Real trade No 1
For our first trade, I tried a quick foray into the foreign exchange markets. Speculating on the sterling/dollar exchange rate has been all the rage for a year or so now, ever since the surge in the FTSE 100 index lost momentum and began to drift sideways.
• Underlying: sterling/US dollar
• Time period: less that one day
Serious forex investors will probably have a specialist currency trading account with the likes of Oanda or FXCM. But spread-bets, CFDs and covered warrants have been very popular with private investors.
I carried out a day-trade, backing sterling against the US dollar using an IG spread-bet account, an Interactive Investor CFD account and Comdirect as my covered warrant broker. I chose an SG June 2005 £1.85 call warrant because it had a good bid-offer spread and high enough gearing to turn a profit from a quick, but modest, rise in the underlying.
With £200 ready to go on the currency warrant, the next task was to open up spread-bet and CFD positions with the right stop-losses. To make the IG spread-bet comparable with the covered warrant trade, I needed to stem my potential loss to £200. I could have done this by betting £1 a point and setting the stop-loss at 200 points below the level at which I opened my position, or by betting £2 a point and setting the stop-loss 100 points lower (or £3 a point with a stop-loss of 67 points, etc).
I could have taken out a guaranteed stop-loss with IG, but the spread on GBP/USD would have been eight points wide, which I considered unattractive for a day trade - especially given the fact that forex markets trade 24 hours a day, thereby reducing gap risk. In the end, I settled for a standard stop-loss 100 points lower (equivalent to a 1 cent strengthening in the dollar) and a £2-a-point bet.
There were no commissions to pay on the spread-bet, but the spread itself was five pips wide - relatively wide for a currency derivative. By scouting around the different spread-betters, I could probably have got that down to around three pips.
For my CFD trade, I used Interactive Investor, which uses a white-label version of the City Index CFD platform. The differences between the spread-bet and the CFD are that the CFD uses dollars not pounds per point, and the minimum stake I was allowed to speculate was $5 per point (strictly speaking, I didn't bet $5 per point, I bought five CFDs for $1 each).
You normally pay a commission or flat-rate fee to trade equity CFDs (around 0.2 per cent or £10 per trade), but currency CFDs are free of fees apart from the spread. The bid-offer spread with Interactive Investor was four pips wide, a slight improvement on IG Index.
To work out the stop-loss needed to protect my £200 stake, I first needed to convert it into dollars at the prevailing exchange rate of $1.90, which equates to $380. Given that I was speculating at the minimum rate of $5 per point, my $380 would have been wiped out after a 76-point fall, so I set my stop-loss at 76 points lower than the 19045 level at which I bought the CFDs (equivalent to an exchange rate of $1.9045 to the pound).
As with spread-bets, the narrower my stop-loss, the more pounds per point I could bet, and the more leverage available from my £200 deposit. I could have bought 10 CFDs (equivalent to betting $10 per point instead of $5), which would have tightened my stop-loss to a drop of just 38 points (a fall of 0.38¢). However, by setting a narrow stop-loss on the volatile sterling-dollar cross, there is a high risk that the stop-loss will kick in early on the trading day. I run the risk of being stopped out before the market moves my way.
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How the FX trades worked out
Trying to open and close three trades on three different software platforms at the same time on the same computer was tricky, but I managed to more or less coordinate the trades. I couldn't execute the SG currency warrant automatically - instead it had to go through a dealer, who manually processed my trade, which may have delayed the moment of execution and affected the price at which I got in and out of the market.
The CFD kicked off with sterling trading at $1.9045. By the time I clicked 'deal' on the IG spread-bet platform, sterling had weakened a few points to $1.9041.
Half an hour later, the dollar began to strengthen and the three positions were showing a loss. I reminded myself that the point of the exercise was not to prove that I could day-trade forex but to compare the different derivatives. And, sure enough, as soon as I took my eye off the screens, sterling began to recover. Three hours later, at $1.9078, I decided to close all my positions. Unfortunately, by the time all three trading platforms were up and running (and not crashing each other), sterling had begun to slip again. Still, I got out at a profit on all three trades.
The biggest profit came from the CFD, which is what you would expect, considering that I had invested at $5 per point with a narrower bid-offer spread than with the spread-bet. I made $55 (or 11 x $5) on the CFD off a 15-point rise in GBP/USD.
Moments later, when I tried to close the spread-bet, my computer froze. I called IG Index and was impressed by the fact that it took only 30 seconds longer to close my trade by phone. By that time, the markets had moved back in my favour a touch. I made a £24 profit from a 17-point rise on the spread-bet, at £2-per-point.
And the internet glitch highlights an important point. However good the software and hardware, there will come a time when you need to trade by phone so it is important that the service is prompt and efficient. During the course of the trading experiment, I also had to call up Comdirect and Interactive Investor, both of whose switchboards were serviceable, but not as speedy as IG's dealing hotline.
The covered warrant trade made a slender £2.13 profit and would have made a substantial loss had I paid the full £25 trading fees to open and close the trades. This is despite the fact that I got the direction of the markets right. This could have reflected the delays in opening and closing the currency warrant trade. It also highlights that the value of the underlying is only one of the several drivers of a warrant's value - the others including volatility, time to expiry, interest rates and proximity to the strike price.
For quick raids in and out of the forex markets, my simple experiment suggests that spread-bets and CFDs are superior to covered warrants. Perhaps there was a warrant that would have given me a better return from the 15-17-point rise in sterling, but I did not know how to find it. The warrant selector tools that allow you to compare and contrast warrant returns under different scenarios do not work for currency warrants.
In contrast, with the spread-bet and the CFD, it was obvious how much money I would make from a given move in the underlying asset. Between the spread-bet and the CFD, the only meaningful difference for the forex trade was that the bid-offer spread was 1 point narrower for the CFD and the minimum deal size was smaller for the spread-bet.
