Trading platforms users are able to use more and more tools that are used by stock trading professionals, but often underestimate the risks. Let’s go through such situations using a specific investment example.
Let’s use stocks indices that are usually long-term investments. How can they become a tool for short-term speculations where trading platforms users often underestimate risks?
Before Internet and mobile operator expansions there were times, when a regular person interested in investing did not have many choices when looking for information. The closest source was the local library or subscription to a magazine. Reports from financial institutions were often expensive and delayed, sometimes for several days.
With today’s infrastructure investors are able to read statements on the Internet, that are issued by various financial institutions, immediately after they are sent to the world. How-to manuals, information and contact data to reach respectable trade brokers may be found in minutes, as well as reviews and experiences of other users. Such amount of information, that general investors have, is unprecedented.
The offer of investment products and tools has expanded with information, too. Stocks indices are popular, hundreds of billions of US dollars are invested into them.
The attractivity and drawbacks of stocks indices when using so-called contracts for difference
Trading stocks indices may be leveled up by using an investment instrument called contract for difference (“CFD”) that works on a leverage effect principle. That means that investors add foreign capital to their own capital, which enables them to get bigger profits as well as higher losses. Leverage height is regulated by ESMA (European Securities and Markets Authority) for major indices, including those mentioned above, to 1:20, for minor stocks indices to 1:10 and for individual stocks to 1:5. By this definition, we may suppose that the regulator assessed the major stocks indices as the least risky out of all offered options, since they the highest leverage is allowed for use.
For a better understanding of how leverage in CFD trading works, we present you with a model case of a stock index. We will work with DAX Cash index movements. The value of this index was 12 062.50 on 18 June 2019 at 8.00am. On the same day at 4.00pm the value of this index was 12 342.70. This meant an increase of 2.32 %.
In the table you can see leverage levels of 1:1 up to 1:20. In this case we will be speculating on growth of the index, so if the index decreases, we will end with a loss. If the index grows, we will earn a profit.
|Leverage||Value at the opening||Value at the closing||Change (%)||Investment (EUR)||Profit/Loss||Spread* (USD)|
Charges: the table shows so-called spread, that is a charge of the broker which is calculated from trader’s profit from the difference between buying and selling price. More information about charges and detailed calculations are available in https://gulfbrokers.com/.
Let’s assume that the trader opened a position at 8.00am and closed the position at 4.00pm. The index has grown by 2.32 % in this time frame. The speculation on growth has paid off. With increasing leverage, we can notice also increased profit, since not using leverage at all meant for the investor only a profit of 232 EUR from an investment of 10,000 EUR. When using leverage, this profit would be 2,320 EUR, and with the maximal allowed leverage height the profit would even be 4,640 EUR. That means a profit of 46.4 % in a single day.
The question remains, if this yield is able to offset the risk, which is high as well. In the other scenario, the leverage of 1:200 would produce a loss of the same amount of 4,640 EUR.
Is the risky trading suitable for you?
Such risky products require a strong discipline and trading experience. Trading of stocks indices through CFD is not suitable for traders, that try to avoid high risks and are rather happy with certainty. Traders that are willing to risk and are sufficiently experienced, may like such instruments more. CFD may bring high profits while using relatively small amounts of own capital. However, the threats of high losses are usually bound with the possibilities of high profits. This means that a reasonable strategy should be used when working with such instruments. And in each case, learning of all basic glossary in detail is necessary.
The affinity to risk is dependent on risk profiles in investment questionnaires. The questionnaire is a tool, that is implemented to protect both parties of the contract before entering an unsuitable business. Every broker is obliged by capital markets trading law to fill in the investment questionnaire with a potential client. The questions and answers then show and evaluate experiences and willingness to risk. The scale, where the potential client is set, then reaches from a very conservative profile, with requirements to have the highest certainty, up to aggressive types of investors that demand highest profits possible and are willing to undergo higher risks.