If you go short the future at 1.3522, and nothing happens to the FX rate, then in one year’s time when the future expires it will be worth exactly the same as the current FX rate: 1.3333. Going short the future at 1.3522, which ends up being worth 1.3333, will earn you (1.3522 – 1.3333) ÷ 1.3520 = 1.4% in profits: exactly the same as the pos itive carry.
What if the future wasn’t priced at 1.3522? If it was priced differently, then you would be able to do a spot FX trade and perfectly hedge it with a futures trade, leaving you with a guaranteed arbitrage profit. ²³ Notice that the difference between future and spot price only reflects the cost of carry: it doesn’t mean the market expects the price of GBPUSD to be higher in one year’s time tha n it is now.
The futures price is the same for both buyers and sellers (at least in principal, ignoring the trading spread which would make the price slightly higher for buyers), so both will earn or pay the same amount of carry. Neither buyer or seller has to worry about the financing spread which would reduce the positive carry earned on a short spot FX position, and increase the negative carry on a lo ng position.
Like CFDs futures have specific contract sizes. The contract size for the GBPUSD future on the CME (Chicago Mercantile Exchange) is
£62,500. Because of the large contract size many futures can only be used by larger traders. AHL, the multi-billion dollar hedge fund I used to work for, are big players in the futures market, and I still trade them myself.
The margin required on a GBPUSD futures contract is currently $1,800. With an exchange rate of 1.3333, the margin corresponds to 1,800 ÷ 1.3333 = £1,350.03, so the maximum leverage factor we are allowed is currently 6,2500 ÷ 1,350.03 = 46.3. This is lower
than is theoretically possible with spread betting or CFDs, but still much higher than the leverage factor of 10 we opted to use in earli er examples.
We can also face margin calls with futures. If we deposited
£6,250, we would have no problems until we lose more than £4,900.
At this point, we have less than £1,350, and since £1,350 per contract is required for margin, we need to cough up some more dough or face the dreaded prospect of auto-liquidation. When trading futures the extra cash needed after losses is called maintenance margin, or variation margin , to distinguish it from the initial margin required in our account befo re we trade.
Futures are derivatives.
They trade on futures exchanges, like the Chicago Mercantile Exc hange (CME).
They have set expiry dates, so the y are dated.
1. Dated CFDs and spread bets
The final category of product we need consider are the dated variations of the OTC derivative products: CFDs and spread bets: Spread bets based on futures.
CFDs based on futures.
Quarterly spread bets and CFDs, not based on futures.
It is easier to create a dated OTC derivative if there is an exchange dated derivative that you can base it on. This makes it easier for brokers to calculate prices, and to hedge their risk, and for customers to check that the pricing is fair. Futures are readily available for many different markets, so dated spread bets and CFDs are usually created with reference to a futures price. However, futures are unavailable for many FX rates, individual shares and ETFs. In these cases, the broker has to create their own derivative product f rom scratch.
Each of the products listed is traded with a set expiry date. So, when shorting GBPUSD with one of these products, you need to specify that you are ‘shorting GBPUSD expiring in June 2019’. You can close the position at any time before the expiry, or, if you want to keep it alive when expiry is imminent, you can close your trade and open the same trade in the next expiry date. As with futures, this is known as rolling yo ur position.
Where relevant, expiry dates usually match the underlying future, although not all possible future expiries will be available as spread bets and CFDs. Where there is no underlying future, expiries are normall y quarterly.
As with futures, there are no financing costs or dividends paid or received: the positive or negative carry of a dated product is 20
built into the price. ²74 In theory, there should be no funding spread for these products, although some cheeky brokers may still charge one.
Trading spreads on dated OTC products tend to be wider than on undated products, but if you trade infrequently, they will work out cheaper, as you do not pay a hefty interest rate spread.
However, dated products are not entirely free of holding costs, since when you roll a dated product you have to close one position and then open another, which will mean paying a trading spread and possibly some commission. Determining which is the most cost-effective product depends on your trading style, and I return to this question later in the book.
These products are all derivatives.
Although they may be based on exchange traded futures or share prices, they al l trade OTC.
They have set expiry dates, so the y are dated.
Summary of product characteristics
• Includes short selling and buyi ng on margin Products and underlying instrument are different There is an important distinction between the type of leveraged product (CFD, future, FX, spread bet…), and the underlying instrument the product is derived from. Sometimes these are the same: we trade FX with spot FX and trade stocks with stock margin buying (or short selling). But we can trade a CFD, spread bet, or future on almost anything: FX, shares, cryptocurrencies and so on. These different groups of instruments are called as set classes.
Table 1 shows which leveraged products can commonly be used to trade underlying instruments in various asset classes. Not all brokers will offer the options shown, and some products are illegal in certai n countries.
Table 1a: Leveraged products and underlying instruments Table 1b: Leveraged products and underlying instruments Some of these underlying instruments we have seen before, whilst oth ers are new:
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¹70 I am ignoring any repayment element of the mortgage. It is common to buy investment properties with an interest-only mortgage. This also makes the example more relevant for leveraged traders, who do not have to repay their loan until the end of the trade.
¹¹ You will sometimes hear traders talking about the ‘cost of carry’ for a negative carry position.
¹² However, the broker will usually hedge their risk by doing a similar trade of their own in the wider OTC market, or on a formal exchange. I will discuss this more in chapter two.
¹³ Typical leverage ratios are lower for stock margin trades than for other types of leveraged product. Under current US law leverage ratios are limited to 1:1 under ‘Regulation T’, equivalent to a leverage factor of 2. Another type of account,
‘portfolio margin’ is available to certain investors, and may allow higher leverage.
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¹74 Some of this funding spread is because brokers can’t borrow or lend at LIBOR themselves, and is a true reflection of their cost of doing business. But most of it is a source of profit for the brokers. Indeed, brokers in OTC products will not need to borrow or lend at all if they can find two customers with offsetting trades. In this case, they can keep the entire funding spread.
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¹75 We actually have enough money to buy 84.15 shares, but you can’t buy fractional shares, so we round down.
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¹76 In reality, only large institutions that owe their brokers millions get called on the phone. Ordinary folks like us will get a sternly-worded email.
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¹77 When we write currency pairs the first currency (here GBP) is the one that will appreciate in value versus the second (here USD) if the exchange rate goes up. The first currency will depreciate relative to the second if the rate falls.
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¹78 Somewhat confusingly with FX there are two possible ways to describe any trade. Going short GBPUSD at a rate of 1.3333 is equivalent to going long USDGBP at a rate of 0.75 since 1 ÷
1.3333 = 0.75
. In both cases we want dollars to get stronger relative to pounds, but with a short GBPUSD trade we want the quoted rate to fall, whilst for a long USDGBP trade the rate needs to rise. Fortunately, there is a convention that dictates how the rate is quoted for a given pair of currencies. In this case GBPUSD is the market tradition.
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¹79 I’ll explain how to calculate the optimal leverage ratio later in the book.
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²70 It’s not all good news, since you can usually offset trading losses against profits. You can’t do this with gambling losses.
²¹ Most brokers will allow much higher leverage than this.
²² These are the ‘IMM FX’ futures which trade on the Chicago Mercantile Exchange. To be pedantic, they actually have monthly expiries for the next year, and quarterly in subsequent years. In
practice, the most popular contract tends to be the next quarterly contract; i.e., March, June, September or December, whichever is next.
²³ This ignores the financing spread and other costs. In practice, arbitrage trading is only possible for large institutions which do not have to worry about financing spreads.
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²74 Dividend payments if we are betting on share prices, and interest payments for bonds, are also included in the price. For many dated products the price is based on the relevant future and, as we’ve already seen, futures prices have financing costs embedded within them.
Chapter Two
Getting Ready to Start Trading
My first job in the financial world was rather mundane. I worked part time answering the phones in a broker’s call-center, whilst studying for an undergraduate degree in economics. This was in early 2000, and although the firm offered online dealing, most older customers still preferred to do their trades whilst speaking to a real person. They had grown up in a world where computers were an expensive luxury, and the only source of share prices for amateur traders was the business pages of a daily newspaper. A friendly and helpful voice on the telephone was an important factor when deciding which broker to trade with.
The world has moved on rapidly since then, there is more to choosing a broker than finding one with a polite telephone manner, and it is essential to acquire certain electronic tools before you can begin trading in today ’s markets.
In this chapter I will explain three choices you need to make before starting trading. So, this involve s selecting: your trading software, hardware a nd data feed which prod uct to trade
your broker.
I end the chapter with a discussion of how much money you will need to be gin trading.
1. Choosing your trading software, hardware and data feed If I asked you to describe a successful trader in their native working environment, you would probably picture someone sitting at a desk with four or more computer monitors. Dazzling arrays of coloured lines festoon the monitors – all produced by an expensive trading software package – analysing streams of data costing thousands of dollars per month. A top-of-the-range laptop is perched on the desk, whilst underneath it a sleek computer
workstation sits, gently humming with latent power. Both machines are plugged into a superfast internet connection which leads straight to the exchange, ensuring their orders are at the head o f the queue.
This picture is very misleading. I blame all the YouTube videos put out by trading ‘gurus’. My favorite video consists of a two-minute tracking shot, showing all 41 monitors that someone allegedly uses to trade. It’s true that when I was working as an investment bank trader, I did indeed have six monitors and two computers, but a set up like that is complete overkill for an ama teur trader.
I recently watched a documentary where an inexperienced trader, who had just completed an introductory course, invested thousands of pounds on a fancy dual monitor trading setup. That hardware cost somewhere between 10% and 50% of the money they had set aside for trading. This is analogous to buying a top of the range power saw to cut two pieces of wood in half. There is no guarantee of higher trading profits if you buy more data, monitors or computers, and for most people these are completely unnecessary.
I manage my own portfolio of shares and funds on the single screen of a battered old laptop, bought second hand for $300. A separate machine, with zero monitors, sits in the corner of my study automatically trading futures: cost $500. My portfolio is relatively large and complicated for an amateur trader, and yet the cost of this budget one-screen setup comes in at significantly less than 0.1% of my port folio value.
For my data feeds, I pay an annual charge of less than 0.003% of my account balance. I do not pay big bucks for a fast internet connection: I will never be faster getting my orders to market than deep-pocketed institutions, so there is no point playing the speed game against them. That is a competition with no s econd prize.
The most basic system in this book requires access to financial data which is available for free on numerous websites, and a few calculations which can be worked out on a pocket calculator. Even the more complex systems in the book can be deployed with free 20
data plus any spreadshe et package. ²75
It’s possible that you may end up automating your trading, which will require further investment, or that with some experience you might need a more powerful machine, but to begin with, almost any computer or internet connected device is sufficient. Do not spend money on fancy hardware or software: save it for trading.
1. Choosing which product to trade
The leveraged products discussed in chapter one are all superficially similar. Usually we buy something which we finance
with some of our own cash, plus a chunk of borrowed money. When short selling we borrow the stock rather than the money. Using leverage magnifies our potential profits, but also increases any losses.
In the case of futures, spread bets and CFDs, the loan doesn’t really exist, but we still have to pay a financing charge. Dated products do not have explicit financing charges, but there is an implicit charge built into their price. Finally, with all products, we can face margin calls if prices move against us, and if things go badly wrong, our position will be automatically liquidated.
However, despite their many similarities, there are still some important differences between the vario us products.
Position sizing and leverage
Re-read the examples above for trading GBPUSD with different products and you may notice something interesting. All four examples had a leverage factor of ten, but the amounts of money involved were quite different. To trade the future, we used
£6,250 in margin; the spread bet and the CFD came in at £1,333
and £1,000 respectively, and we traded FX with less than £100. As a rule, futures are only accessible to relatively large traders.
In contrast, spread bets and CFDs offer smaller, minimum size positions, making them more suitable for the average trader, whilst position sizes in FX can be very s mall indeed.
The allowable maximum leverage also varies from product to product, but, as you will discover later in the book, a prudent trader would rarely use the maximum allowab le leverage.
Costs
Futures are often used by CFD and spread bet brokers to hedge their exposures, futures that their own clients can’t trade because of their large margin requirements. These brokers perform the same service as a wealthy kid buying sweets for their poorer friends. Most of the children can’t afford to buy an entire bag, so the richest buys sweets in bulk, and then sells a few to each of their customers. The whole bags of sweets are like the futures that less wealthy traders can’t afford and the individual sweets are spread b ets or CFDs.
Naturally the well-heeled child is going to make a profit on this. They might sell a $1 bag of 20 sweets for 10 cent each, totalling $2 for a $1 profit. Similarly, brokers aren’t charities
– they have to cover their operating costs, any losses from feckless clients who go bust, and still make profits for t heir owners.
As a result, CFD and spread bet
s are usually more expensive than futures. CFD and spread bet brokers will usually quote wider
traded spreads than on futures. But, if you don’t have the capital to trade futures, you will have to stick with CFDs or spread bets; just like the poorer kids have to buy their sweets a t a mark-up.
Calculating the cost of trading different products and instruments is a relatively complex task. I will return to this subject in c hapter four.
Trading with a broker versus on exchange You trade on an exchange when you trade futures, or use a margin account to trade shares, although your trades are always routed via a broker. With spread bets, CFDs and FX, you are trading directly with the broker . Trading with a broker is relatively risky, whilst trading on an exchange is safer. When you trade on an exchange the settlement of your trades is guaranteed by a clearing house . These are highly regulated organisations with significant capital backing from many different sources, and an implicit or explicit government guarantee. They are much, much safer than any broker.
The pool of capital within a clearing house guarantees that your broker can collect any profits you have made from traders who have lost money. It is very unlikely that you will lose money because a clearing house has gone bust, as no clearing house has 20
failed in over thirty years. ²76 But, in the seven years I spent working in hedge funds, three large brokers effectively went bust (Lehman Brothers, Bear Stearns and MF Global).
However, the presence of clearing houses does not mean that exchange trading is completely safe. Brokers still hold your cash in their own accounts. In reputable jurisdictions, like the US
and the UK, these accounts are supposed to be segregated to prevent brokers stealing or ‘borrowing’ your cash. Should your broker go down the tubes, government insurance and bankruptcy courts might repay your money, but it could take a long time. I have friends who are still owed money by MF Global as I write this chapter, seven years after its bankruptcy.
Nevertheless, brokers trading on the OTC market have a much higher failure rate than those which pass customer orders on to exchanges. As well as the safety net offered by the clearing house, brokers who are exchange members are governed by stricter rules, which help protect traders. Generally, it is safer to use a broker that sends your trader to an exchange, than to use a broker t hat doesn’t.
Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders Page 5
