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The ups and downs of derivatives

Sep 06 2018 09:16
Simon Brown

Recently, there was some more bad news for MTN. 

The Central Bank of Nigeria (CBN) is claiming that MTN illegally repatriated dividends from Nigeria back to South Africa and is demanding that MTN return $8.1bn. 

It’s also demanding a tax payment of about $2bn. Keep in mind that the 2015 MTN Nigerian fine was some $5bn, so this is massive.

MTN has denied any wrongdoing and unlike in 2015, at least the telecoms company released a Sens announcement pertaining to the $8.1bn claim to market timeously.

However, the point I want to focus on is not so much MTN, but rather on traders using derivatives* (gearing) and single-stock risk. 

I wrote this column on the morning the MTN news broke and the share was trading down 22% on that day’s close. 

A trader of MTN may have been short the share and looking to profit from a price decline and would have been popping champagne with their breakfast. 

But the inverse is the trader who was long MTN overnight, expecting to profit from a price rise – they would have been unable to even eat breakfast as they’d have been sick to the stomach with the losses on their portfolio.

Assuming a trader is geared at between 7 to 10 times using futures or contracts for difference (CFDs), their losses that morning would have been in the order of 150% to 220%, and there was no real way to protect as this move happened overnight with no opportunity to exit ahead of the collapse. 

This is a major disaster for a trading portfolio – for the cash balance of the portfolio, but also to the emotional wellbeing of the trader.

The problem is that there is no way to protect yourself against such an event. 

Sure, sometimes when really bad news breaks, a trader may be on the right side of the trade and profit handsomely, but eventually they will be on the wrong side and see their portfolio being destroyed.

Further, it is important to accept that any stock has the capacity to one day break really bad news that will cripple a trader’s portfolio or, alternatively, to jump markedly higher on a takeover announcement – hurting those traders who are short the stock.

One possible solution is many smaller trading positions within a trading portfolio, but this becomes very difficult to manage. 

In my days of stock trading I couldn’t ever manage more than four open positions, so the risk of a single event was still significant. 

For me, the solution to the risk of a single-stock move was simply to stop trading stocks altogether. I now only trade indices and forex (FX). 

Sure, an index can collapse, but that is a very infrequent black swan event. Even in the worst days of the 2008/09 crisis, we never saw more than a 5% gap from a close to an open and I am very able to manage that level of risk within a trading portfolio.

I also want to stress two important points on FX trading. Firstly, do not start with FX trading. This is where the global professional traders lurk, and they’ll take your money before your coffee is cold. 

Get experience (and profitable) trading an index (ALMI is excellent at R1 a point) before slowly moving into FX. Secondly, only trade the major FX crosses; yen, US dollar, pound sterling and euro.

A last point: I am writing about traders here. Sure, investors have also been burnt by this news, but as they’re not geared, the loss is just the 22% – and not multiplied by the gearing that derivative traders use.

*A derivative enables a trader to trade a position size of say R100 000 with only R10?000 to R15 000 cash, but taking profit or loss off the full R100 000. 

This article originally appeared in the 13 September edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

mtn  |  trade  |  portfolio

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