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Alternatives to Trading in a Shaky Economy

Almost six years later, the recession of 2007-2008 hovers on the edge of rearing its ugly head again unless the major world economies find a way to stabilize and steadily grow. The unemployment rate and the American economy have had some relief, however, the threat of another recession is very real. For example, imports and exports for the United States in 2012 were extremely lopsided with the weight on imports. The country accepted $2.09 trillion in imports, but exported only $1.41 trillion. In other words the U.S. had a net outflow of  .68 Trillion.  In the long run, this will be a drain on our economy. But what does that have to do with an individual?

Protect Yourself by Minimizing Risk

The key of course is to maximize return while minimizing risk. If used properly tactics that are often considered “high risk” like options and futures can actually be used to minimize risk. The key of course is the word “properly”. RiskTwo other tactics used by individual traders are Contract for Difference, or CFD, and Spread Betting. The CFD is a flexible alternative to traditional trading, and provides greater leverage and if used properly can be used to mitigate risk. Spread betting is different than options or futures and it takes a bit of practice to learn the idiosyncrasies.

How CFDs Work

The CFD is a contract. Basically, you are contracting to own the difference between the current price and a future price. So if the current price of the underlying instrument is $100 and the future price is $120 you own the $20 difference. But if the price goes to $80 you own that $20 loss as well. Whatever prices the financial instruments open and close at, the CFD pays the difference between the two amounts. The trader decides upon the market in which to trade. Instead of purchasing the instrument for the full price, the trader opens a CFD, and makes a margin deposit to cover potential losses. Say the trader wants to buy 1,000 shares in a company. The trader could purchase a traditional stock price and pay the full value, or the trader could purchase 1,000 CFDs. The CFD is flexible, provides leverage and contracts without an expiration date allow traders to close their positions when they choose.

How Spread Betting Works

The general idea of spread betting is to create an active market for both sides of a wager, even if the outcome of an event may appear to be biased towards one side or the other. Spread betting was originally invented for sports betting where a strong team may be matched up against a weaker team; i.e. a favorite vs. an underdog. If the wager was simply “Will the favorite win?”, more bets are likely to be made for the favorite, possibly to such an extent that there would be very few betters willing to take the underdog. But by saying they have to win by 4 points or 10 points or whatever people will be willing to take both sides.

These days investors in the U.K can use spread betting on the stock market as well. The spread has to do with the difference between the price a financial instrument sells for and the price it buys for. Profits may be hefty, as will losses, and traders should use stop loss to protect their interests.

Wikipedia provides this example:

Suppose Lloyds TSB is trading on the market at 410p bid, and 411p offer. A spread-betting company is also offering 410-411p. We use cash bets with no definite expiry, or “rolling daily bets” as they are referred to by the spread betting companies. If I think the share price is going to go up, I might bet £10 a point (i.e., £10 per penny the shares moves) at 411p. We use the offer price since I am “buying” the share (betting on its increase). Note that my total loss (if LloydsTSB went to zero) could be up to £4110, so this is as risky as buying 1000 of the shares normally. If a bet goes overnight, the bettor is charged a financing cost (or receives it, if the bettor is shorting the stock). This might be set at LIBOR + a certain percentage, usually around 2/3%. Thus, in the example, if Lloyds TSB are trading at 411p, then for every day I keep the bet open I am charged [taking finance cost to be 7%] ((411p x 10) * 7% / 365 ) = £0.78821 (or 78.8p). On top of this, the bettor needs an amount (AKA collateral) in the spread-betting account to cover potential losses. Usually this is either 5 or 10% of the total exposure you are taking on but can go up to 100% on illiquid stocks. In this case £4110 * 0.1 or 0.05 = £411.00 or £ 205.50

If at the end of the bet Lloyds TSB traded at 400-401p, I need to cover that £4110 – £400*10 (£4000) = £110 difference by putting extra deposit (or collateral) into the account. The bettor will usually receive all dividends and other corporate adjustments in the financing charge each night. For example, suppose Lloyds TSB goes ex-dividend with dividend of 23.5p. The bettor will receive that amount. The exact amount received varies depending on the rules and policies of the spread betting company, and the taxes that are normally charged in the home tax country of the shares.

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Brett Chatz was born in Johannesburg, Gauteng, South Africa. He attended the internationally accredited University of South Africa, where he completed the prestigious Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. In concert with the primary degree, he completed several Bachelor of Arts courses, most notably English poetry and literature. Nowadays Brett contributes informative essays for the globally renowned spread betting and CFD trading provider, InterTrader.com.

Image courtesy of Stuart Miles / FreeDigitalPhotos.net

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