In this article we examine two types of leveraged instruments, CFDs and MINI Warrants, and look at the risk profiles for a simple long strategy. Warren Buffet called derivatives “financial weapons of mass destruction [WMDs], carrying dangers that, while now latent, are potentially lethal”.
The Volatility Index is a measure of fear in the market and in the recent market’s rise since late last year volatility has been incredibly subdued. However this does belie short sharp moves in individual stocks – for some examples look at the recent moves in gold stocks and mining services companies.
It is 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, MINI Warrants and Contracts for Difference (CFDs) quickly come to mind. The recent market volatility in individual stocks has decimated some CFD trading accounts, while those who have been trading with defined risk through the use of MINI Warrants are in a better shape.
It is not only the gold stocks and mining services companies that can produce nasty surprises. In today’s sample trade we look at the bellwether stock Coca-Cola Amatil Limited (CCL), which recently caught traders out.
The Coca-Cola Trade
Back in mid-April Coca-Cola was trading at a two-month low and had retraced 8% from its all-time highs. Some traders may have been tempted by the fact that it was trading on a PE of 16 and a dividend yield of 5%, fully franked.
CCL has been a stable in many long-term portfolios, with its consistent yield of around 5% and it appeared to be offering traders an opportunity to join in on the trade when it bounced of its $14.20 support for a second time on April 22nd.
The trade plan would have been something like this: Purchase 5,000 CCL on break above $14.50 with a target of $15.25, using a stop below the recent low of $14.20 (see the chart below).
Coca Cola entered on 23rd April $14.55 – looked to be consolidating above $14.20.
There would be a healthy profit if the trade went according to plan and hits its target. See calculations below.
The trade stood to make 83% using CFDs or 4% trading straight shares.
CFDs versus MINI LONG Warrants
If the trader was impressed with the potential profits offered by the CFD trade, but was conscious that the market has run hard and may be due for a pullback in the near-term, they could choose to use MINI LONG Warrants for the trade instead.
To profit from the view that Coca-Cola was due for a run higher she purchased CCLKOB (CCL Long MINI Warrants) at $1.60. This is the equivalent of buying CCL at $14.55. These warrants give you a 1 for 1 buy exposure on CCL stock with 89% gearing and a built in stop loss feature (at $14.28) which helps minimise the trade risk. Place a stop loss on CCLKOB at $1.33 after trade entry (15% risk on trade). This is the equivalent of $14.28 on the CCL stock. First profit target on CCLKOB at $2.22 (33% reward on trade). This is the equivalent of $15.25 on the CCL stock.
Again there would be a healthy profit if the trade went according to plan using MINI LONG Warrants. See calculations below.
The MINI Long warrant trade stood to make a 36% gain, which compares to 89% using CFDs and 4% trading straight shares.
Trade Outcome
As the trade unfolded the stock price failed to reach the projected target of $15.25, but the trader felt comfortable to stay in the trade leaving her stop below the previous swing low of $14.20. On May 7th prior to market open Coca-Cola Amatil (CCL) announced that it expected first-half earnings to fall as much as 9% on-year, after its Australian soft drinks unit was hurt by a retail price war and subdued spending by consumers. This news saw the stock sell off severely on open.
We have calculated the profit and loss (P&L) for the trades using MNand 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.
Reality Check
As anyone who held Coca-Cola shares on the 7th of May would know, the company came out and reported a profit downgrade and the shares plunged over 5% on the open. The P&L calculations are detailed below:
Coca Cola Trade – Nasty GAP after earnings downgrade – Ouch!!
This “nasty surprise” was a shock to the bank account as you can see: the stock holder would have lost -6%, and the Long MINI Warrant trade would have resulted in a -45% loss.
However the CFD holder would have lost a whopping 104% overnight, that is all the money they put into the trade and then some, and this loss would have blown out to -140% (and more) if the trade did not get closed out within the first hour of trading.
Conclusion
Mind the gaps and beware of WMDs of the financial variety. Beware of trading for yield, as capital loss can far outweigh any income from dividends, as shown in this Coca-Cola trade.
When trading leveraged instruments you profits can quickly evaporate, so it pays to monitor the trade carefully. Fortunately our clients exited at our more conservative profit target around the $15.00 level.
When choosing your trading instrument be aware that CFD trades can end up costing more than you initially outlaid on the trade. CFDs are promoted because of their high leverage, but this leverage can be a two edged sword and can work both ways, as shown in today’s article.
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 Coca-Cola example.
MINI Warrants can be used 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 Coca-Cola trade as our example, but there have been any number of similar examples in recent times, including Downer EDI, Monadelphous, United Group, Sims Metal and Worley Parsons this morning, all of which have fallen 12% to 16% within a few trading days, often gapping on open.
Options and warrants can be used to increase your performance, while reducing your risk and still participating in potential profits from moves in the underlying stock. Also, once the stock has moved they can be used to hedge and or protect the position.
Utilise the features in the d2mxIRESS software to trade plan your trades for a particular options strategy using your specific trade selection criteria. You will save time and potentially reduce your trading risk.
For more trade ideas and recommendations on how to trade in this market, sign up for a free trial of the D2MX Daily Trading Report, which provides a daily serving of insightful market analysis and trade recommendations from the D2MX Advisory team, including:
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Michael Hevern
Investment Adviser – D2MX Advisory
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
Disclaimer: Using leverage to invest can be a two edged sword, as it can magnify your returns when the stock price rises, but will in turn magnify the losses if the trade does not perform as expected.
