Here’s how to avoid disaster when trades go bust... | Fin24
 
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Here’s how to avoid disaster when trades go bust...

Oct 31 2019 14:43
Simon Brown

Simon Brown, founder and director of JustOneLap.com.

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A few months back, I wrote about trading and how hard 2019 has been for many traders. Since then, a number of readers contacted me about their own experiences, of which pretty much all resulted in losing money so far this year. 

I was fortunate that when I started trading in the mid-90s, all there was to trade was equities. Then, in late 1997, options (via listed warrants) were introduced. While options provided gearing, your downside was still capped at 100% because an option is the right to buy or sell, not the obligation. So, if things went horribly wrong, you could walk away from the option with no further obligation.

Now sure, a 100% loss in a trade is bad. 

But the readers I refer to above are all traders who lost way more than 100%. This is because futures or contracts for difference (CFDs) are an obligation. This means you can lose a lot more than you started with.

Let’s use an example. Using either a futures contract or a CFD, you get exposure to, say, R50 000 worth of a share you think will be moving higher. But you don’t pay the full R50 000. You pay a deposit of around R5?000. Essentially, the remaining R45?000 has been lent to you.

Then something horrific happens to the share and it drops, say 25%, over a couple of days or weeks. Of course, such a drop is not an uncommon event in the current market. A drop of this size on R50 000 would mean you lose R12 500. But because you’ve only paid in R5 000 initially, you now need to pay an additional R7 500. You’ve lost more than you started with.

The problem here is broadly four-fold: gearing, shares, stop-losses and risk management.

Firstly, gearing is dangerous. You’re trading with borrowed money and, let’s be honest, when you start trading you don’t know what you’re doing. Quite frankly, using borrowed money to trade is a crazy idea. The solution here is to completely avoid futures or CFDs when you start trading. Instead, just start trading with normal listed shares. Sure, the above 25% fall would have hurt a lot, but it would actually only have hurt 25% and not 150%, as could have happened in a geared example.

Yes, trading shares without gearing is slow going. But when you’re a learner trader, slow is exactly how you should be going. Going full- steam ahead from day one will see you wipe out your portfolio, and then some.

The second issue is, frankly, the actual shares. Shares carry huge single-event risk. Think of all the sudden collapses we’ve seen in the last few years; from Steinhoff, which fell more than 50% in a single day (and then even further), to the more recent Tongaat Hulett debacle. And a bunch of others. 

A piece of very bad news (or very good news) can see a share move extremely quickly, whereas indices move a lot slower because they are a basket of shares. 

Yes, indices do crash. But the worst example was Black Monday, on 19 October 1987, when we saw a global market crash. Yet, the Black Monday crash saw markets down just over 20% in a day which, compared to Steinhoff, is a walk in the park. 

If you want to trade in indices, I would recommend starting out trading the local Almi, which is the mini contract on the Top 40 Index. Risk is R1 a point. You can start with a modest R10 000 and still apply proper risk management. In time you can graduate to the Alsi contract, which still tracks the Top?40, but at R10 a point (and some R100 000 required per contract you trade).

The other two issues I mentioned were stop-losses specifically, and, more broadly, risk management. I will go into these themes in the next issue where I’ll share some ideas, such as the 2% rule (which, if properly applied, means you’d need 50 losing trades in a row to go bust).

This article originally appeared in the 7 November edition of finweek magazine. Buy and download the magazine here or subscribe to our newsletter here

investment  |  trading  |  derivatives
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