David Kuo talks to David Jones from IG Index.
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David:
This is MoneyTalk, the weekly investing podcast from the Motley Fool. I'm David Kuo, and today we will be looking at whether spread betting is right for you. My guest is David Jones, Chief Market Strategist at IG Index. Welcome to the Motley Fool, David.
David J:
Thank you.
David:
Right, spread betting – can we start by explaining to people who don't know what spread betting is, is it just a bad spoonerism for bed spreading?
David J:
No, the best way of describing it, I think, it's the ideal way of trading a financial market if you have a short to medium term timeframe. Let's take the FTSE as an example, let's say the FTSE is trading at 5,200, you think the FTSE is going to go up over the next month – and we could buy, or you could buy, the FTSE on a spread bet, let's say you bought £2 a point at 5,200. Over the course of the next few weeks, the FTSE rises to 5,400, of course as the market's rising, the spread bet price is rising as well, so all spread betting does, it's a derivative that just mimics what's going on in the underlying market, but if you thought the FTSE was going to fall, you can sell short using spread betting, so it's a very transparent way of trading a whole host of markets with a short to medium term time horizon.
It's not ideal for long term, let's say you thought Marks & Spencer was going to go up over the next two years, you could trade Marks & Sparks using spread betting, but it's not the most efficient way of doing it, holding it over two years. If you thought it was going to go up over the next two months, the perfect way of trading it.
David:
So your example of the FTSE is quite interesting, just because I think it's going to go up, there could be somebody out there who thinks it's going to go down as well, so we're betting against each other. Now, if I win it means he loses, is that how it works?
David J:
In an ideal world, from us, from our point of view, as a spread betting company, that is the way it would work, where half the clients think something's going to go up, half of them think it's going to go down, they trade accordingly, we sit in the middle and take a spread, because of course there's a bid off a spread, so let's say, I said 5,200 for the FTSE, if you were selling it might be 5,198 to sell, so there's a spread there.
David:
Of just two points?
David J:
There's a two point spread, yeah.
David:
That's all you need, in order to make money?
David J:
Oh yeah, from our point of view, that's the great thing, over the years, because spread betting has got so competitive over the last ten years, ten years go the spread on the FTSE might have been six to eight points, but with so many companies coming in, so many more people now doing it, it's quite a cost-effective way of trading. So going back to the question, as a spread betting company, is that what we want – ideally half of the clients are positive, half are negative; in reality it never works that way, there's always going to be a shift, so companies like us, let's say all of our clients are buying, then companies like us, like IG, will be active in the underlying market, whether it's shares or currencies or futures, hedging our risk, so to make sure that, if the customer is making money, they're not making the money off us at our expense.
So again, a popular misconception is that companies like us are only happy if clients lose, and this could not be further from the truth, because we hedge our risk away, we want clients to stay profitable year in, year out, and keep trading, and then we keep making our little bit of spread every time they trade.
David:
So I suppose you really want a volatile market, don't you? You don't really want the market to be flat?
David J:
No, that's exactly right, and if you look historically over the last couple of years particularly, the busy times for us have been when the markets have been volatile, because of course, if you're a directional trader, you want a market that moves, whether it's up or down, you want some sort of market movement, so when markets are volatile, we definitely see trading volumes amongst our clients really jump up.
David:
OK, now one thing that people closely associate with spread betting is margin trading. Can you explain margin trading to somebody who's not familiar with the term at all?
David J:
I will, and I'll use the example of shares again, if I may, just so, this may be a subject that's familiar to us all. Let's say you thought Vodafone were going to go up in price.
David:
They have today, by the way.
David J:
Have they? – very good. Let's say they're going to go up, and they're trading at let's say 140, £1.40 to buy the shares. Let's talk about it from a shares example first of all, if you want to buy a thousand shares in Vodafone, it's going to cost you, you're going to buy a thousand shares at £1.40 a share, that's £1,400 plus commission plus stamp duty. So if you do that through a stockbroker, you need all of that money, you need to have at least £1,400 in your account. With spread betting, it's all about trading on margin, and the whole idea behind margin is, it uses leverage, so it means you put up a small sum of money, smaller sum of money, to control a relatively bigger position in the financial market.
So if we take that Vodafone one as our example, if we did a trade using spread betting, which was buying Vodafone £10 a point, which is the equivalent of having a thousand shares in Vodafone, because for every point and every penny it moves, it's worth £10 profit to us; rather than putting up £1,400, because you're trading on margin, our margin, IG's margin for Vodafone, is 5%, so you only need to put up 5% of the total value of your position, so in that example, to control £1,400 worth of Vodafone, it would tie up £70 within your account.
David:
But that sounds quite risky to me?
David J:
It is, and it's a point we all make, if you ever go and look at any of these spread betting websites, you will see risk notices plastered all over them, because it's important to understand, of course, even when ....
David:
What – you're telling people not to do it?
David J:
Well, we say, just be aware of what you're doing before you do it, because even though you've only put up £70, you've still got a £1,400 position in Vodafone, if Vodafone drops, for example 10%, you will lose £140, so it's important to understand when spread betting, that your initial risk is not just limited to the initial deposit, you could lose more, which is why it's very important, which we're going to get onto a bit later, but to think about things like stop losses, and think about how big your trades are in relation to the risk capital you've got at your disposal.
David:
So somebody who's listening to this podcast now and says, right, there are all these notices plastered all over IG Index's website telling me not to do it, but I still want to do it – how much should he or she start within the account to enjoy spread betting?
David J:
That's a very good question, and again it's a difficult one, because with us you can open an account with zero, so you can open an account, you don't need to fund it, of course when you want to start trading, you need to put some money in it then. So we have people who have zero in their account, and then we have, I think the largest amount we ever had was somewhere in the hundred millions, so that's the spread in terms of account sizes. The typical account in the UK opens with around £1,000, that's typical, and I think our typical client in the UK is just your average UK private investor, that's our typical client profile.
David:
OK, so can we go back to your example about the FTSE, right? If I thought that the FTSE was going to fall, and I bet a pound for every point that it falls, and there I am, I've put my bet in place, and instead of falling, the FTSE starts to rise, and it continually rises. Now, isn't there a danger at some point in time that my entire account will be wiped out, because if I bet one pound for every point that it rises, and it goes up a thousand points, the thousand pounds that I had in there would be gone?
David J:
That's exactly the case, how you've illustrated there, if you sold one pound a point, and if you said, let's say the FTSE went up a hundred points every day for the next ten days, and you had a thousand in your account, then your account would be wiped out, and this is the risk. This is why it's important to think about using things like stop loss, and to have an idea, have a level in mind, when you put the trade on, whether it's the FTSE, whether it's gold, whether it's Marks & Spencer, have a level and say, well look, I think the market's going to do this; however, if I'm wrong, and the market gets to x level, I am going to come out of the trade.
So going back to your FTSE example, let's say you think, right, the FTSE's at 5198, I'm going to sell it, I think it's going down, but, if the market rises a hundred points, I'll admit I was wrong, or my timing was out, and I'll get out to trade another day. I think sticking your head in the sand, and hoping it comes back, is a very dangerous approach with these leveraged sort of products.
David:
So this is your way of managing the risk, and not to lose everything in your spread betting account?
David J:
Definitely, I think an important part of any short-term trading plan should be the most important part, if it goes wrong, where do I get out? And placing the stop loss directly in when you do your trade.
David:
So where do you suggest people, I mean, what is the cut-off point for people to lose in their portfolio?
David J:
There are many different attitudes towards managing risk, but I think one that I subscribe to is, first of all, let's say you have a thousand pounds in your account, is to break that down into separate chunks, and think, well OK, how much am I happy to risk on any one trade? And most sensible, conservative approaches to risk management, which I would subscribe to, suggest that you don't really want to be risking more than 3% of your account in any one trade. That doesn't mean you have to use 3% stop losses, but it does mean, if I've got a thousand pounds in my account, if any trade goes wrong, I only want to be losing 30 pence. So if it does go wrong, I live to trade another day. Now again, in my opinion, that means certain volatile markets, like the Dow and the FTSE, are probably not ideal for you, if you can only risk losing £30, and you're doing one pound a point, you're not giving the market much time to move around. So I think people with maybe the smaller accounts are better off looking at slightly more relaxed markets, such as shares, where we don't see the same sort of volatility we see in the indices.
David:
So in terms of the spectrum, you're saying that shares are less volatile, and foreign exchange is the most volatile – is that it?
David J:
I would say, as a general rule of thumb, of course we have seen some particularly volatile moves over the last couple of years, but as a general rule of thumb, shares, because they are less volatile, can offer a somewhat more relaxed introduction to trading on margin, rather than trading the FTSE, which can easily trade in a 50 – 60 point range every day, and of course then again there's currencies, and one of the appeals of currencies is they can move 200 - 300 points in a day, but again that can be particularly scary if you're quite new to trading.
David:
Right, so you mentioned this 3% of your portfolio that you can afford to lose before you close out a position, and then open up another one. Now 3%, if you get it wrong 30 times, it means that you've actually lost your entire pot. What do you say to somebody that's made 30 continuously wrong bets on their spread betting?
David J:
Maybe short-term trading isn't your thing, I think. I think we have to accept, if you're going be an active trader, and an active short-term trader, you have to accept that the law of averages does come into this, and you are going to hit fantastic streaks, where you think you can do no wrong, and you think you're George Soros, and then you're going to hit particularly bad streaks, where you have five, six, seven loses in a row, and this conservative approach, risking a relatively small size of your pot, is to protect you against a losing streak, where you have a bad run, and you have a series of losing trades, but I think if you're getting 30 in a row, it's maybe the trading gods' way of telling that maybe trading isn't for you.
David:
Maybe go out and do some gardening instead. Now, whenever I see spread betters, and you have a lot of them on television, they've always got charts behind them, they're looking at screens all over the place. So how do charts help people in spread betting?
David J:
Many people, I think, when it comes to short-term trading and spread betting like technical analysis, they look at different levels and they're looking at trends and all that sort of stuff. My background is in technical analysis, my first job in financial markets was as a currency technical analyst, and I think one of the problems is with technical analysis is there is definitely a tendency to overcomplicate things, and you see all these crazy charts with Elliott wave and Fibonacci, and MACD and all this stuff, so I think charts can help you when it comes to trading, but to use them in maybe a simplistic way, definitely from the managing risk side of things, I mean at the point I was doing this interview today, over the last couple of weeks, the Dow Jones, whenever it's rallied up to about 10,300, 10,320, the market's run out of steam, so to chartists, that whole 10,320 level is what's known as resistance, so if we were looking to sell the Dow, then having a stop loss somewhere above that level, where we say look, if the market does get through here, then clearly sentiment has changed, and we want to get out the trade.
So I would use charts to identify major turning points for this particular market, where if we see that level broken, then maybe it's time to throw in the towel on the trade, but I'd say, don't get too bogged down in the minutiae of trying to find the perfect system, the perfect little indicator, the perfect combination of rules, where every trade is going to be a winner, because unfortunately, in the real world, you have to take some losses along with some profits, that's just how it works.
David:
So do you believe in trends then?
David J:
Oh completely, I completely believe in trends. If you look at any market, particularly at the moment, and we've got the FTSE back to March, the rally we've had since March is still going; the trend in gold that's been going since October 2008; we had a fantastic trend in the euro against the dollar last year, and that's reversing this year. So I think there are trends out there, it's easy to spot them, and it's easy to spot them in hindsight, of course; the difficult bit is jumping on them now and riding them for as long as you think they're going to carry on for.
David:
But isn't it also true that the trend is your friend, until it bends at the end?
David J:
Until it bends at the end.
David:
That's right, so as far as people are concerned, when they have a look at charts, I mean I can show you a chart, and the two of us will look at it, and you will see something completely different to me, it's like those inkspots with butterflies on them, you will see a butterfly and I'll see a zebra, won't we? But isn't that the problem with charts, that we see what we want to see in them?
David J:
I think the inkspots one is maybe a little bit cruel, but I would agree, to an extent, there can be quite a high degree of subjectivity, and I think people will see what they want to see. If you're holding a share, and you're down 20% on the share, and you want to believe, you still really want to hold your share, because you've fallen in love with it, which of course is a terrible thing to do as an investor, you shouldn't fall in love with your investments, you will find a reason, by looking at a chart, or looking at the tea leaves, to try and convince you to hold this. I think the way you have to look at it is dispassionately, and it's very often I find, your first reaction is the correct one, if there is a trend in a market, you should look at a chart and it should slap you in the face, you shouldn't be having to stare at a chart for 30 minutes going cross-eyed to try and find an opportunity. If you are looking at that one, there probably isn't an opportunity there, but if you look at something like gold at the moment, or the FTSE over the past year, there are very clear trends in place, and it should really slap you in the face.
David:
But when I look at gold, I see it actually sort of hitting a peak, and it's coming back down, and I actually sort of think, well 1,200, it can't really go much further than that, whereas other people would say, but look at the longer-term trend, it's going to hit 2,000, and that is what I'm saying, two people will look at the same thing and just see two completely different trends.
David J:
But I think that's true for fundamentals as well, because of course if everyone looked at something and thought the same thing, we wouldn't have a market, would we? If everyone decided the fair price for gold was a thousand, it would be a thousand tomorrow, and it would never move, so I think it's a good job that there are these differences of opinions, because nothing would move, but I do agree there is always going to be a degree of subjectivity, in reality.
David:
OK, so what is the most common reason for people losing money when they spread bet then? – apart from misreading the charts?
David J:
Yeah, apart from misreading the market, and getting it wrong 30 times on the trot. I think the biggest mistake that we all make in the beginning is to trade too big relative to the size of our account, so whether your account is £500 or £50,000, I think the mistake too many of us make at the start is to risk far too big a chunk of that money, because again we may have an idea that we've fallen in love with the share, or we're convinced that gold is going to $1,500 an ounce, and we're just going to hang doggedly onto that position, and that's the risk, that's the most common one. With short-term trading, if you have a problem with admitting you're wrong, will be a very expensive pastime, and I think if you couple that up with taking too big a position on the trades, and it goes wrong very quickly, very quickly you can wipe out a significant chunk of your account. So my advice would always be, trade small, and it's a cliché, but it's a marathon, not a sprint, do not come into this expecting to double your account by the end of the month.
David:
OK, now can I ask you a slightly philosophical question – what has spread betting got to do with investing? – in your own time.
David J:
The quick answer to that is probably very little, because spread betting, like I said right at the beginning, is the ideal way for short-term trading, and for me, short-term trading, because a common misconception is it's only for really short-term, jumping in and out 50 times a day, but for me it's ideal for trades of maybe a few seconds to a few months, so within that timeframe, whether you want to call that short-term investing, I don't know, to me that's sort of medium-term trading. So I think it's a different way of looking at the markets, rather than the investment point of view.
One way you could use it, again it's maybe not the ideal way of using it, but if you thought, let's say you had a portfolio of £50,000 of blue chip stocks, and you were worried in the short term the market was going to sell off, but for capital gains tax reasons maybe, you didn't want to sell out your shares, and one way you could hedge the risk of the market sliding is by using spread betting, so you'd hang on to your physical stocks, but you could short sell the FTSE for example, so if the FTSE drops, you make money on the spread bet, but you've lost money on your physical stocks. But I think spread betting and investing are complementary, but they are different camps, and it's for me, it's all to do with the timeframes.
David:
OK. Now I have one final question for you, and answer this as honestly as you can, right? If you were to bet that sterling were to fall against say a currency such as the US dollar – is that unpatriotic?
David J:
I suppose you could say it is unpatriotic.
David:
As a Brit, shouldn't we be talking up the pound, rather than to say, do you know what, I think the pound is going to fall against a foreign currency? Is it slightly unpatriotic? This is one of the big charges that people have when you short a particular currency. I know George Soros got into trouble by trying to short-term, say, the Kuala Lumpur stock market and also the Malaysian ringgit at the time, after he brought down the Bank of England and shorted the pound. Is it in some ways unpatriotic to do this?
David J:
I suppose, looking at it in black-and-white, it is, but I think unless you are George Soros, your £3 a point sell on sterling is not really going to have too much of an impact, so I'd say, if you think sterling's going to fall, you can't prop it up on your own, so why not try and make at least a little bit of tax-free money on the way down? I wouldn't get too worried about selling sterling if you think it's going to weaken.
David:
OK, I think we'll end the podcast there, that was a great answer, by the way, that you're not entirely unpatriotic just because you want to short sterling or the FTSE.
Now David, I end each podcast with a quote, and I try and find a quote that I think will sum up what this podcast really means to people, and the quote today comes from Anon, and he says, "If you must play, decide upon three things at the start: the rules of the game, the stakes, and the quitting time" – does that make sense?
David J:
That's incredibly appropriate, I think, for short-term trading and spread betting, full stop.
David:
Right, now, before you go, I have a copy of your book to give away, and for listeners to this podcast, you can win a copy of this book if you can answer this one simple question: can you tell me what the unit of currency in Vietnam is please? And please email your answers to moneytalk@fool.co.uk.
Now this has been Money Talk, I have been David Kuo, and my guest has been David Jones, Market Strategist at IG Index. If you have a comment about today's show, you can post it on the Money Talk web page, which you can find at www.fool.co.uk/podcast. If you have a suggestion for future shows, you can email me at moneytalk@fool.co.uk. Have a great week everyone, and thank you David.
