days I’ll win; some days I’ll lose. The way I have made money trading indices is with ‘swing trading’ – looking for the standard deviation moves when a particular index has moved by 2 or 3 standard deviations from trend and it is excessively oversold/overbought; in essence playing corrective moves. Many seasoned traders view day trading on indices as being akin to betting on spider crawling. In fact, if you think about it, why do many spreadbet firms offer 1/2 or zero points spreads? Answer – because punters lose much more than they make. Question 2 – how many millionaire index day traders do you know?

Some other tips that I would suggest you consider and that certainly work for me are the following:

1. Have a ‘hedge’ or two in the portfolio

If you are long equities overall, having done your homework on the stocks you are trading, being aware that the market can take a tumble out of the blue is a good mindset to have; having an inversely correlated position on like a short index play or currency pair that moves in the opposite direction, for example dollar swiss, will allow you to mitigate a draw down.

2. Take a frequent breaks

It’s amazing, to me anyway, what a week or two away from the markets can do for your trading when you return.

Don’t get yourself into a situation where you ‘need’ to be next to the screen constantly – you are basically feeding an addiction here. If you are comfortable with your positions, entries and account margin situation, then there should be no real need to watch every tick movement.

3. Avoid at all costs ever, ever, ever being on margin

This screws with your mind as you (a) have either over traded or (b) the market is telling you that you are wrong (in the short term anyway) – probably a mixture of both. Either ways, you don’t want to be there.

Finally, I read a very interesting article recently on perhaps the most well known hedge fund manager of recent years – John Paulson, the man who made $15bn shorting the US housing market in 2008. Here is a quote from him that he made following a halving of his fl agship Advantage Plus fund in 2011, and another 12% drop so far in 2012 –

‘Sometimes it’s diffi cult to interpret the markets, so we’re not going to play a winning hand every day. Our goal is not to outperform all the time – that’s not possible. We want to outperform over time.’ If even revered hedge fund managers with ‘more money than God’ accept that it is not possible to make money all the time and also experience drawdowns of the magnitude that Paulson has, that, in itself, should illustrate to spreadbettors & CFD traders that trading is not easy and the fi rst base is always risk control.

Article reproduced from the August edition of Spreadbet eMagazine