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How Simon Thompson trades

Created:
7 March 2008
Written by:
Simon Thompson

The high volatility in equity markets may be a dream for professional day traders, but private investors have also been making hay. So, to show how you too can profit from index trading, we take you through trading techniques for contracts for difference (CFDs), covered put warrants and spread betting.

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Listed Short-index CFDs

Back in early January, we suggested taking out a short-listed CFD, C433, on the FTSE 250 index ('Bad tidings', 7 January 2008), both as an insurance policy against a deteriorating macroeconomic background, as well as a hedge against the risk that news of downgrades to the credit ratings of the US bond insurers could be the catalyst for another setback in the equity markets.

In the event, both scenarios played out and the FTSE 250 plunged from 10,200 on Monday 7 January to a low of 8903 on the morning of Tuesday 22 January. And, as can be seen in the graph below, the 13 per cent fall in the index was linear in nature as the previous support level of 10120 on the index - which had arrested declines in both November and December - gave way in spectacular fashion as we had predicted. And, because we were using a leveraged product, these gains were magnified greatly.

To recap, we had chosen this short-listed CFD because it had a guaranteed stop-loss of 12550, a stop-loss of 12500 and ran through to 11 July. So, not only did the product give us enough time for our bearish scenario to play out but, because the stop-loss had been set above the FTSE 250's all-time high, there was no chance of being stopped out. In addition, the tight two-point bid-offer spread was attractive, as was the 2350 points of intrinsic value - the difference between the guaranteed stop-loss of 12550 and the market price of 10200. True, we also had to pay another 234 points on the CFD to reflect the fact that, as we were shorting, we also had to pay out dividends on the constituent companies making up the index. Still, the price we paid - 2,584p per CFD (the contract size is one CFD per point on the index) - proved a bargain. Indeed, when the CFD peaked at 3,880p on 22 January, we had made a 50 per cent return on our investment in only 12 trading days.

Or, to look at it another way, if you had shorted the FTSE 250 at a modest £10 per point using the C433 CFD, you would have bought 1,000 of the CFDs at a cost of £25,840. Ten days later, having seen the index plunge in value by 1,300 points, you would have made a £13,000 profit.

Covered put warrants

Another way to short the index is through covered warrants. For example, Société Générale has a covered put warrant, SA39, on the FTSE 250 index with an exercise price of 12000, expiry date of 20 June 2008 and parity of 1000:1. The latter refers to the number of warrants required to give exposure to one contract on the index itself. Back in early January, when the FTSE 250 index was trading at 10200, this warrant was priced at 210p. At the time, the put warrant had 180p of intrinsic value - calculated by deducting the index market price of 10200 from the exercise price of 12000 and then dividing by the parity ratio of 1000 - and 30p of time value. In other words, if held to expiry the index would have needed to have fallen 300 points to 9900 to recoup the 210p per warrant price we were paying. However, by the morning of Tuesday 22 January, the index had done more than this and was trading at 8905 and the warrants had risen to 310p - a gain of 47.6 per cent. This compares favourably with the 12.7 per cent fall in the FTSE 250, highlighting the gearing effect of the product.

Spread Betting

Like CFDs and covered call warrants, spread betting is exempt from stamp duty. But there is one other major advantage, too - spread betting is free of capital gains tax. However, using spread bets in these markets requires high levels of discipline - due to the high levels of volatility - to avoid being stopped out of a position, only to see the market reverse the next day. Indeed, since the end of November, there have only been three days when the FTSE 100 has not moved more than 1 per cent from peak to trough intraday. And it is worth remembering that the higher the leverage used, the greater the risk to your capital if the trade goes against you.

For example, anyone with the foresight to short the FTSE 100 on 2 January when the index was trading at 6500 would have cleaned up - the blue-chip index plunged to 5340 three weeks later. A down bet of £50 per point - which would have required a margin of £10,000, or the equivalent of 200 points to open the position - would have generated a profit of 1160 points, or £58,000 over just 15 trading days. However, with the FTSE 100 moving up and down 200 points-plus intraday recently, index trading requires nerves of steel.

FURTHER READING...

Main feature: Fast markets, big profits

Volatility: Traders' tales

Learn more about CFDs, covered warrants and spread betting through our Guide to Derivatives.

Read more of Simon's columns here - and check out his Bargain Share Portfolio for 2008.

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