In this article we examine two types of leveraged instruments, CFDs and Exchange Traded Options, and look at the risk profiles for a simple long strategy. Warren Buffet called derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.
Except for the dark days of the GFC, the recent market volatility has been unprecedented, as is illustrated by the VIX chart below. The VIX is the CBOE Volatility index, which is a measure of fear in the market. It is clear that we have not seen this level of fear since the uncertain times when Japan was hit by the earthquake disaster back in March.
FIGURE 2: CBOE Volatility Index (VIX)
It’s often said that the only thing that an investor can control in trading is their risk, and this is particularly important when dealing with leveraged trading instruments.
When traders think of trading with leverage Options and Contracts for Difference (CFDs) quickly come to mind. The recent market volatility has decimated many CFD trading accounts, while those who have been trading with defined risk through the use of Options are in a better position.
Sample Trade: David Jones
FIGURE 2: David Jones at 8th July – looked to be consolidating above $3.90.
A recent trade which caught traders out was in David Jones (DJS). Back in early July David Jones was trading at a two-year low and had retraced 32% from its two-year highs. But some traders may have been tempted by the fact that it was trading on a PE of 11 and a dividend yield of 8.2%, fully franked.
On the 8th of July it managed to break to a monthly high and was closing near its high for the session. Had you taken a long position with a view to trade DJS for a 10% move, you would have opened the position around $4.00 and looked to place your stop around $3.84 (or 4%). We have calculated the profit and loss (P&L) for the trades using options and CFDs and this highlights some of the risks and benefits associated with using leveraged trading instruments, particularly when you are hit by a nasty surprise.
The CFD Trade
Had the trade performed as expected the P&L would have looked like this:
FIGURE 3: Profit & Loss in a David Jones CFD Trade
If the trade had performed as planned those who purchased the stock would have a return on investment of 9%, but if you used CFDs your return on investment would have ballooned out to over 300%. Not bad.
Reality Check
FIGURE 4: David Jones shares price plunges after profit downgrade on July 14th – Ouch!!
As anyone who held DJS shares on the 14th of July would know, the company came out and reported a profit downgrade and the shares plunged over 15% on the open. The P&L calculations are detailed below:
This “nasty surprise” was a shock to the bank account as you can see: the stock holder would have lost 17%, but the CFD holder would have lost a whopping 540% overnight.
The Options Trade
One way to avoid the prospect of a nasty surprise is to position yourself in the trade using Options. On the 8th of July DJS 400 AUG11 Calls were trading at 14 cents per contract, so you could have bought the right to buy the stock at $4.00 for 14 cents per share, and the P&L calculations are shown below:
Your maximum risk is $1,480 (or 100% loss) and as the trade unfolded you would have lost that amount. However the trade has been a success, in that you have defined your risk and have not lost any additional money due to the release of the DJS profit downgrade. This compares to the $3,710 loss (or a ROI of -17% loss) on the share position or the $6,874 loss (or ROI of -543% loss) on the CFD position as outlined above.
Conclusion
Mind the gaps and beware of WMDs of the financial variety.
When a stock’s share price gaps, particularly on market open, you can face extraordinary losses, particularly when you are trading using leverage instruments like CFDs, as illustrated in this David Jones example.
Options can be used in order to reduce your risk, while still participating in potential profits from a move in the underlying stock price using a limited risk strategy.
We have highlighted the David Jones trade as our example, but there have been any number of similar examples in recent times due to the elevated market volatility, including Billabong, BlueScope Steel, QBE, Qantas, Macquarie Bank and Woodside, all of which have fallen 15% to 20% within a few trading days and in most cases gapping on open.
Use Options to define your risk, particularly in volatile market conditions such as we’re experiencing at the moment. In future articles we will talk about the High Yield Covered Put strategy and the Stock Repair strategy, which are particularly relevant to this market.
Utilise the features in the Market Analyser software to plan your trades for the particular Options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk. Sign up for a free 14-day software trial here.
By Michael Hevern
Head of Research
See also:
Options Trading for All Types of Market Environments (Part 1): The Protective Put
Options Trading for All Types of Market Environments (Part 2): The Covered Call
Options Trading for All Types of Market Environments (Part 3): The Covered Call Collar
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MDS Financial Advisory Services offers general advice on trading Options to generate consistent steady income on your investment portfolio. Call 1300 610 024 for further information.
