Spread betting: five tips for would-be traders

The sort of volatility we’ve seen during the coronavirus outbreak tends to draw new traders to the stockmarket like moths to a flame. Spread-betting firm IG Index recently reported an influx of 22,500 clients in just 36 days. The problem is, most new traders are ill-prepared to cope with the realities of trading. Understanding the five concepts in this article won’t turn you into a stockmarket wizard overnight, but it might help you to avoid being the proverbial moth – and give you a better idea of whether trading would suit you or not. 

1. Position sizing: don’t bet the house on one stock

The two most important concepts to understand before trading are “position sizing” and “risk management”. The size of your positions determines your level of risk – your potential capital loss. Many new traders pile in with a large percentage of their portfolio, which is their first mistake. They then see those positions gradually eroded, because new traders aren’t prepared to cut their losses. This is their second mistake. “The first cut is the cheapest” is one of the best-known market mantras for a reason. Of the traders I know who have blown their accounts, every single instance was due to having either too much exposure to one position, a failure to cut losses early, or both.

The goal when position sizing is to make your position big enough to mean something, but not large enough to do serious damage. You will inevitably get hurt when trading. Avoiding overexposure to any one position is the only way to significantly mitigate the very real risk of blowing your account. I never put more than 10% of my total account into a single stock – not even for a short-term trade. For example, many traders piled in after seeing the directors of beer, wine and spirits supplier Conviviality buying the stock in March 2018 in the wake of a profit warning– yet just four days later the listing was suspended and eventually the share price was written down to 0p. The total loss of 10% of a portfolio is painful – but it’s not fatal. 

A further trick with position sizing is to scale your positions. When you’re winning consistently, you want to be gradually increasing your position sizes in order to compound your account faster. For example, if your overall portfolio grows by 10%, you can increase your position sizing by 10% too. Remember, however – this is even more critical when losing. By scaling down your accounts when losing, you increase the number of trades you can place before you blow your account. Remember: capital preservation is key in this business. Downside risk must always come first. 

2. Risk management: always know the downside

The size of your positions may vary depending on the placement of your stop-loss (the point at which you will exit the trade if it is going against you), but you should aim to keep the risk per trade a consistent size. If you are not consistent about how much money you can lose on any one trade, then how can you expect to make consistent profits? Losing isn’t a choice – but the amount you lose is always a choice. If you can keep your nicks and cuts small, and minimise your risk each time, then you give yourself the opportunity to stay in business. 

Here’s an example. Say we have two trading positions of £2,000 and £4,000, with a 10% stop on each. In trade one we will lose £200, and in trade two we’ll lose £400. However, in some positions, a looser stop will be required. If “support” (a technical analysis term referring to a level at which the share price has historically rebounded) is 15% away and we are running a 10% stop, then it’s likely we’ll be flushed out of the position. 

To adjust our position size for risk, we first take our monetary risk on the trade (the amount that we are prepared to lose on the position) and divide this by the difference between our entry price and intended exit price (or stop loss). This gives us the number of shares that we need to buy. 

So say we wanted to buy shares in Sammy’s Sandwiches at 20p and if it falls to 16p, we’ll cut our losses. This would give us 4p risk per share (the difference between the entry and exit). Now say we want to risk a maximum of £500 on the trade. Our calculation would be £500 / 4p = 12,500 shares to buy. Using this calculation, you can keep your risk constant, while adjusting your position sizes for better entries. 

For more from Michael, visit shiftingshares.com

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