As a believer in the philosophy that ‘timing the market’ is more important than time in the market (although both are necessary), we must endeavour to learn a number of new trading specific paradigms and prevent some of our old societal paradigms from impacting our trading.

I’ve written about some of these paradigms in previous Journal postings but today I’d like to focus on those who feel they needn’t lose to be able to win. Only by losing can we accept the fact that in order to achieve profitable gains over time, not all our trades will be winners. Less than half our trades may in fact be winners, but over time our trading system or methodology can be very, very profitable. It is this ability to accept the losing trades, to not fear losing and to stick to a trading system with an edge that will result in out-performance in the long run. It is this thinking and acceptance of losing that will make you a winner.

The importance of individual trades must lose relevance in the context of the overall performance of the system over time. This is a massive paradigm shift for most that enter the trading world. In the initial phases of trading careers most tend to focus solely on the outcome of each trade. Through attachment they ride the emotional roller-coaster associated with outcome thinking until they either:

1. learn to accept losing by shifting their focus to the long term performance of their system by understanding probabilities and hence what an edge is, or

2. give up altogether through frustration or lack of funds left in their trading account.

Accepting losing trades is difficult for those conditioned in life to be ‘winners’ and who mistakenly attempt to eliminate losing trades. There is not a trader or trading system on the planet that is right 100% of the time. There are very few that are right in excess of 80% of the time. Most traders know and accept this at the logical conscious level but because they have not ingrained it at the subconscious level they will be prone to trading errors, as if they don’t accept losing at the conscious level. Your subconscious always does your bidding for you.

The majority of systems fall into the 35 – 55% range of winning trades. Such traders and systems are profitable though because they know when to cut the losing trades and how to let the winning trades run. They are also acutely aware of position sizing and money management techniques that allow them to minimise their losses from the losing trades and maximise their returns from the winning trades. They are not looking for the ‘holy grail’ or perfection – merely to achieve the probabilities of their researched system over time – their edge.

Through the use of such a probabilistic edge, these traders are able to all but eliminate the fear and greed emotions which, if left unchecked, can begin to control the unprepared trader. This can cause them to begin second guessing the system, not enter valid trades, execute invalid trades, ignore stops and take too small or too large position sizes as they begin to attempt to gamble their way out of the mess they have created – all trading errors manifested through poor trading psychology.

This is a sure fire way to being beaten up both financially and psychologically by the markets. Those using a proven mechanical strategy and who have acquired the necessary psychological make up are at the complete opposite end of the spectrum – calmly executing entry and exit signals based on the rules and focusing on the total returns of the system rather than on the outcome of each individual trade. They are not swayed by greed and fear and are emotionally removed from the outcome of each trade. They have removed their ego from the trading process and place no value on the outcome of each trade – only that it is one of many in a long term approach to profitability. Winning and losing are states of mind. Which one do you have?

Last week we explained the concept of leverage and the benefits and drawbacks the use of leverage can have for the average active investor. This week we would like to focus on the use of CFDs as a leveraged instrument for increasing exposure to the stock market and share some stories and suggestions on how best to use leverage within your portfolio.

It is unfortunate but the great majority of investors that use leverage not only lose part of their capital, some lose the lot! This is not just anecdotal evidence but is factual when talking to brokers in the industry. I have personally had discussions with brokers, past and present, in Australia and overseas, who have confirmed that their average CFD account holder or futures account holder take nine months, on average, to wipe out their entire account. Some of the major reasons for this include:-

1. The leverage available with CFDs is too great. For the majority of CFD investors, leveraging a portfolio at 7 to 10 times its original starting capital is far too great. As in our example from last week, the temptation is to use the available leverage to take on position sizes that are way too big for the capital in the account. At 10 times leverage, a $100,000 face value position can be controlled with just $10,000. If the position drops in value by 15%, the investor has lost his $10,000 of capital PLUS an additional $5000.00 that needs to be provided to the CFD provider, that is, a 150% loss trade!

The GFC proves that the world’s financial fraternity as a whole cannot handle too much leverage!

2. Most CFD traders start with a small capital base and then leverage it up. CFDs and leverage have been a blessing to some investors who have the necessary skills to trade with leverage but it has also been a blessing to some of the CFD providers who have preyed on the ill-equipped CFD trader.

The information that I am about to share with you is probably not widely known by the bulk of CFD traders the world over. Most market maker CFD providers run what's called an 'A book' and 'B book' operation by profiling their customers. The ‘A book’ comprises large net worth traders or institutions who are skilled enough to make money on a regular basis and the ‘B book’ comprises smaller traders who are ill-equipped to trade with leverage and hence have the odds stacked against them. Some estimate that the 'A book' holds around 20% of clients whilst the 'B book' holds the remaining 80%. Where this really gets interesting is that the CFD provider actually places the trades of the ‘A book’ client into the market and hence carries no risk, or hedges the positions through other instruments. However, the CFD provider takes risk with the 'B book' betting on the fact that these clients as a whole will lose money on a regular basis and hence does not place these trades into the market or hedge them.

The 'B book' scenario is similar to that of a casino as the CFD provider (the ‘house’) assesses that they have a positive edge in their favour through the lack of trading skills of this demographic of CFD trader. I am outlining this for one reason. The CFD providers realise that the bulk of CFD traders trade with no money management, no risk management, no researched exit strategy, little or no trading plan, do not have an EDGE and more importantly, do not have the psychological wherewithal to handle trading with large leverage. This turns a commissions and spreads business into a casino with a house edge which is extremely profitable on the back of losing traders.

I’m not saying that this is inherently wrong. It is just the way that it is. Much like a casino. The problem is that most human beings cannot help themselves and hence need rules to guide their behaviour whether it be via government laws or via the rules of a trading system.

3. The roller coaster ride of investing in the market becomes magnified with leverage. This magnification cripples many investors into making psychological trading errors of magnitude and these mistakes can be catastrophic to a portfolio on an ongoing basis.

4. The majority of investors don't use a researched strategy with an edge, trading plan, money management and risk management techniques. This lack of rigour and lack of a tested rules-based process cripples traders. Trading with leverage requires the disciplined application of a strategy with clear and unambiguous rules-based calls to action.

5. The bulk of CFD investors continue to leverage their profits until an outlier event that their rules do not protect against wipes out the majority, if not all, of their capital base. A mistake that many CFD investors make is that they continue to leverage profits without taking them off the table. This leverage on leverage effect can create massive draw down and wipe-out in some instances. What is required is to regularly remove capital from a leveraged portfolio and invest it in other lower risk un-leveraged strategies. We all need to be able to sleep at night. As an investor your goal should be to get as much capital as possible invested in un-leveraged strategies. Leverage is merely a stepping stone to speeding up a wealth building process until a pre-defined level is reached.

A simple rule in a trading plan such as not allowing more than 25% of your entire investment base to be exposed to leveraged trading will go a long way to protecting a portfolio from wipe out. Apparently the entire Lehman Bros business was leveraged at 30x at the time of its collapse!

6. Similarly, another mistake leveraged CFD traders make is that they continue to trade with leverage in unfavourable markets trying to recoup losses.

Let’s look at an example.

At ShareFinder we provide investors with SPA3 un-leveraged and SPA3CFD leveraged trading rules. When a client has a large capital base (in-excess of $150K) we suggest they only take part of their capital and invest it in SPA3CFD, that's if they would like to trade with leverage. Our research and experience tells us that the draw down with SPA3CFD will be greater than SPA3 un-leveraged.

I will use the current ShareFinder SPA3CFD public portfolio to explain draw down in a little more detail.

On 30 May 2008, $40K was injected into the SPA3CFD public portfolio and the portfolio was leveraged to 3.2x its original injection. The portfolio was started near the beginning of a SPA3 Low Risk market which allowed both stock and CFD positions in the portfolio. To explain this further, SPA3CFD is designed to increase exposure in a rising market, or SPA3 Low Risk market, and decrease exposure in a falling market or SPA3 High Risk market. The system mechanically triggers the Low and High Risk market periods which removes discretion from the CFD trader.

Only weeks after starting the portfolio the market changed direction and SPA3 triggered a High Risk market. From the $40K injection the portfolio quickly retraced to $28,357 on 12 June 2008, a 29.1% drawdown in less than 2 weeks! I can clearly remember one customer ringing me and mentioning that the CFD portfolio may “ruin our reputation.” At the time I re-enforced that we firmly believed that the portfolio would come out of draw down at some stage and that we would continue our daily processes and trust the SPA3CFD EDGE. For the next six months the portfolio did as it is was designed to do. It held it’s own and only went down marginally through one of the steepest market retracement periods in the last 30 years.

The blue line is the SPA3CFD equity curve and the black line is the ALL-ORDS Index.

On 13 February 2009 SPA3 triggered a Low Risk market which allowed the portfolio to once again gain exposure to a potentially rising market. CFD positions could now be added to the portfolio with the purpose of capitalising on new potential market gains. However, the market did not rise immediately and the portfolio reached its maximum draw down of 39.25% on 12 March 2009 before it started rising. Let us point out that this is deep draw down but it is to be expected with leverage in an adverse market. Remember that the portfolio is leveraged at 3.2x it collateral compared to some CFD portfolios that leverage as much as 7 to 10 times, or even more.

From the maximum draw down on 12 March 2009 the portfolio has now risen 348.9%, or from $24,319 to $109,166. The principles of SPA3 have allowed the SPA3CFD portfolio to let the leveraged profits run during the good times and protect the capital from wipe out during the bad. We trusted our EDGE and continued to stick to the rules as we know that over a large sample SPA3 is proven to out-perform the index. Based on research, SPA3CFD should return around double the annual compounded returns than SPA3. These are the odds and we know that they are in our favour hence we can leverage with confidence. It also helps us minimise or potentially eliminate trading errors.

If you are considering using leverage in your investing endeavours please establish a set of rules before you expose your capital. If you set exits and have a pre-established plan you will have a higher probability of success than if you don’t. And always remember to not put all your eggs in a leveraged basket.

Much is made of the use of leverage in trading to increase returns on both investment and trading portfolio’s. But what exactly is leverage and how can we use it effectively to improve our returns? The big issue that is usually highlighted but little understood is that leverage is a double edged sword. Just as it can be used to improve our returns, leverage can also have catastrophic results for those that fail to understand its use and effective implementation.

Leverage is the use of a derivative product that allows you to control a much larger chunk of a particular stock or commodity than would be possible using all your own cash. A futures contract for example allows you to trade large amounts of a commodity for a fraction of the cost of the underlying contract value. Share CFDs and options are similar in that they allow you to have exposure to more shares for a fraction of the outlay.

Leverage occurs whenever money is ‘geared–up’ to make a larger investment in a market. The larger investment and associated potential returns would not be possible without the loan. An everyday example that we are all familiar with is borrowing money to buy a house in the real estate market.

Example: John buys a house for $500,000 using $100,000 of his own money and a loan of $400,000 from the bank. He has leveraged his own money by a factor of 5 to acquire an investment he could not otherwise afford.

In the financial market leverage can be created through leveraged instruments such as a CFD, option, or futures contract. Each one may have a different leverage factor but the principle is the same. Financial institutions, including Banks, Brokers and Market Makers, are all providers of these instruments and will set their own characteristics for each. Trading using leveraged instruments is different to trading on margin. We will discuss the use of margin loans in another Blog.

Any investment using a leveraged instrument requires a financial contribution from two parties. The previously mentioned loan usually forms the largest percentage and comes from the provider. The remainder is made up with your money and is termed the initial margin, initial deposit or simply margin.
You must be totally aware that leverage comes with greater risk. If the value of the larger investment moves against you, your absolute loss is much greater than it would have been without leverage. With some leveraged instruments you could lose more than your initial margin. Leverage magnifies both gains and losses.

Example: John buys $100,000 face value of shares in XYZ using CFDs with a 10% deposit or $10,000 of his own money. He effectively has a loan of $90,000 from the CFD provider; a leverage factor of 10. The value of XYZ shares fall by 4% to $96,000. He sells the entire position to produce a gross loss of $4,000 or 40% on his original $10,000. John now only has $6,000 to reinvest.

It is therefore critical when trading with leverage that you have a proven methodology in which money and risk management rules control the risk to your portfolio. It is often the case that investors with a small amount of start-up capital are the one’s drawn to the use of leverage like ‘moths to a light’ in an attempt to increase their capital base quickly. Without a thorough understanding of the application and effects of leverage they are unfortunately often adversely affected by the markets because they are too highly leveraged without a true understanding of the consequences.

We spoke with a ‘trader’ only yesterday who couldn’t understand why he was so nervous about a trade he had put on and why he had been so adversely affected by a small price move against his position. This person had a $40,000 trading account with a CFD provider. Using the leverage available he had purchased 50,000 CSR shares at $2.04. This left him with a face value position of $102,000.00. When the price dropped to $1.94, just 10c, he was stopped out of the trade with a loss of $5000.00 or 12.5% of his original trading capital. To put this into perspective, loss trades should be, on average, between 0.5% and 2.5% of the ‘un-leveraged portfolio value’. Those that wish to take large risk might go as high as 5% but 12.5% is on track to portfolio ruin.

The key when using leverage is to understand it properly and to always protect your capital. The lure of big winners through the use of leverage is more often than not tempered by the big potential losses that can occur, such as in the above example.

“Longevity in the world of leveraged trading isn’t measured by how much you make when you’re hot. It’s defined by how little you lose when you’re cold.” Author unknown.

Of course, this applies to all trading but is magnified when trading with leverage.

Next week we will look at some strategies that we employ in the SPACFD trading methodology to effectively manage and control the use of leveraged instruments in the overall portfolio. We will also discuss what type of investor is suited to leverage and what the maximum amount of capital is that an investor could consider to trade with leverage.

This posting was recently brought to my attention. It originates from an international trading site and is repeated here verbatim. Trader John lists in point form the 38 steps it has taken him to become a successful and profitable trader. I think this is a very pertinent article as it outlines in a simple yet powerful document the journey that is familiar to all of us as we seek to become unconsciously competent in our trading and active investing activities.

Reading through Trader John’s points you will no doubt recognise that you have experienced some, if not all of his events and feelings in your own trading journey. It may also provide you with an opportunity to reflect on where you are on your journey and the many milestones you have reached and passed.

What is also very important to most of us is the realisation that ALL those who set out on this journey experience very similar feelings, emotions and actions at some stage. So, next time you are feeling stuck, have a series of losing trades, or are just feeling frustrated with the markets and your own perceived lack of progress, have another read through these 38 points. Identify which point you are at and make the decision to overcome and rise above the situation and keep progressing forward. After all, trading and investing, like all things in life, is a journey, not a destination. Our resolve and skill will continue to be tested - each test is an opportunity to grow and improve.

1. We accumulate information - buying books, going to seminars and researching.
2. We begin to trade with our 'new' knowledge.
3. We consistently 'donate' and then realise we may need more knowledge or information.
4. We accumulate more information.
5. We switch the commodities we are currently following.
6. We go back into the market and trade with our 'updated' knowledge.
7. We get 'beat up' again and begin to lose some of our confidence. Fear starts setting in.
8. We start to listen to 'outside news' and to other traders.
9. We go back into the market and continue to 'donate'.
10. We switch commodities again.
11. We search for more information.
12. We go back into the market and start to see a little progress.
13. We get 'over-confident' and the market humbles us.
14. We start to understand that trading successfully is going to take more time and more knowledge than we       anticipated. MOST PEOPLE WILL GIVE UP AT THIS POINT, AS THEY REALISE WORK IS INVOLVED.
15. We get serious and start concentrating on learning a 'real' methodology.
16. We trade our methodology with some success, but realise that something is missing.
17. We begin to understand the need for having rules to apply our methodology.
18. We take a sabbatical from trading to develop and research our trading rules.
19. We start trading again, this time with rules and find some success, but over all we still hesitate when it       comes time to execute.
20. We add, subtract and modify rules as we see a need to be more proficient with our rules.
21. We feel we are very close to crossing that threshold of successful trading.
22. We start to take responsibility for our trading results as we understand that our success is in us, not the       methodology.
23. We continue to trade and become more proficient with our methodology and our rules.
24. As we trade we still have a tendency to violate our rules and our results are still erratic.
25. We know we are close.
26. We go back and research our rules.
27. We build the confidence in our rules and go back into the market and trade.
28. Our trading results are getting better, but we are still hesitating in executing our rules.
29. We now see the importance of following our rules as we see the results of our trades when we don't follow       the rules.
30. We begin to see that our lack of success is within us (a lack of discipline in following the rules because of       some kind of fear) and we begin to work on knowing ourselves better.
31. We continue to trade and the market teaches us more and more about ourselves.
32. We master our methodology and our trading rules.
33. We begin to consistently make money.
34. We get a little over-confident and the market humbles us.
35. We continue to learn our lessons.
36. We stop thinking and allow our rules to trade for us (trading becomes boring, but successful) and our       trading account continues to grow as we increase our contract size.
37. We are making more money than we ever dreamed possible.
38. We go on with our lives and accomplish many of the goals we had always dreamed of.

As an advocate of using a mechanical approach to trading and investing, it is point 36 that I find the most important. It is at this point that we finally realise that this whole caper is not about us, our ego and our need to be right and to control. It is about overcoming fears through empathy and trust which are manifested through surrendering to the rules of a systematic process with a researched and proven ‘edge’ over the market. Accept and achieve this and points 37 and 38 will follow, almost magically.

As always, I wish you consistent and objective trading.