Trade in CFD’s

CFD’s - one of the most publicised and talked about trading instruments to hit the Australian retail investment scene in quite some time. We have put together this little introductory page to ensure that you understand the basics of these highly leveraged, highly risky products.

What are CFD’s?
A contract for difference (CFD) is fundamentally an agreement between two parties, where one of those parties pays to the other, an amount of money based on the price movement in a security. However neither party has any obligation to acquire or deliver the actual underlying security. This transaction simply comprises the parties settling the difference between the purchase price and the sale price.

People trade in CFDs for various reasons, such as speculation. For example, share CFD traders may be investors wanting to profit from intra-day or overnight, or longer-term market movements in the underlying shares.

Some people trade share CFDs to hedge their exposures to the underlying shares. In this way CFDs become a risk management tool, allowing holders of underlying shares to lock in an effective sale price for those he shares by taking a “short” CFD position. If the price of the underlying shares held by the investor falls, the “short CFD positions” will wholly or partly offset the losses incurred on the actual shares held.

How It Works
You can take a “long” or “short” leveraged position – all you do is simply provide a cash deposit (known as the initial margin) as collateral. Each business day, the position is marked-to-market, with the consequential payments being made between the parties. Although a CFD replicates the price movement of the underlying instrument or security, you have no right or obligation to acquire or deliver the instrument or security itself and do not entitle you to any voting rights.

You can take both “long” (buy) and “short” (sell) CFD positions to open positions. If you take a long position, you profit from a rise in the underlying instrument or securities price, and you lose if the underlying instrument or securities price falls. Conversely, if you take a short position, you profit from a fall in the underlying instrument or securities price, and lose if the underlying instrument or securities price rises.

The volume of CFDs you can short in a single day may be limited due to limited borrowing availability in the underlying market.  And when short selling CFDs, you may experience forced closure of a position if your CFD gets recalled.

Large Upside BUT Big Downside!
CFDs can be a very highly leveraged play, enabling users to outlay a relatively small amount (in the form of initial margin) to secure exposure to the underlying share. As always with leverage, it can work against you as well as for you - large losses as well as large gains are always possibilities…

So you can buy 10,000 of shares in a company at $1.00 and pay your broker $10,000 (plus costs), or you can buy the company CFD and use an Initial Margin of $1,000 (plus costs). For the experienced investor, this leverage can provide a cost effective means of profiting from the performance of the underlying shares (if it does actually perform of course) without buying the actual share.

Use Conditional Orders

Use Conditional Orders

A conditional order is simply an order you place with your broker, to undertake an action (e.g. buying or selling a share) based on a certain condition specified by you.

One of the most common conditional orders involves instructing your broker to monitor a particular stock on your behalf, and should the share price reach your nominated target, to buy (or sell) it for you.

There are basically two parts to a conditional order. The first part is your order to buy or sell a particular stock. The second part is the conditions you set. These conditions include the price the stock must reach and the quantity of stock you want to trade. Your broker then monitors the market, and as soon as your conditions are met, your order sent to the market for execution.

Conditional orders can be very useful in several ways. Firstly, they can save you a lot of time spent watching the market minute by minute. Secondly, they can help you think ahead and set out a plan for what you are going to do. Conditional orders can help you automatically stick to a trading strategy as there is no need to keep watching the market - when the conditions you have nominated occur, your request is actioned.

Of course there are more complex conditional orders that go beyond simple price and volume conditions, through to advanced price tracking and straddle orders. Ask your broker what sorts of conditional orders they accept.

Conditional orders are very much part of the wise-owl.com approach, because as part of our stringent risk management protocols, we nominate Stop Loss and Profit Stop Levels with each recommendation.

These types of orders are also advantageous in that they can take the emotion out of the trade no need to agonise over your decision once the order is set. And they can also not only help you develop a more focused trading plan, but also help you lock in profits and minimise losses. 

Online broking works. Millions of people use online brokers. So who is the best online broker for you?

Brokers, advisers, and their firms have to be licensed or registered, as well as making certain important information available to the public. Because individual investors needs vary so much, there are quite a few online brokers out there and that in turns means doing your homework to find the one, or perhaps several, that are right for you. Here are some general suggestions to help you get started.

Two important considerations are:
* the range and quality of customer service
* the fees you will pay to trade

One of the most important aspects of customer service is how easy it is to reach a real fellow human when you need help. Are the company’s fees low because it runs on a skeleton staff that won’t be able to return your call for a week? We hope not!

Though online investing is supposed to make it easier to interact with the brokerage and make trades, unusually high volume on the site (often caused by unusually high volume in the overall market) can mean delays online. So while being forced to make a voice might make you feel like all those internet advances are for naught, it’s good to know that there are real live human brokers who will actually take your call when needed.

Good service also includes the provision of search tools and other tools and data to assist your decision-making. You’ll find some tools and research data work well for you while others don’t - just keep exploring various sites and use whatever keeps working for you.

While many of the bigger sites offer similar services, there can be significant variations in cost. Consider the average size of your trading parcels and how often you plan to trade, then do the simple arithmetic to determine if the differences in trading costs are significant enough to warrant changing brokers.

We recommend calling the site before opening an account to ask a number of questions, including:

* What kinds of fees does the firm charge?
* Do the fees change depending on the type of account the customer has?
* Do you need to meet an account minimum to open an account? (these can vary)
* Do you need to maintain an account minimum?
* What happens if you don’t make any trades for a while?

There can be a lot of hidden fees, and just by calling to ask these questions you should be able to get a feel for how customer service friendly they are.

Do be sure to check the final costs before you commit to an online broker. Ultimately however it will come down to you finding a site and service that works your way and that you feel comfortable and secure with. A little bit of the right homework can make all the difference.

Manage Your Risk

Manage Your Risk

Portfolio Risk Management is fundamental to the steady growth of your portfolio, and the protection of your hard earned investment capital.

A quick explanation of the Risk Management Strategy

Many investors & traders use a ‘rule of thumb’ of 5%-10% stop loss/risk factor with their capital. wise-owl.com does not. The stringent risk management strategy applies a limit of 2-3% of portfolio capital per trade.

Let’s assume you have $25,000 to invest. Applying the wise-owl.com rule, the risk exposure per trade is $500 (i.e. $25,000 x 2%).

In other words, the maximum you stand to lose if the trade falls below the stop loss level is $500 or 2% of your capital.

Following the ‘5-10%’ rule, you would stand to between of 5% and 10% of your capital, some $1,250 to $2,500 ($25,000 x 5% = $1,250 or $25,000 x 10% = $2,500). 

Equities Report each week you see the trade size formula:

Once you have determined your risk profile (i.e. whether you want to risk 2% or 3% of your capital per trade), you can use the online calculators we provide on the strategy page of each week’s Equities Report to automatically generate the trade size for that stock.

Using Risk Management to Maximise Returns, Minimise Losses

Many investors first look at ‘hit rates’ alone to determine the relative ’success’ of a portfolio. This can be a most inaccurate gauge of the success of any individual’s, report’s or research house’s recommendations. Why? Because results measured by these ‘hit rates’ - such as ‘80% of the stocks picked are winners’ can be very misleading. The 20% of stocks you got wrong might result in a loss that is bigger than the gain made on winning stocks, thus bringing your overall return into the negative.

This is where overall portfolio risk management comes into its own…

A Case Study
Consider the three model portfolios below all based on real wise-owl.com recommendations.

Portfolio 1 demonstrates a good ‘hit rate’ of 70% (7 out of 10 stocks are ‘winners’ - a pretty good hit rate in anyone’s book). It could represent a conservative DIY investor with a small number of speculative stocks mixed in for variety.

Portfolios 2 and 3 both have lower hit rates (50% and 30% respectively). However, the return for Portfolio 1 is less than for both Portfolio 2 and Portfolio 3! Why? Because sometimes a few major negative returns can destroy a whole lot of positive (but smaller) returns. And that is why a simplistic comparison based just on hit rates can be so misleading.

Portfolio 2 has 50% hit rate, and is a mix of top 300 stocks and some smaller cap recommendations - a fairly aggressive portfolio for a growth investor - and the results reflect this. Even with 50% of the stocks yielding a negative return, the portfolio shows strong growth over the period.

Similarly Portfolio 3, with just a 30% ‘hit rate’ still displays dynamic growth and high returns, characterised by a high proportion of ’speculative’ stocks typical of an aggressive investor. Whilst both selections display speculative characteristics, the wise-owl.com risk management strategy of employing stop loss levels to minimise downside, and locking in profits when the stock is on its way up, has led to very strong returns, despite a relatively low ‘hit rate.’

The Stop Loss and Profit Stop 
It is a price level that you set in advance, at which you will sell that particular stock. We use it to know when to say goodbye to a stock before it really damages your portfolio by eroding the hard-won profits you have realised on other performers.

The stop loss levels you see in our reports each week are inextricably linked to the risk management strategy, and are designed to minimise losses and maximise longer term capital appreciation.

The profit stop is in essence a revised stop loss put in place when a recommendation starts to realise growth. Another way of looking at this is as a safety net, helping you lock in profits along the way, and thus maximise the value in any performer. Too many times investors watch and wait as a stock goes up, only to have it slide back, and see a 70% (unrealised!) profit slip into the negative…

Technical Analysis

Analysis Part II

Carrying on from Fundamental Analysis, Technical Analysis is also used by the wise-owl.com team to ensure our recommendations have passed all the key check-list items we have before we recommend any stock.

Technical Analysis
Technical analysis is at its most basic, an analytic, empirical approach used to to determine when and how a shares current market price is likely to change. We do this by studying historical performance of stocks, and looking at statistics such as price and volume, to identify patterns of future performance. Technical analysis is a study of the actual share price movement, not the fundamentals of the company. Put simply, in contrast to the fundamental approach, technical analysis effectively looks at what is happening, not what should be happening.

The movement of a stock is defined by such concepts as barriers, channels, wedges, breaks etc which relate to the patterns of movement of the chart of the stock price.

The editorials of Charles H. Dow (1851-1902), journalist, first editor of the Wall Street Journal and co-founder of Dow Jones and Company, are widely accepted as the foundation of this approach.

The approach was refined after his death by Hamilton, Rhea and Schaefer, and was eventually collectively referred to as Dow Theory, even though Dow himself never used the term. The Dow Jones Industrial Average stock market index too, still bears his name.

In summary, Dow Theory proposes that major market trends are composed of three phases: accumulation phase, public participation phase, and distribution phase.

During the accumulation phase “in the know” investors are actively buying (selling) stock - in contrast to the general market. During this phase, the stock price changes little, because these investors are just a small part of the market. When the market wakes up to these activities, a rapid price change occurs when trend followers and other technically oriented investors participate. This phase continues until rampant speculation occurs. At this point, astute investors begin to distribute their holdings to the market (distribution phase).

Since one of the most important aspects of technical analysis is to trade with the trend, and not against it, it becomes imperative that all trends - short, medium and long term - are analysed. An arrow, as shown below, will indicate the direction the Investing team believes the stock is heading in:

trend is up
trend is down
trend is sideways or range trading

One of the main strength’s of Technical Analysis is in identifying when a move in the share price is likely to occur. Each recommendation comes with technical commentary - to demonstrate, here is an actual extract from a wise-owl.com ASX200 Report recommendation; 

“A break out of a large descending wedge pattern saw the stock begin to trade a large bullish channel at the end of 2002. This break pushed the stock from a low of $2.60 in October 2002 to a high of $5.25 in December 2004. Since then, the stock has traded sideways in a flag formation, with a recent break implying an end to this consolidation period. The all time high of $5.50 has recently been broken, with new highs being created. The main risk would be a drop below the first support level at $5.02, which would bring critical support of $4.78 into play.”

In summary, Fundamental Analysis can tell you what to buy, but not necessarily when to buy. Technical Analysis can be used to identify when to buy into a share and when to get out of the share. This is why wise-owl.com uses both forms of analysis to ensure a rigorous appraisal of all stock recommendations meet the criteria before we recommend a stock.

Fundamental analysis
Fundamental analysis involves identifying the ‘value’ or ‘growth’ proposition of a stock using a range of methods. This approach endeavours to understand the fundamental drivers of this stock, analysing factors such as the company’s operations, the market in which it operates and general economic issues, in order to understand the stability and growth potential of a company.

Quantitative analysis
Investing has developed a quantitative approach, much like a ‘health check’ that looks for certain characteristics of out-performing stocks such as:

* an experienced management team
* strong cash flows and profit margins
* attractive financial performance ratios
* sector comparisons

The balance sheet can provide a measure of historical performance on key quantitative data that we use to analyse the stock. Historical performance is often compared against the current performance to pick up any signs of ‘out performance’.

Every stock has a different story and the key share price drivers identified in the fundamental & quantitative analyses determine whether it is a growth or value story.

Some of the key factors addressed in our reports include:

Revenue & Profitability
All revenue & profitability calculations are based on the last 3 years of available data.

To fully comprehend and accurately analyse the data included in the Revenue & Profitability table, it’s important that you understand the terms of each entry.

How each of the elements that make up the Revenue & Profitability table are calculated, and hints on how to track figures over the 12-month are summarised below.

Sector comparison
A comparison against the sector is the last fundamental analysis undertaken to determine the stock’s value. In our reports we summarise key ratio’s and performance indicators, compared to the sector average on rolling 12 month period.

Ratio Calculations and indicative behaviours
A few of the most common key ratio’s, how they are calculated and some ‘hints’ they may indicate are,