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Real trades: introduction

Created:
27 May 2005

If you want an accurate steer on the pros and cons of spread-bets, contracts for difference (CFDs) and covered warrants, you cannot beat real-life trading.

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With that in mind, I set up a trading experiment by opening accounts with a spread-betting firm, a CFD provider and a covered warrant broker, and deposited £300 in each. I then opened and closed three different trades designed to bring out the best and worst of each derivative.

The three trades varied in terms of the underlying asset, from the sterling/US dollar exchange rate to the FTSE 100 index to an individual stock, Vodafone. I also varied the durations of the trades - a few hours for the currency trade, a day for the Footsie position and one week for Vodafone.

The purpose was not to see how much money I could make - although profits were helpful, considering that I was investing the company's cash. Instead, the point was to tease out the differences in risks, returns, fees, spreads, commissions and the overall trading experience.

But even though I did all I could to make the trades comparable and the money at risk for each trade was limited to £200, perfect comparisons were tricky.

With a covered warrant trade, the maximum you can possibly lose is the initial stake. With a spread-bet or a CFD, you could lose your entire stake and more if the markets turned against you. Stop-losses are available, but they do not protect you from gap risk. Some spread-betters and CFD providers offer guaranteed stop-losses but they charge clients an extra fee for this through a wider bid-offer spread or higher commission.

For that reason, if you start with a covered warrant trade and try to match it as closely as possible using a spread-bet or a CFD, you will have to bolt on guaranteed stop-losses, which only a minority of investors choose to do. However, if you start with a standard spread-bet or a CFD trade, you cannot recreate the risk/reward balance with a covered warrant because the warrant comes with built-in protection that cannot be stripped away.

As a compromise, I used non-guaranteed stop-losses for the CFD and spread-bet trades so that the most I could lose per trade (barring exceptional circumstances) was £200 - the same as the initial stake for the spread bet.

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