CSS Guides to Trading

Foreword

One of the first tasks we set ourselves was setting out the specific guidelines that clients could refer to when they embarked on trading and investing in the complex new world of securities and derivatives.

We often explain investing by reference to our guides and examples. We think it has helped provide an understanding of how for example CFD returns are generated.

At its heart the intention behind our guides was to ensure clients had a good understanding of what they were doing before they did it!

We are happy to provide you with our guides as they demonstrate our conscientious approach.

This booklet combines:-

The Beginner’s guide to CFD trading

The Advanced guide to CFD trading

The Beginner’s Guide to Technical Analysis

The Guide to Risk and Leverage

The Bond / Fixed Income investment guide

Behavioural and Psychological Aspects to Investment Markets

To find out more about any of these topics please feel free to talk to us, as we would enjoy discussing these further.

We would like to highlight that whether you are new to this area, or have been investing for years it is well worth talking to us and getting our views. You might be pleasantly surprised by our advisory service.

Wayne Collins Luca Sarri Brian Statham

CSS Investments, Guide to trading foreword – 04.06.2013

The Beginner’s guide to CFD trading

What is CFD trading and how does it work?

Equity CFDs

Worked examples of CFDs vs stock investment

“Shorting” equities using CFDs

Trading index CFDs

Trading sector CFDs

Types of orders and other tools applying to both CFDs and equities

Margin and payments

What is CFD trading and how does it work?A Contract for Difference (CFD) is a method of trading shares, stock indices, currencies or commodities enabling the investor to take positions in rising and falling markets, without buying or selling physical assets or incurring stamp duty charges. CFDs are the most appropriate means for engaging in short-term trading.

CFDs are a useful investor tool and comprise a significant portion of daily LSE trading. The ability to trade CFDs is available for most official list shares but also major indices including the FTSE 100, FTSE 250, FTSE All Share, Dow Jones 30, S&P 500, DAX 30, CAC 40 and Euro Stoxx 50.

A CFD is an agreement between two parties to exchange the difference between the closing price of the contract and the opening price of the contract. Typically an investor “goes long” ie buys exposure to a rising asset or “goes short” by buying exposure to an asset falling in value.

When an investor uses a CFD then leverage comes into play. Leverage works as follows. If I bought a house for let’s say £1,000 and property prices fall 20% my surveyor will value the house at £800. If I then sold the property at £800 I would have lost £200 or 20% of my investment. Without leverage my loss would mirror the market’s movement.

If however I bought the house using a 50% deposit then my equity in the house is worth £300. I would still have lost £200 but it would be a higher proportion of my initial equity investment of £500. I would have lost 40% of my initial investment. My use of leverage has magnified the market’s loss.

Leverage can work greatly to an investor’s advantage. If I had bought the house many years ago, let’s say for £1,000, I put down a 25% deposit ie £250 and borrowed £750 on interest only repayment terms. In this case, I originally had quite a low deposit but I had control over an appreciating asset worth four times my starting equity. My property is now worth £5,000 hence my equity in the property has gone from £250 to £4,250 a 17 fold increase on my initial investment. This demonstrates the power of leverage in an environment where prices rise over the long term.

CFDs work exactly the same way! The small initial outlay, the margin equates to the deposit in the property example, can control shares worth substantially more.

CSS Investments, The Beginner’s guide to CFD trading – 04.06.2013

Using our system you would typically deposit 10% for share CFDs and between 5% and 10% for index CFDs. This is known as “margin” and is put up by the investor and represents the capital that is immediately at risk. Margin effectively works to leverage up or down the overall trade, if a client pays 50% margin then that would mean for every £100 of underlying value there is £50 of equity.

You will be required to pay a financing charge if you “go long” (usually a premium of 2.5% above LIBOR) for the outstanding amount, ie if you deposit 10% then you have to borrow 90%. You will receive financing if you sell a short position (usually LIBOR -2.5%) at a daily rate pro-rated at annual rates (daily financing = closing day value of the open position x rate% / 365).

If a position is opened and closed the same day ie an investor “goes long” then “goes short” then financing payments are not relevant.

Financing costs are linked to interest rates!There is no fixed expiry date for CFD trading, a trade is closed when the client decides to collect profits or cut their losses. Share dealing must be done on agreed settlement dates (T dates).

Using our platform a client will have direct access to the market either by calling our brokers or via online access. The pricing mechanism is very transparent and makes it easy for clients to work out their trading positions and exposures.

Using the platform any client trades would need to be closed internally, ie positions could not be transferred or netted off with another broker.

Engaging in CFD trading amounts to accepting exposure to risk, please note our Risk Warning to ensure that you understand the workings of leverage before opening an account with CSS.

There are ways to manage risk exposure using “stop loss” orders. These work to cap your gain or loss per trade and can be entered at the time of making the trade or afterwards. Please note however that stop losses are not guaranteed.

Equity CFDThe platform offers CFD trading on UK, US, European, Japanese, Hong Kong and Australian equities.

A “Long” position in the underlying equities is profitable if the share price rises post the trade. It requires the payment of a daily financing charge. A “long” position also receives dividend payment at the close of business on the day before the ex-dividend date.

A “short” position in CFDs will profit if share prices fall. It may receive daily financing income but will lose money if share prices rise. A “short” position gets dividends debited at the close of business the day before the ex-dividend date. Running a “short” position means you are effectively selling shares that you do not own.

Reasons for using CFDsBoth short and long positions add significant flexibility for clients because if they were trading equities they would have to deliver the shares subject to contract. This would be a far more capital intensive exercise. It should also be noted that CFDs do not currently attract any stamp duty.

“Shorting” is an important tool in “bear” markets or during periods of volatile trading, or just after a big gain in shares or simply to hedge an existing portfolio.

“Shorting” is treated as potentially increasing market volatility and on occasion regulatory bodies have banned the practice of short selling.

Behind the scenes when an investor buys an Equity CFD the dealer is engaging in the opposite trade ie if the investor goes long Vodafone at 120p the dealer is short Vodafone at the same price.

In the events of a rights issue, bonus issue, stock splits or stock consolidations CFD positions are adjusted to replicate the corporate action on the underlying shares. These will be applied on the close of business on the preceding business day to the ex-corporate action date.

Trading strategies using CFDs:-Hedging against market movements or against an existing portfolio.

Markets are volatile. Our CFDs enable clients to hedge against an existing portfolio, without having to sell the portfolio which may trigger tax charges or other complications. Using the platform we can advise clients on how best to structure an effective hedge for existing portfolios.

“Pairs” trading; this is a sophisticated technique allowing trading in similar companies. If for example you believe one company is expensive relative to another, the CFDs can be used to long the cheaper stock and short the more expensive stock.

Equity CFDs are perfect for “bottom up” investors or “stockpickers” who want to back companies whose prospects are not reflected in the shares.

Please see our worked example of CFD Trading vs Share Dealing (on an Advisory account). Please be aware that CFD Trading is higher risk than Share Dealing as you can lose more than your initial investment rapidly and substantially. Also you should be aware that with CFDs you do not own the underlying instrument so there are no share certificates issued and you do not have any voting rights.

Opening the trade:-

CSS Investments CFD – “LONG” Share Dealing – “BUY”

BP CFD quote BP share quote

Bid 488p – Offer 488.75p Bid 488p – Offer 488.75p

Buy price 488.75p Buy price 488.75p

No of CFDs: 1,000 No of shares: 1,000

Underlying value of shares: £4887.50 Underlying value of shares: £4887.50

Stamp Duty: N/A Stamp Duty: £24.44

Commission: £24.44 Commission: £48.88

Compliance Charge: £15.00 Compliance Charge: £15.00

Initial Margin: £488.75 Consideration: £4,975.82

Total Debit from CFD a/c: £528.19 Total Cost: £4,975.82

The major difference with CFDs is the initial cost amounts to the total debt (ie the initial margin plus commission).

Closing the trade a week later...

BP CFD quote BP share quote

Bid 525p - Offer 525.5p Bid 525p – Offer 525.5p

Sell price 525p Sell price 525p

Underlying value of sale proceeds: £5,250. Sale proceeds: £5,250.

Commission: £26.25 Commission £52.50

Compliance Charge: £15.00 Compliance Charge: £15.00

Financing Expense: £2.81 (calculated on a daily basis) Financing £0.00

Profit on the Trade: £279.00 Profit on Trade: £206.69

Return on Investment: 52.82% Return on Investment: 4.15%

In calculating the profit on the trades on the CFD side, we take the underlying value of the sale proceeds and subtract commissions & compliance charges on both opening and closing the CFD; we subtract the financing costs and the underlying value of the shares.

Clearly owing to the geared effects of the CFD trade against a stock trade the return on investment using the CFD route is magnified.

Please note: If BP shares had fallen during the period and it was decided to cut the position there would have been a corresponding loss created. Examples of losing trades can be found in the FAQ’s section on our website.

“Shorting equities using CFDs”In this example we have assumed that the investor has £1,000 in their deposit account. This is sufficient margin for trading up to around £5,000 worth of shares.

If you take the view that in the short-term a share is overpriced then you would “short” ie sell a short. When opening the trade, the “short” transaction would look like this:-

Open Trade

Price of Marks and Spencer 450p

Number of shares 1,000

Value of shares £4,500

Stamp Duty (No stamp duty on CFDs)*

Commission £22.50

Compliance charge £15.00

Margin (10%) £450.00

Closing Trade; 1 month later

Price of Marks and Spencer 400p

Number of shares 1,000

Value of Shares £4,000

Stamp Duty (No stamp duty on CFDs)*

Commission £20.00

Compliance charge £15.00

Financing Expense £7.48 (calculated on a daily basis)

Overall Profit on trade £420.02

* Tax laws are subject to change.

Trading Index CFDsThe same principles apply with index CFDs, again we use the index value, we deduct commissions, compliance charges and financing charges for long positions, we add financing income for short positions and use margin. Again we assume the client has £1,000 in their deposit account.

FTSE 100 CFD Bid 6,595 / Offer 6,599

Opening Trade – SELL ie “Short”

Sell Price 6,595

Number of CFDs 2

Underlying value of trade £13,190

Commission £19.79 (15 bps)

Compliance charge £15.00

Initial Margin (deposit) 5% £659.50

Closing Trade – BUY (1 month later) ie “long” Bid 6,510 / 6,514 (NB -81 pts)

Buy Price 6,514

Number of CFDs 2

Underlying value of trade £13,028

Commission £19.54 (15 bps)

Compliance charge £15.00

Financing Expense £21.92 (calculated on a daily basis)

Overall Profit on Trade £70.76

Return on Investment 10.73%

Please note: If the FTSE 100 had risen during the same period and it was decided to cut the position, there would have been a corresponding loss created. Examples of losing trades can be found in the FAQ’s section on our website.

A note on financing income (short) and financing expenses (long) – interest is charged by reference to 3 month LIBOR and a 2.5% spread to LIBOR over the duration of the CFD measured in no of days. Hence a short would receive positive financing income only in the event that 3 month LIBOR exceeded the 2.5% spread.

In the above example the financing charge would be 0.505% (20th May 2013) -2.5% * (£13190 (open CFD)) x (1 month i.e. 1/12 or 0.083333)

The calculation would be( -1.995%* £13190) /12 = -£21.92

Bear in mind CFDs are like REPO agreements. When an investor buys a CFD he is borrowing the underlying shares (hence paying interest on the loan), when he is shorting the CFD he is lending the underlying shares ( receiving interest).

Our platform quotes competitive two way prices for CFDs on leading stock indices. The CFD index product helps investors take a view on the market generally without having to go into the specifics of individual stock investment.

The product also adjusts for dividends. Obviously this will depend on dividend payout levels, however long CFDs receive dividend adjustment credits, short CFDs will have dividend adjustments debited.

Types of orders and other tools applying to CFD tradesAn order is an instruction to the broker to buy or sell. There are a number of different types of orders:

a) A “limit” order ie buy 1000 Marks & Spencer CFDs limit 250p this means the client cannot pay more than 250p per CFD.

Limit orders are an important tool for all CFD traders as it helps risk management especially in circumstances where markets are moving rapidly.

b) A “market” order ie buy 1000 Marks & Spencer CFDs this is executed “at the market” ie at the market offer price. The principle is the same as the “at best” order in share trading.

Stop losses are the usual tool for controlling risk and hence the magnitude of profit or loss.

c) A simple “stop loss” can be put onto a CFD trade at the time of the trade and afterwards. Hence taking the Marks & Spencer example let’s say at the time of the trade we put on a stop loss at 240p, hence should the shares fall to 240p the shares would be sold and the position would close out automatically hence the expression “the trade was stop lossed out”.

d) A “trailing stop loss” is useful for protecting against a fall in the share price whilst maintaining exposure to further gains. A trailing stop loss would set a stop loss at a fixed percentage under the share price. If the share price rises, the stop loss rises in direct proportion. If the share price falls, the stop loss fixes and the shares are sold when the share price hits the stop loss. The trailing stop helps investors protect against loss without having to monitor the share price. Please be aware however that stop loss orders are not guaranteed. Ask your broker for more information.

Margin & Payment requirementsAny CFD position is valued constantly relative to the market. This may require further margin payments during the day if the shares are volatile or if the CFD position requires further margin.

At the close of business every day the CFD position is evaluated for margin requirements. The CSS Trader account does this automatically.

If the CFD position is loss-making and the loss exceeds the original margin then the account holder has to pay further funds into the account to replenish the margin. This is called the “maintenance margin” the amount of margin that must be maintained at all times on the account.

In the context of US markets, the NYSE and the Nasdaq the dealer must ensure that a 50% “initial margin” is available in cash or securities before a trade is placed. After the trade is placed the dealer must ensure that the “maintenance margin” is adhered to. This means a margin of 25% ie equity of 25% in the account.

For example if a deposit of £2,500 is being used as initial margin to support a £10,000 CFD position and the CFD position falls in value to £8,000 then the deposit would have to be topped up by £1,500 to maintain the required margin of 25%. Failure to maintain the required margin can result in your positions being closed at a loss to you.

Should the level of margin utilisation exceed the required margin and a client fails to reduce exposure or add cash then the system would automatically liquidate the portfolio to ensure the account does not go into default.

The Advanced guide to CFD trading

CFDs an insiders’ view

Define and determine the long-term portfolio and how it should operate

Define and determine the trading portfolio and how it should operate

Monitoring an open position

CFD / stock portfolio trading & risk management

“Pairs trading”

Direct Market Access (DMA)

Fundamental trading; building a diary of events

Charting and Technical analysis, MACD, Stochastics, Relative Strength Index

In house seminars and education programmes

CSS Investments, The Advanced guide to CFD trading – 04.06.2013

CFDs an insiders’ viewAnyone trading CFDs appreciates the need to stay on top of fast moving markets.

Advanced traders need to be nimble and fast in a volatile environment.

It is essential to maintain a focused approach and emotional detachment from trading.

Whether you agree that stock valuations are determined by fundamental or by technical analysis, it is worth being aware of factors that pertain to other investors’ decision making to explain, understand and profit from market movements. Advanced techniques enable CFD traders to be aware of factors that pertain to both fundamentals and the charts improving their predictive ability.

Advanced trading is a bit like driving a car, you may be a careful driver, but you need to look out for other drivers who may not be as careful.

Recent experience, i.e. since 2000 has shown the UK and US stockmarkets can be inherently volatile. Other countries notably the BRIC group have shown divergent long term trends but are even more volatile in the short-term.

The participants have changed, the fund managers, pension funds and institutional investors are still there, but in diminishing number, however increasingly the focus has shifted from long-term “buy and hold” to short term factors and short-term investors. Over one third of traded stock volumes are linked to CFD trading which is very heavily biased towards short-term trading where investors may take a view based on the following days or weeks.

The main clients of prime brokerage departments of firms like JP Morgan and Goldman Sachs are hedge funds taking short term positions.

Increasingly portfolios are “open positions” i.e. they are tradable and volatile. This tends to magnify movements leading prices to “overshoot” both up and down.

Define and determine the long-term portfolio A long-term “buy and hold” portfolio also needs to be managed, in a more conservative way, infrequently perhaps, but it does need experienced management.

Long term “Buy and hold” portfolios come in many guises. It could be a pension fund, a trust fund, a share save scheme, a retirement lump sum award, a long term bonus plan or a cherished portfolio of “Sid” type 1980s privatisations.

One example:-Staff at the major banks and brokers, were amongst the biggest losers in the 2008 bear market, because bonuses were stock options. Good news in a bull market, but destructive in a bear market.

Due to the 3-5 year lock-ins and other methods designed to smooth out the stock issuance of major bonus payers, employees found themselves hamstrung. Many bonus plan recipients worried that a large portion of their net worth in addition to their job, was with one company and out of their control. Many wanted to hedge the exposure to their employee. You can privately buy insurance against job loss, and cover your stock held under bonus plans, or bond exposure via Credit Default Swaps (CDS).

The main challenge is the long lead times of stock awards – it is difficult to hedge precisely against stock awards five years hence.

But you can do it effectively with nearer term awards. The plan is to short sell the near-term awards if possible balancing the value of the short sale with the “longs” i.e. the long-term incentive plan awards. Say you were expecting a previous bonus of 1,000 XYZ shares to vest in February – the advanced trader would sell these forward via a CFD or put option.

A hedge against a bonus entitlement is more complex given the long stop dates, i.e. hedges become less effective over longer periods but more effective over short periods:-

a) One method is to buy put options i.e. “insurance” over the existing exposure or a multiple of the existing exposure with the surplus representing the bonus. This effectively locks in a price for the existing shares and the bonus shares. This assumes the company awarding the bonus is a listed company and traded options are available.

b) Use stock CFDs to sell the position against a portfolio of announced bonus entitlements; clearly this approach will lead to an ongoing moving bear position that will require financing against an existing portfolio of assets (obviously not including the bonus entitlement). The position will unwind when the bonus is received when the stock position can “convert” against the CFD of the same stock. However the advantage over options is the likelihood of better availability and liquidity of CFDs than options.

c) Using index CFDs to sell a bonus entitlement against the market is an approximate hedge that would be expensive if the market rose suddenly but very positive in the event of a big bear market such as 2008.

A hedge against an existing long-term portfolio can be rough, approximate or exact depending on the nature of the asset mix or asset/ liability being hedged against. The following is a guide on the various options:-

a) Portfolios of FTSE 100 shares, such as an index tracker fund; an appropriate hedge would be a FTSE 100 put option; with a one year expiry date. This is portfolio insurance and is a relatively costly way of covering the downside risk. Alternatively an index short CFD position achieves the same objective but will need to be collateralised against a portfolio of FTSE 100 securities or cash.

b) A diversified portfolio of ten/twenty UK shares; a hedge may be a FTSE 250 put option, an imperfect hedge or writing put options against individual shares. Alternatively a short on a FTSE 250 CFD will amount to an approximate hedge.

c) A portfolio consisting of fewer than 5 shares with large exposures to one or two companies. Given the limited availability of traded options in many cases, short CFD positions should be used against the larger exposures, or specific company put options.

Define and determine the trading portfolio and how it should operateThe first key question is which portfolios should be classed as trading portfolios.

The biggest mistakes are made when CFD traders become “emotionally attached” to individual stocks or to portfolios. This may be due to a fondness for the company itself, a keen understanding of the business and its inherent value or simply due to a long association. Shares or portfolios that investors are emotionally attached to should not form part of a trading portfolio. They should be segregated from a trading portfolio and treated separately like a long term portfolio.

Stock portfolios or individual stockholdings that are pledged as collateral against loans or held against other portfolios or held in employee savings accounts should not form part of a trading portfolio.

Trading portfolios should essentially be those portfolios consisting solely of stocks, CFDs or any other instrument that is an open position for short-term trading that the trader is willing to trade.

Stock and CFD portfolios are “marked to market”. This is an accounting convention that means valuations are determined by the market place and movements in market prices are automatically reflected in portfolio valuations. Marking to market means portfolios are regularly changing and investors should be watchful of price movements.

Monitoring an open positionThe key issue is who does the job of monitoring, and managing the trading portfolio. This job should be either done by the advanced trader, on the advice of their brokers or by computers via automated buy and sell orders.

This means that an advanced approach must encompass and use the tools for stock monitoring, essentially these days this job is done via online advisory or execution only accounts.

Monitoring portfolio open positions is essential and determining how and who should monitor “open positions” is a key question for advanced traders.

DECISION: Which portfolios or securities should comprise the trading portfolio?

DECISION: Do we appoint an experienced CFD / stockbrokers to manage the trading account or do we become day traders ourselves?

DECISION: Do we commit these decisions to a broker with discretionary authority?

CFD / stock portfolio trading & risk managementWith CFD trading, risk management is essential so we are summarising below:-

The starting point must be the level of risk that the trader is willing to accept.

Only the investor can know and determine their risk tolerance on their portfolio and by extension on individual positions. This should be decided at the outset i.e. if I have a £50,000 portfolio – I am willing to lose £15,000 or 30%. With a stop loss at this level the portfolio should be sold if the portfolio hits this level. Please note that stop losses are not guaranteed. Ask your broker for more information.

DECISION: Key trading rule is to decide on absolute loss limits on the portfolio.

DECISION: Should it be a rolling stop loss i.e. should it be at an adjustable level that moves up when the portfolio moves up but stays static against a market fall.

DECISION: The advanced trader should also decide on upside gains limits; at what point should profits be bagged i.e. what triggers should be in place.

Assuming a portfolio with 20 positions of equal value then if one company goes into administration, assuming the others stay the same, the portfolio has lost 5%. A loss may be reduced or augmented by movements in other portfolio positions.

If the portfolio has only 10 positions then the loss on one failure is 10%. The amount of risk at any one point is a function of the number of positions and the weighting of each position.

Risk management at the portfolio level is the most effective way of managing overall risk. A big mistake is to start trading with just one or two positions and a cash balance and expecting immediate performance.

Risk management at the individual stock level is essential to avoid the situation where the advanced trader is reliant on the portfolio to diversify out risk by itself.

We may recommend setting stop losses on both open positions and at portfolio level, depending on individual investor circumstances.

Firstly with CFDs, it’s important to recognise that short selling has the potential to be very expensive if you get it wrong.

Secondly in a trading environment the right tools need to be implemented.

We would recommend the advanced trader makes use of the following:-1. Portfolio analysis functions; risk and return calculations against their required level of return or their stop loss.

2. Portfolio asset/ sector allocation, optimization and simulation functions (basically monitoring the portfolio against the Markowitz efficient frontier). This analysis will offer views on which stocks should be added or removed from a portfolio to become more closely aligned with the efficient frontier.

3. Value at Risk (VaR) tools helping the trader determine the maximum amount of daily loss using statistical analysis incorporating standard deviations, hence the relative position of the portfolio to the VaR.

4. Research and changes in recommendations on companies from major institutions and economic data releases.

5. The timing of dividend, scrip, and corporate actions. These can have a significant short term impact on stock/CFD prices.

These are primarily analytical risk management tools.

The advanced trader will also have to use inputs for risk management, to summarise these are:-

1. Limit and stop orders at individual stock levels and at portfolio level i.e. once the price meets a limit it is sold.

2. Trailing stop trading system; used to cement gains and is triggered when the stock/ CFD starts to fall.

3. Pound Cost Averaging; building a portfolio over a period of days, weeks or months.

4. Conversely taking profits or reducing positions or portfolio size at portfolio reviews i.e. every week or every month.

5. Use an Excel spreadsheet to allocate and monitor portfolio assets, monitor income and returns.

6. Monitor any leverage or debt held against portfolio assets.

Pairs Trading“Pairs” trading was developed in the 1980s by quantitative analysts at Morgan Stanley. The theory is based on the inter-sector correlation between similar types of companies. This often works well in sectors where there are set valuation benchmarks such as discounts to adjusted net asset value.

Some examples include:-• Land Securities (LAND) and British Land (BLND)

• BHP Billiton (BLT) and Rio Tinto (RIO)

• Barclays (BARC) and Lloyds TSB (LLOY)

• Tesco (TSCO) and Marks & Spencer (MKS)

The “pairs” trade is focused on the trade in the direction of the shares relative to each other. The trade would be to go LONG on one stock and SHORT on the other.

A long / short strategy is essentially self financing and market neutral i.e. if the market moves lower then gains on the short would be similar to losses on the long position.

Step 1: The trick is to choose the right pair. Multinationals with similar operations, in the same countries, similar sized companies in the same sector such as BHP and Rio Tinto have similar Betas and move in similar ways relative to the market.

Step 2: Balance the trade; If Tesco is trading at 400p and M&S is trading at 200p then buying 1,000 shares of Tesco and selling 1,000 M&S would be an unbalanced trade and the overall market direction would not be totally nullified. If the overall market fell 15% then spread trader would lose money as they would be in effect only half short of M&S. To get both sides right simply divide one into the other i.e. for every 1 share long in Tesco should have 2 shares short of M&S.

Step 3: [OPTIONAL] It might be worth considering using Beta analysis to test different sides of trades. Beta (ß) analysis tests the sensitivity of the stock to the market index. According to ß theory there is a relationship between the company’s share price movement and that of the market.

ß > 1; share price movement will be greater than the market

ß = 1; share price movement should approximate the market’s movement

ß = 0 no relationship between the share price movement and the market’s movement

ß = -1 the share price will move inversely to the market i.e. if the market moves up 5% the stock will move down 5%

ß = >-1; share price movement will be greater than the market in the opposite direction i.e. if the market rose 2% a stock with a ß of -3 would move down 6%

In relation to pairs trading, companies with very different betas should produce larger swings in price relative to market movements.

Step 4: Deciding for and against a suitable “pairs” trade. It might not be worthwhile to trade a pair where the relationship is between the two is not showing divergence.

The below example is from NYSE; we have applied MACD and Stochastic indicators. The two stocks are TK Corporation (TK) a large oil tanker company and Overseas Ship holding Group (OSG), another large oil tanker company.

As the technical chart below shows the stock movements are closely correlated with the stochastic indicators very close together and the MACD also close to the signal. This is not a good pairs trade as gains in a LONG position in TK Corporation is likely to be netted off against a SHORT position in OSG.

The below example is a much better pairs trade. Again we use two very similar companies in the same industry, the fi rst Millennium & Copthorne (MLC) and Intercontinental Hotels (IHG).

As the chart shows normally these stocks move very tightly together however very recently the divergence has increased; a relative gap of 15% has opened up. This suggests a LONG position in IHG and a SHORT position in MLC.

This example is a decent “pairs” trade.

Direct Market Access Direct Market Access (DMA) is a service that allows private investors to buy and sell shares directly with other investors on the London Stock Exchange electronic order book.

Private investors have traditionally placed buy and sell orders with their brokers who normally execute these with specialist market makers known as Retail Service Providers (RSPs).

What DMA means is that investors can now take control of their trades by placing buy and sell orders directly with other market participants on the order book. DMA allows visibility on the buyers and sellers i.e. the order book. It gives the advanced trader a higher chance of getting their transaction done at the asking price.

With DMA you still need to trade via a broker but through one that offers a DMA service. Collins Sarri Statham Investments does offer DMA, please contact us to find out further information about this service.

In short, DMA enables you to set your price inside the bid/offer spread which is visible to the entire market and allows access to the UK’s deepest pool of liquidity where most trading takes place. DMA provides you with the greatest opportunity to trade at the best price possible.

A DMA simulator is available on the www.londonstockexchange.com website.

DECISION: We would recommend advanced traders use DMA. However this is a decision for the individual.

It is important that advanced trading incorporates real time prices and as much pricing transparency as possible. DMA is appropriate to this objective.

Fundamental trading; building a diary of events!An advanced trader strategy using fundamentals uses a distinct approach. Let us assume it is the 1980s and we are armed with a Filofax diary planner!

Using fundamentals, the approach should be to get a picture of companies reporting over the next week. Forthcoming results are published in the Financial Times Companies Section.

Step 1: Pick a number of companies preparing to report; preferably a liquid blue chip company; Diarise the dates of their results.

Step 2: [Obtain research notes from the company’s public relations] optional step. This helps build an understanding of the company’s key value drivers.

Step 3: Identify from published data the consensus revenue, EPS and dividend forecasts; these can be obtained on Yahoo! Finance and www.bloomberg.com

Step 4: Where the company has published interim results or quarterly results then briefly review these to assess what EPS the company reported at H1 and the outlook statement from the board on the full year results. This should give a guide as to the likelihood of the company meeting or exceeding forecasts.

Step 5: If the market is confident of better than consensus earnings then ahead of the results the research forecasts would have on balance seen more upgrades than downgrades. The reverse also holds true. Try to avoid companies whose forecasts have come down prior to the results.

Step 6: On the day of the results, review the results; these are released prior to market open. Assuming the EPS forecasts are ahead of consensus numbers then the shares should rise at the open. If the shares open unchanged then they are likely to improve during the day.

It is important in reviewing the results to check both the reported results and the outlook statement. Earnings forecasts ahead of consensus and positive outlook statements are the most bullish indicator. On target earnings can be offset by a mixed or negative outlook statement.

Step 7: Many companies host analyst presentations on the morning of the results announcements leading to reports emerging around midday. A positive slew of reports at midday often leads to further buying of the stock around midday/ early afternoon.

Step 8: Diarise the dividend payments into the calendar for stocks that are traded, as there is often a run-up in the share price in the third working day prior to the ex-dividend date.

Charting and Technical Analysis in CFDDECISION: Which tools are available for monitoring technical trading patterns?

There are a number of useful websites for charting and technical analysis; in www.uk.fi nance.yahoo.com and www.stockchart.com. You could also sign up for a demo account with Collins Sarri Statham at www.css-investments.com which provides you with a full charting package.

The MACD “moving average convergence divergence” indicator

The MACD shows the difference between the exponential moving averages (EMA) of two periods typically a “slow” 26 day period and a “fast” 12 day period; i.e. MACD = EMA [12] of price – EMA [26] of price. A signal line is then created by smoothing with a further shorter EMA. The signal = EMA [9] of MACD. A pictorial histogram is then generated which shows up as a candlestick chart.

The histogram = MACD – signal. The MACD is a trend following indicator used to identify trend changes. It provides three signals.

When the MACD falls below the signal line; it is a bearish signal.

The MACD rises above the signal line then that is a bullish signal.

Divergence when the price diverges from the MACD it is the end of the current trend and possibly a “bull” signal if the divergence is on the upside.

Moves relative to the zero line signal are important. When the MACD is above zero this signals upwards momentum ; the reverse is true when the MACD is below zero.

The MACD is an advanced technique in CFD trading as it gives a clear glimpse of relative strength and weakness and is closely followed by traders. We recommend CFD traders review the MACD for bullish and bearish signals.

The Stochastic OscillatorThis is a momentum indicator used in technical analysis to compare closing prices of a commodity to its price range over a given time span. Like the MACD indicator it operates to smooth out prices and enable trend discovery. The idea is prices tend to close near recent highs in bull markets and near their lows in bear markets. Bull and bear signals can be spotted when the stochastic oscillator crosses its moving average.

STS= 100 x closing price – low price high price – low price

The “Fast” stochastic oscillator or Stoch %K calculates the ratio of two closing price statistics: the difference between the latest closing price and the lowest price in the last N days divided by the difference between the highest and lowest prices in the last N days.

%K= 100 x CP today – Low lowest 14 Days High highest 14 days- Low lowest 14 Days

%D = 100 x CP today – Low lowest 3 Days High highest 3 days – Low lowest 3 days

Example: Land Securities share price (29th Dec 2008 to 16th January 2009)

Periods High Low Close29 Dec 08 922 887 89930 Dec 08 923 897 90931 Dec 08 928 895 9212 Jan 09 953 906 9495 Jan 09 983 918 9376 Jan 09 1034 948 10057 Jan 09 1051 990 9998 Jan 09 1010 960 9849 Jan 09 998 953 96512 Jan 09 965 923 93913 Jan 09 929 881 89214 Jan 09 903 804 81215 Jan 09 827 752 76516 Jan 09 784 746 751

%K= 100 x ( 751-746) (1051-746) = 1.64

%D= 100 x (751- 746) (903-746) = 3.18

The stochastic oscillator provides signals above 80 then “overbought”; or under 20 “oversold”.

The above measures show that the stock is oversold.

There are three types of stochastic oscillator; fast, slow and full.

Traders do not need to calculate the stochastic oscillator. It is often added in as a device / tool.

Bollinger BandsAnother technical trading tool created in the early 1980s providing a relative defi nition of highs and lows. This feature can aid in pattern recognition and in comparing price action for decision making.

The Bollinger bands consist of :-a) A middle band being an N period of simple moving average.

b) An upper band at K times an N period standard deviation above the middle band.

c) A lower band at K times an N period standard deviation below the middle band.

Typical values for N and K are 20 and 2

The Bollinger band is a tool often available on charting websites and is a useful tool in providing a channel pattern of trading ranges.

Relative Strength Index (RSI)This is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to defi ne overbought and oversold conditions. It is calculated using the formula:-

RSI = 100 – 100 / 1+RS

RS = average of x day’s up closes / average of x days down closes

An RSI reading must be between 0 and 100; readings of over 70 suggest overbought; whilst under 30 suggest oversold. The RSI index on the Barclays chart below is 20 ie oversold.

In house seminars and educational programmes Attending training on these techniques is recommended. Courses are available on line or via tutorials, many of which can be done in a day or two days. You can sign up for Collins Sarri Statham seminars at www.css-investments.com/seminars.

An easy way to start is using the trading simulator.

Recommended reading: “Advanced Financial Risk Management; Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management” by Donald Van Deventer and “The Black Swan” by Nassim Taleb.

The Beginner’s guide to Technical Analysis

“What is technical analysis and how does it work?”

Introduction

The Basics

The Use of trend

Trend lines

Support and resistance

The importance of volume

What is a chart?

Chart types

Chart patterns

Moving averages

Indicators and Oscillators

Conclusion

IntroductionThe methods used to analyse securities and make investment decisions falls into two main categories: fundamental and technical analysis. Fundamental analysis involves assessing a company’s value based on the characteristics of a company in order to estimate its value. Technicians use a completely different approach. They focus on price movement extrapolating trends.

Technical analysis uses a variety of different studies to assess the supply and demand of the market in an attempt to determine what direction or trend will continue in the future. In my opinion technical analysis attempts to take the emotion out of trading and extract the “background noise” in order to make an informed decision.

The Basics Technical analysis exists so that an investor can evaluate a company or asset through past prices, market activity, volume and current price action instead of attempting to assess the asset’s intrinsic value.

There are a variety of different technical traders. Some rely on chart patterns, others use technical indicators and oscillators however most use a combination of the two.

CSS Investments, The Beginner’s guide to Technical Analysis – 04.06.2013

The main beliefs of a technical analyst include:-

1. The market discounts everything - This suggests that a price already refl ects everything that is happening and that could affect the company including fundamental factors. Technicians believe that the company’s fundamentals along with broader economic factors and market psychology are all priced in which removes the need to consider these factors separately.

2. Price moves in trends - if a trend is established then it is more likely that a subsequent move will be in the same direction as the prevailing trend.

3. History tends to repeat itself (though usually not precisely... past performance is not necessarily a guide to future performance).

The Use of trendOne of the most important concepts in technical analysis is the trend. A trend is merely the general direction that a security or market is headed. The chart below shows a positive trend.

Although the above chart shows you the trend it is not always as easy to defi ne a trend. Put into words an uptrend is classifi ed as a series of higher highs and higher lows, while a downtrend is one of lower lows and lower highs.

Trend linesA trend line is a technique that adds a line to a chart to represent the trend in the market or a stock. A trend is any point along a chart that ideally can be connected by three points.

It is important to be able to understand and identify trends so that you can trade with, rather than against them. One of the most important sayings in technical analysis is “the trend is your friend”, this illustrates how important trend analysis is for technical traders.

Support and ResistanceThe next major concept is that of support and resistance. You will often hear technical analysts talk about a battle between bulls and bears, or the struggle between buyers and sellers. This can be seen when prices rise and fall from similar levels regularly.

As above, support is the level that the price seldom falls below and resistance on the other hand is the level that it seldom surpasses.

These support and resistance levels are important in terms of market psychology, because round numbers are used automatically as points of support and resistance.

When an important level of support or resistance is broken then it is customary for the role to be reversed.

Support and resistance analysis is an important part of a trend because it can be used to make trading decisions and identify when a trend is reversing.

Support and resistance levels both test and confi rm trends and need to be monitored by anyone who uses technical analysis. In practise it is sensible when placing orders near support or resistance to actually ensure that your buy order at support is slightly higher than the actual point of support and when selling you have your sell order slightly under the level of resistance. On the other hand if you are placing stop orders you should set up the order slightly below the level of support for example.

The importance of volumeWhilst price is the primary element in technical analysis, volume is also very important.

Volume is simply the number of shares or contracts that trade over a given period of time. The higher the volume the more active the security. You can determine the level of volume by looking at the bottom of a chart with volume attached where you can fi nd volume illustrated via bar graphs.

(See chart on next page.)

Volume is important because it is required to confi rm trends and chart patterns. Any price movement up or down with relatively high volume is seen as a stronger more relevant move than one with a similar move with weak volume. Volume should move with the trend. If prices are moving in an upward trend, volume should increase. If the relationship weakens between volume and price movement it is usually a sign of market weakness.

It is also worth noting that volume generally precedes price. For example if volume starts to decrease in an uptrend, it is usually a sign that the upward run is coming to an end.

What is a chart? A chart is simply a graphical representation of a series of prices over a time period.

When looking at a chart you must be aware of the time scale, the price scale and the price point properties used.

Chart typesThere are four main types of charts that are used by investors and traders depending on the information that they are seeking and their individual skill levels. The chart types are; the line chart, the bar chart, the candlestick chart and the point and fi gure chart.

Chart patternsA chart pattern is a distinct formation on a stock chart that creates a trading signal, or a sign of future price movements. Chartists use these patterns to identify current trends and trend reversals and to trigger buy and sell signals. Chart patterns are based on the assumption that history repeats itself. The theory is that certain patterns are seen many times and identifi cation of one of these patterns can help predict the future outcome or movement of a stock. Naturally technical analysis is an art not a science therefore there are no guaranteed outcomes!

There are two simple main types of patterns within this specifi c area of technical analysis: reversals and continuation. A reversal pattern will suggest a change in trend on completion of the pattern and a continuation will on the other hand signal that the trend will simply continue when the pattern is completed. The following few charts will detail a number of the potential charts that you can fi nd.

Head and Shoulders These are two of the most popular chart patterns in technical analysis. A head and shoulders is a reversal pattern when formed which signals that the security is likely to move against the previous trend. As you can see in the charts below the one on the left is a conventional head and shoulders and the one on the right is an inverse head and shoulders and is used to signal a reversal in a downtrend.

Cup and Handle A cup and handle chart is a bullish continuation pattern in which the upward trend has paused but will continue in an upward direction once the pattern is confi rmed.

Double tops and Double bottomsThis chart pattern that signals a trend reversal is considered to be reliable and commonly used. This pattern is usually created after a sustained trend and then tests support or resistance twice and is unable to break through.

However one should note that a double bottom or double top is ONLY confi rmed when you see a break of the previous low or high. This is illustrated above on the right hand chart whereby the price action must trade through the horizontal trend line in order to trigger the buy signal (or sell signal for double top)

TrianglesTriangles are some of the most well known and common patterns within technical analysis. The three main types are the symmetrical triangle, ascending continuation triangle and the descending continuation triangle as seen below.

Flag and PennantThese two short term chart patterns are continuation patterns that are formed when there is a sharp price movement followed by a generally sideways price movement. The pattern is then completed when there is another sharp price movement in the same direction as the move that started the trend.

GapsA gap in a chart is another invaluable pattern whereby there is a space created between a trading period and the following trading period. Gaps would normally show that something of signifi cance has happened. There are three types of gaps: 1) breakaway, 2) runaway and 3) exhaustion.

Common gaps: These are sometimes referred to as trading gap or an area gap and are usually uneventful. They can be caused by a stock going ex-dividend when trading volume is low. Such gaps are common and are often fi lled quickly which means that price reverts back and retraces back to where the gap started.

Breakaway gap: These occur when price action is breaking out of their trading range. A breakaway gap should be accompanied by a signifi cant increase in volume. This pattern often develops where people often are caught out on the wrong side of the position and have to rush to close positions hence causing a spiking of volume. It is better if volume spikes after the gap has formed.

Runaway gaps: These are also called measuring gaps, and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous day’s close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by signifi cant news events that cause new interest in the stock.

Exhaustion gaps: These gaps happen near the end of a good up or downtrend. They are many times the fi rst signal of the end of that move. They are identifi ed by high volume and large price difference between the previous day’s close and the new opening price. They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.

It is almost a state of panic if the gap appears during a long down move where pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly fi lled as prices reverse their trend. Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock. The prices gap up with huge volume; then, there is great profi t taking and the demand for the stock totally dries up. Prices drop, and a signifi cant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profi t from.

Moving averages It is common for charts to vary greatly in price which often makes it diffi cult for traders to assess the overall trend of the security. In order to combat this it is sensible to employ moving averages. A moving average is the average price of a security over a set amount of time. By plotting this average price you then can achieve a smoothed out average which enables an easier assessment of the relevant trend.

Indicators and Oscillators Indicators are calculations based on the price and the volume of a security that measure such things like money fl ow, trends, volatility and momentum. Indicators are used in conjunction to the actual price movements and add information to the analysis of securities. Indicators are used in the main to confi rm price movements and the quality of chart patterns, and to form buy and sell signals.

There are two main types of indicators; leading and lagging. A leading indicator precedes price movements whereas lagging indicators confi rm as they follow price movements.

There are two types of indicator construction; those that fall in a bounded range and those that do not. The ones that fall within a range are referred to oscillators and these are the most common. Oscillators have a range, for example between zero and 100, and a signal period where the security is overbought or oversold. The two main ways that these are used to form buy and sell signals are through crossovers and divergence.

The main oscillators that are used are the accumulation/distribution line, average directional index, aroon, moving average convergence divergence (MACD), relative strength index, on balance volume and the stochastic oscillator.

In my opinion the most important oscillators are the relative strength index, moving averages convergence divergence and stochastics.

Relative Strength Index (RSI)The RSI effectively helps to signal overbought and oversold conditions. The indicator is plotted between in a range between zero and 100. A reading above 70 would usually be classed as overbought while a number below 30 would usually be classed as oversold.

Moving Average Convergence Divergence (MACD)The MACD is another very well known and widely used oscillator. This indicator is comprised of two exponential moving averages, which measure momentum in the security. The MACD is simply the difference between these two moving averages plotted against the centre line. The idea behind this momentum indicator is to measure short term momentum compared to longer term momentum to help signal the current direction of momentum. When the MACD is positive, it signals that the shorter term moving average is above the longer term moving average and suggests upward momentum. The opposite holds true when the MACD is negative. The most common buy signals occur when the MACD crosses above the signal line, while sell signals often occur when the MACD crosses below the signal line.

Stochastic OscillatorAnother commonly used oscillator is the stochastic oscillator. It is similar to the RSI and plotted with a range of 0 to 100 however overbought conditions are found at over 80 and oversold below 20. The best signals are produced when the two lines cross at either overbought or oversold conditions.

ConclusionI believe that an understanding of the basic tenets of technical analysis can sometimes give you an edge over other investors. I think that technical analysis used in conjunction with fundamental analysis is the best way of operating for any individual studying the market.

It is important to note that technical analysis is not an exact science and there is never a right or wrong answer as it is always open to the discretion of whoever is analyzing the security or asset.

Author: Andrew Myers BA MSTA 16th May 2013.

The Guide to Risk and Leverage

What is Risk in the context of equity investments?

What is leverage and how does this impact portfolio investment and CFD trading?

How do we manage the two?

Conclusion

What is risk in the context of equity investments?“Risk” according to the Oxford dictionary is; “hazard: a source of danger, a possibility of incurring loss or misfortune.”

With investments, capital risks are accepted in the expectation of a positive outcome.

Total Risk in investment is a combination of two forms of risk:-

Total Risk

Unsystematic “diversifiable” risk Systematic “undiversifiable” risk

a) Risks that affect that a) Risks that affect the whole market. particular stock.

b) Can be diversified away in a b) Cannot be diversified away, investors portfolio of shares and bonds. require a risk premium to compensate.

A fully diversified investor holding a diversified portfolio is taking systematic risk but a negligible amount of unsystematic risk.

An investor holding a portfolio with a small number of shares i.e. less than five is holding far more unsystematic risk and taking more total risk. Such a portfolio could be considered more risky if invested in the same industry sector, such as mining or banking.

Studies have shown that market risk fluctuates year on year, but that over 30+ years it has averaged 8% pa.

Market risk is a bit like investing in wine. Some years are better than others. Some are vintage years, some are average years and some are, well pretty awful years.

A wise man once said; “It is alright to speculate, you have just got to know when you are doing it, how much you are risking, and for what reasons”.

The concept of risk is that the investor needs to be compensated, and should be paid by receiving higher returns for taking higher risk in the portfolio than risk free investments. It’s like insurance where the insurance underwriter accepts risk for a premium.

What is leverage and how does this impact portfolio investment and CFD trading?

When an investor borrows money, which happens automatically when a Long CFD trade is placed, the investor is increasing his portfolio’s exposure to risky assets.

Adding CFD positions to an existing portfolio increases exposure to the market as the full value of the CFD position is added to the net exposure.

CSS Investments, The Guide to Risk and Leverage – 04.06.2013

An example of this, not taking into consideration additional trading fees and charges:

Step 1: Client Mr Low Leverage

Client has a low attitude to risk regarding CFDs i.e. a leverage requirement of 1-2 times account value. This is the amount of leverage we would suggest for inexperienced clients.

His current stock portfolio is as follows:

STOCK Quantity Price Consideration

British Petroleum 1000 4.50 £4,500

Compass Group 3000 5.50 £16,500

Intercontinental Hotel 1000 11.20 £11,200

Vodafone 4000 1.35 £5,400

Portfolio Value /Exposure £37,600

Cash £5,000

Account value £42,600 If the market dropped by 10% you could expect this client to lose £3,760 from his account value (£37,600 x 10% = £3,760). Not taking into consideration other fees and charges.

These ‘if the market...‘ are the sought of questions that the broker and client must consider constantly when deciding on what investments to make or recommend.

Step 2: Client then adds some Long CFD positions to his portfolio.

CFD Quantity Price Consideration

Glaxo 500 12.00 £6,000

Home Retail 2000 2.50 £5,000

Marks and Spencer’s 4000 3.50 £14,000

Sainsbury 2000 3.20 £6,400

Xstrata 1000 10.00 £10,000

CFD Portfolio Value/Exposure £41,400 Exposure to Stocks = £37,600 Exposure to CFDs = £41,400 Total Market exposure = £79,000

Total leverage = Total Market exposure (£79,000) = 1.85

Account value (37,600 + 5,000 cash = £42,600)

Thus the client has a leverage factor of 1.85 times.

If the market were to move up 10% the effect on the clients account would be as follows:

Exposure to Stocks = £41,360 Profit on CFDs = £4,140 Cash = £5,000 Total Account value = £50,500 an increase of £7900 or 18.5%

If the market were to move down 10% the effect on the clients account would be as follows:

Exposure to Stocks = £33,840 Loss on CFDs = £4,140 Cash = £5,000 Total Account value = £34,700 a decrease of £7900 or 18.5%

Step 1: Client Mr High Leverage

Client has a high attitude to risk regarding CFDs i.e. a leverage requirement of 4-8 times account value. Clients who opt for high leverage are usually experienced traders.

His current stock portfolio is as follows.

STOCK Quantity Price Consideration

British Petroleum 1000 4.50 £4,500

Compass Group 3000 5.50 £16,500

Intercontinental Hotel 1000 11.20 £11,200

Vodafone 4000 1.35 £5,400

Portfolio Value /Exposure £37,600

Cash £5,000

Account value £42,600

Step 2: Client Mr High Leverage then adds some Long CFD positions to his portfolio.

CFD Quantity Price Consideration

Glaxo 4000 12.00 £48,000

Home Retail 20000 2.50 £50,000

Marks and Spencer’s 10000 3.50 £35,000

Sainsbury 10000 3.20 £32,000

Xstrata 5000 10.00 £50,000

CFD Portfolio Value/Exposure £215,000 Exposure to Stocks = £37,600 Exposure to CFDs = £215,000 Total Market exposure = £252,600

Total leverage = Total Market exposure (252,600) = 5.92

Account value (37,600 + 5,000 cash = £42,600)

Thus the client has a leverage factor of 5.92 times. If the market were to move up 10% the effect on the clients account would be as follows:

Exposure to Stocks = £41,360 Profit on CFDs = £21,500 Cash = £5,000 Total Account value = £67,860 an increase of £25,260 or 59.2%

If the market were to move down 10% the effect on the clients account would be as follows:

Exposure to Stocks = £33,840 Loss on CFDs = £21,500 Cash = £5,000 Total Account value = £17,340 a decrease of £25,260 or 59.2%

In both these examples we have assumed a long only portfolio and assumed all stocks are moving up or down in correlation to the % market move. In practice each stock will move independently of the market and clients may have long and short positions on at the same time.

Stocks with a high beta value (the beta measures the volatility of a stock in relation to the market) such as banking or mining stocks will tend to move greater than the market moves.

What does adding CFD transactions to a portfolio mean?

a) All CFD open positions are treated as debt for the purposes of calculating portfolio leverage. By adding CFD exposure we are increasing market exposure and introducing leverage into the portfolio.

b) Total exposure rises when we add CFD exposure but until the CFDs are in profit they do not add to the account value.

c) The CFD exposures are similar to a separate portfolio, with either a positive or negative value moving independently to the stock portfolio.

How do we manage the two?Managing risk is an ongoing process for both the broker and client. You need to understand the potential for leverage to increase or decrease returns.

You must be conscious of the movement in total exposure (i.e. CFDs and equities) as portfolio returns will directly be impacted by the ratio of total exposure to account value and the higher the leverage multiple the higher the sensitivity to market movements.

If for example you have cash plus CFD positions that amount to a leverage of 5x the account value you should be aware that a 5% negative market movement is likely to result in a loss of 25% in the account value.

Broadly leverage is defined in terms of the multiple of net exposure to net account value.

• “Very low leverage” is defined as CFD/ FX positions worth between 0-1x the account value.

• “Low leverage” is defined as CFD/FX positions worth 1-2x the account value.

• “Medium leverage” is defined as CFD/ FX positions worth 2-4x the account value. This is the maximum leverage that we believe an ordinary retail investor should be taking, naturally this will vary dependent on the investor’s personal circumstances and objectives.

• “High leverage” is defined as CFD/FX positions worth 4-8x the account value.

• “Very high leverage” is defined as CFD/FX positions worth in excess of 8x the account value.

In rising “bull” markets we would want to add CFD exposure – but be ready to reduce the leverage multiple quickly on signs of a market turn.

In declining “bear” markets we would want to reduce CFD exposure to a minimum but also be ready to add leverage quickly on signs of a market turn.

Holding CFD positions has implications for cash levels in the portfolio. It is advisable to hold more cash in a portfolio with CFDs than in a pure stock portfolio to finance CFD positions and margin requirements.

ConclusionTrading CFD’s require investors to be aware of the workings of leverage and how it works to magnify market movements and changes to account values. CFD’s and in fact all derivative products that use leverage are high risk investments and you can lose more than your initial margin (or deposit) if the position goes against you. You should also take into consideration the additional fees and charges that will affect your bottom line.

The Bond / Fixed Income investment guide

1) What is a Bond?

i) Essential features of a Bond

ii) Basic Bond terminology

iii) Bonds the “pros” and “cons”

iv) “Working out the yield” or return on Bonds

v) A typical Bond transaction

vi) Different types of Bonds

vii) Risk factors pertaining to Bonds and other fixed income investment

2) How can Bonds be used as part of a balanced portfolio?

i) Essential Features of a BondA bond is a promise to repay a debt on agreed terms at an agreed time. The bond is the result of a contract that governs the repayment terms and the rights of the respective parties. The terms of the bond are known as “covenants”.

Bonds are bought and sold in financial markets usually via a dealer network and financial intermediaries. UK gilts are issued by the UK Treasury via the Debt Management Office and bought and sold via GEMMs “gilt edged market makers”.

The borrower is generally known as the “Issuer” or the “Borrower”. The “bond holder” is known as the lender, the holder or the creditor, these terms are interchangeable.

Interest payments or “coupons” are cash payments made to the bondholder typically quarterly, every six months or every year depending on the bond covenants. The bond holder receives these coupons usually gross (without tax deducted) in cash straight into their trading account.

The Bond “Relationship”

Pays Receives

Issuer Bond-holder

Receives Pays

Interest (coupons) + Redemption (face value) payments

Proceeds of bond issue (face value)

CSS Investments, The Bond / Fixed Income investment guide – 04.06.2013

Investing in bonds is a bit like investing in mortgage lending agreements. The Issuer agrees to repay the amount borrowed over an agreed number of years at a fixed interest rate or at a variable interest rate to the bond holder. At the end of the agreed term the loan is repaid.

Take the example of a UK gilt ; Treasury 4% 2022; this will pay 4% of the face value every year up to an including 2022. In 2022 the UK Treasury will also repay “redeem” £100 in cash per £100 of gilt. Before this date the price of the bond is determined by buyers and sellers, it can vary considerably from its £100 face value during its life.

The main bond “Issuers” are Governments (known as “Sovereigns”), Municipalities, Companies, Agencies, and Supranational Institutions. Bonds are offered by Issuers to financial institutions, such as major banks who typically sell them onto their own clients, pension funds, fund managers and insurance companies.

Once issued, bonds can be bought and sold until their redemption date. They are bought and sold via a dealer network, on the LSE retail bond order book or other exchanges.

The Issuer can make a tender offer to acquire its bonds from bond holders. The bond holder can tender his bonds to an offer and receive cash from the Issuer. Bond tenders have become more common since 2008.

Bonds are ISA eligible as long as they have at least five years to maturity when they are purchased for an ISA and are either listed on a recognised stock exchange or are the obligation of a parent company whose shares are listed on a recognised stock exchange.

Bonds can be held in investment accounts, in the same way as shares.

ii) Basic Bond terminology“Issuer”: the party seeking to raise funds/ or who has borrowed funds via the issue of a bond

“Investor/ Holder”: the party holding the bond (which represents the loan to the Issuer)

“Coupon”; the interest rate paid per annum to the Investor

“Yield”; the return on the bond

“Face Value”; the amount borrowed as stated on the bond

“Trading at a discount”; the bond price is lower than face value

“Trading at a premium”; the bond is higher than face value

“Tenor/ Term”; the length of time until the bond maturity date.

“Maturity Date”; the date on which the Issuer has to repay the face value to the Investor

Regardless of the face value of the bond its price is determined by supply and demand, it may rise or fall depending on a number of factors.

The bond price is usually quoted as a percentage of face value.

There is an inverse relationship between money market interest rates and the bond’s price. As a general rule when interest rates rise the price of the bond falls and vice versa.

Terminology Face Value Current Market Value Bond description

“Bond is at a discount” £100 £95 “at 95” or “5 under par”

“Bond at par” £100 £100 “at 100” or “at par”

“Bond is at a premium” £100 £105 “at 105” or “5 over par”

iii) Bonds – the pros and cons Bond investors should consider the pros and cons of fixed income investment relative to other asset classes such as shares (equities), property and commodities.

A bond generates predictable cash flow which helps if there is a requirement for predictable income or if other asset classes are unpredictable. Bonds are considered “safe” low volatility assets when conditions are unpredictable.

Bonds are ISA eligible provided they have more than 5 years to maturity when acquired (and there is no holder option for early redemption) and the bond is listed on a recognised stock exchange or issued by a company whose shares are listed.

What are the drawbacks with bonds? All bonds are valued in future money (a commodity that is printed by central banks). If the central bank prints too much money, the economy can experience hyperinflation which destroys the value of bonds. This happened in pre-war Germany, in Brazil in the 1980s etc. Bond prices can be manipulated by central banks via quantitative easing bond buying programmes.

Investing in bonds is unlikely to deliver triple digit returns because conventional bonds are repaid at “par” or 100 at a fixed date in the future. Hence if a bond trades at under par, eg £90 per £100 nominal then there will be a £10 capital gain on redemption. If the bond trades at £110 then there will be a £10 loss on redemption. This assumes the Issuer honours the bond covenants. In the normal course of events bonds do not deliver exceptional rates of return.

The main drawback of bond investment is that net returns can be small relative to other asset classes.

The tax treatment of bonds is known as the “chargeable events regime” and is contained in Part 4 Chapter 9 of the Income Tax Act 2005. Broadly coupon interest is treated as taxable income. Capital gains on gilts and most qualifying corporate bonds are tax free. The Bond holder needs to calculate and declare bond income in their tax self-assessment. Bonds held in an ISA or SIPP are exempt from taxes on their coupons and gains.

How do asset classes measure up to bonds?

Asset Class Cashflow Volatility Inflation Risk Liquidity

Bonds Fixed Low Not inflation proof unless IL

Low Variable

Equities Variable Medium Long term inflation proof

Medium High

Property Variable Medium Long term inflation proof

Low Low

Commodities Negative High Inflation proof in very long term

High High

Source; CSS Investments

Because investors do not know precisely what £100 will buy in the future, the bond’s future cash bears inflation risk unless the bond is index linked. Given the majority of bonds are conventional bonds and not index linked, a period of high inflation would lower the real value of bond future cash flows.

Hence fixed bond cashflows will incorporate investors’ best guess of the inflation. Bond investors need to be compensated for the risk of higher inflation over the longer term. If inflation starts to rise this has negative consequences for bonds.

The appeal of bonds varies depending on an investor’s age and risk preferences. An elderly investor or pension fund near to maturity would necessarily hold more bonds as they would require income generating assets to fund retirement. A risk averse investor would prefer the more certain returns offered by bonds over other more problematic asset classes.

How does bond investment hold up in different economic circumstances? Bond investment can be very appealing in a weak or stagnant economy or if company profits are declining. It is less appealing if inflation is rising or if the economy is experiencing strong GDP growth.

iv) Working out the “yield” or return on Bonds a) Assume the market value of a 1 year £100 bond with a 5% coupon is 100.

Calculate the flat yield.

Annual Coupon 5%*£100 £5

Yield on bond £5/£100 * 100% 5%

The yield on the bond is 5%.

b) Let’s assume the bond had a 10 year tenor and the bond price was 102. It gets a bit more complicated due to the need to adjust the return given the price being above face value. This is known as a YIELD TO MATURITY CALCULATION

The calculation using the long formula below delivers 4.752% as a yield to maturity.

Using a less formal approach this can be estimated as follows:

Step 1 calculate the annual premium you are paying:

=Premium paid on bond/ tenor years

=£2/ 10 or £0.2

Step 2 calculate the annual premium as a percentage of market value

=£0.2/ 102 *100%

=0.2%

Step 3 Deduct the annual premium from the annual coupon

=Yield on bond – annual premium on bond

=5%-0.2%

=4.8% is the approx annual yield on the 10 year bond

NB if the bond had been at 98 and not 102 then the annual premium would be added to the coupon.

Approx TYM =C + F-P

n

F+P2

C = Coupon/Interest Payment

F = Face Value

P = Price

n = years to maturity

The above is a more precise formula for calculating bond yield to maturity returns.

v) A typical Bond transaction Let us look at this like a role play:-

Client: “I wish to invest £20,000 in a quality bond offering a yield above six per cent.”

Broker/ Dealer; “Ok there is a bond; from XYZ co with a coupon of 6% and maturing in March 2022, it is quoted at 95 / 96 the yield to maturity is 6.59% and is rated A. There are 50 days of accrued interest for the buyer and the bond has a £100 minimum size”.

Client; “Ok that sounds good, what would be the annual income on that bond?”

Broker/ Dealer; “Well we could buy £20,500 XYZ co which would pay £1230 per annum divided into 2 semi-annual payments in September and March.

Client; “I understand, please run through the settlement and dealing costs.”

Broker/ Dealer; “Well the bond would be £19,680 (£20,500 x 0.96) plus 50 days accrued interest would cost £168.49 and there is 0.5% commission hence £98.40 so the total cost would be £19,946.89.”

Client; “ok I would like to proceed, let’s buy £20,500 XYZ at 96”

vi) Different types of Bonds a) “Conventional” or “straight” bonds; these pay the holder a fixed coupon and on a fixed date in the future

the Issuer has an obligation to redeem the bond.

eg. HSBC 6.5% 2023; this bond will pay 6.5% per £100 every year until it matures on 7th July 2023.

Conventional bonds can have “step-up” features where the coupon rises at future dates. Conventional bonds are the most common types of bond in issue.

b) “Perpetual” bonds; the bonds have a fixed coupon but the Issuer is not under an obligation to redeem. Hence the holder will receive a series of equal coupon payments indefinitely.

eg Cheltenham & Gloucester 11.75% perpetual

The bond pays 11.75% or £11.75 per £100 nominal bond every year.

c) A “Zero Coupon”; bond pays no coupon but the Issuer is bound to redeem the bond at par ie. 100 at a future date. The benefit is the interest is rolled up into a lump sum payment. Zero coupon bonds were popular during the Eighties and Nineties.

d) “Hybrid bonds”; Hybrids combine conventional, perpetual and convertible features and may be sold initially with warrants attached. They may have redemption dates at the Issuer’s option, they may allow for coupon payments to be varied and stopped under certain conditions.

e) “Exchangeable” bonds; Typically these are used by parent companies with large shareholdings in subsidiary companies that they wish to reduce. These bonds are issued by the parent company and remain their obligation until the bonds are converted into shares in the subsidiary company at some future date or series of dates. It is possible the conversion right vests with either the Issuer or the Holder.

f) Convertible Bonds; a convertible bond carries the right for the bond holder to convert the bond into shares at a future date at fixed terms. It is normally issued by a company and convertible into its own shares. The price of the convertible bonds reflects both the income stream and the “convert” option i.e. the value of conversion into the shares.

g) Index Linked Bonds; a bond whose payments to the holder are determined by reference to an index, typically the inflation index. Hence the bond’s value and payments will rise according to movements in inflation. Whilst future index linked payments can be estimated, it is not possible to precisely forecast payments from an index linked bond.

h) Floating Rate Bonds; the coupon on the bond resets quarterly, six months or annually according to LIBOR, the Bank of England Base Rate or some other measure of market interest rate such as the 6 month T-bill rate. Typically the bond will pay a premium to the market; i.e. the bond will promise to pay 0.5%-3% above the market interest rate. Hence a “floater” is useful when interest rates start to rise.

i) National Savings Income Bonds / Tax Exempt Special Savings Bonds / Premium Bonds

Typically these bonds are related to individual account deposits and have to be held for a minimum time period to earn a pre-set interest rate which may be fixed by the depositor for a given time period. National Savings products are not themselves bought and sold in a secondary market. If investors require encashment they need to give National Savings adequate notice for this to take place.

j) “Bond funds”; are investment portfolios, mutual funds/ unit trusts or exchange traded funds that hold a large portfolio of different bonds. Investors buying into bond fund units are buying into an investment company that is run by an investment manager or a board of managers who will charge the fund an annual cost and possibly a performance fee. A typical bond fund obtains an annual income but unlike holding a bond portfolio directly there is no fixed maturity or redemption date for the fund. Bond funds can be wound down, if this happens the proceeds of the fund would then be distributed to unit holders.

vii) Risk factors pertaining to Bonds and other fixed income investmenta) Interest Rate Risk; This relates to the risk that changes in money market interest rates will alter the

attractiveness of a bond’s fixed coupon. At its most simple, if interest rates were 10%, an investor would not want to buy a bond with a 5% coupon. Hence the 5% bond would decline in value until it offered a 10% yield.

The UK has experienced periods of rapid movement in interest rates and periods of no movement. The same is true in other countries.

In late 1990 the Bank of England base rate stood at 15% leading to a rise in 30 year UK bond yields to 12%. On 16th September 1992 the UK left the European Exchange rate mechanism leading to a decline in interest rates. By 1994 the Bank of England had lowered base rates to 5.25% and 30 year bond yields stood at 6.5%. These movements led to gains of approximately 70% in UK long gilt prices over the four year period.

The Bank of England base rate has been held at 0.5% since 5th March 2009 – the longest ever period without movement. This is part of a move by the world’s central banks to keep interest rates very low to stimulate economic growth via lowering the price of loans and increasing loan demand.

b) Duration; this is a measure of the riskiness of the bond with respect to cash returns and interest rates.

Generally the longer the bond’s term, the greater its interest rate sensitivity. For example a 20 year bond is very sensitive to interest rate changes.

This is due to the operation of “Duration” a concept with two distinct meanings.

*Macaulay Duration is the weighted average time (measured in years/ months) until sufficient cash flow are received that would “repay” the initial bond investment i.e. a Macaulay duration of 5 years means that an investor would have to wait five years for the bond’s cash flows to repay his initial investment.

*Then there is “Modified Duration” the name given to the sensitivity of the bond to movements in the interest rate yield curve. For example if the modified duration is 5% that means for every +/- 1% move in the bond yield curve (with a maturity relevant to the bond) the price of the bond would rise or fall 5%.

Conceptually duration is similar to the concept of Beta in the Capital Asset Pricing Model for equities. A high Beta equity suggests the share price will be very sensitive to the equity market.

To work out how much a particular bond price will rise or fall if its yield to maturity changes you multiply its modified duration by the change in interest rates.

Consider a ten year gilt maturing in 2022- the Treasury 4% 2022, currently priced at £118.94 with a yield to maturity of 1.721%, which I note from the Debt Management Office website has a modified duration of 8:-

If the yield rises by 0.5% then the price will fall by 4% (0.5 x 8 = 4)

If the yield rises by 1% then the bond price will fall by 8% (1 x 8 = 8)

If the yield rises by 2% then the price will fall by 16% (2 x 8 = 16)

The overall movement in interest rates is called the “interest rate cycle” and is related to the economic cycle. The length of the economic cycle is not clear, but typical cycles can be 5-10+ years.

The Interest Rate Cycle

Time

InterestRatesFalling

InterestRatesRising

PeakPeak

Contraction Expansion

BondPricesRising

BondPricesFallingStock

PricesFalling

StockPricesRising

Source: www.seguinfinancial.com

The “Taylor rule” is a rule of thumb that suggests if inflation rises 1% then interest rates should rise 1.5%. However since 2008 this has not applied to economic circumstances.

Broadly the interest rate cycle suggests bonds prices rise when the economy is contracting and decline when the economy is expanding.

c) Credit Rating; The Issuer’s credit rating is determined by the main Credit Rating Agencies, Standard & Poor, Moody’s Investor Services and Fitch Rating. Using credit analysis methods, the rating agencies measure and judge the Issuer’s credit worthiness principally their ability and willingness to service debt, the Issuer’s access to capital markets and the environment facing the Issuer. The credit analysts then provide the Issuer with a Rating and an Outlook.

Bond investors need to watch the credit rating as it is a major factor influencing the bond’s price. The “outlook” gives a short-term view of the likely next movement in the rating and is often important in determining short-term price trends.

Changes in credit rating or changes in the outlook increase what is called “downgrade risk”. A bond can experience periods prior to a downgrade where its price falls because investors are expecting a downgrade.

d) Inflation risk; the major risk facing fixed income investments is the risk of periods of high inflation. Inflation reduces the present value of cash flows considerably.

Short term bonds are not greatly impacted by inflationary risk as investors tend to predict short-term inflation. Long dated bonds carry a much greater inflation risk due to the difficulty predicting inflation over long periods of time.

The reverse also applies, periods of deflation (i.e. falling retail prices) would be positive for bond prices. Deflation has been experienced for brief periods in Japan. The UK has experienced very low inflation but not actual deflation.

e) Event risk; this relates to the risk that the Issuer experiences a major bad event that impacts the Issuer’s creditworthiness. Event risk happens when the issuer is acquired by a company with a lot of debt or if the company is hit by a disaster (examples include BAA’s buyout by Ferrovial and the BP Gulf of Mexico oil spill).

f) Default Risk; this relates to the risk that the Issuer is unable or unwilling to meet his coupon obligations in relation to the bond. A bond default is likely to lead to a court order by the bondholders to demand payment, failing which bondholders may use the legal remedy of seeking a wind-up of the Issuer’s business, if that option is available. A permanent default, i.e. if the Issuer went into administration normally means a bond losing over 90% of its value.

2) How can Bonds be used as part of a balanced portfolio?*Bonds bring diversification benefits, and hence reduce risk because bond prices may not move in step with equity investments or commodity investments they provide diversification benefits.

Consider the following example, which considers different portfolio total returns for two different portfolios, A has 50% equities/ 50% bonds, B has 75% equities and 25% bonds in three different scenarios A (equities return 10%/ bonds 5%), B (equities return 0%, bond 5%) and C (equities -10% and bonds 0%).

Scenario A (EQ 10%/ Bond 5%) B (EQ 0%/ Bond 5%) C (EQ -10%/ Bond 0%)

Portfolio A (50% each) 7.5% 2.5% -5%

Portfolio B

(75% E/ 25% B) 8.75% 1.25% -7.5%

According to a study by the Sigmund Weis School of Business, in 2008 investors who held only financial stocks lost 55% of their portfolios on average while investors holding the S&P 500 index lost 37%. Investors who held a weighting of 40% bonds with 60% US S&P 500 stocks lost 18%.

*Bonds increase portfolio income and cash visibility

The dates on which bond coupons are payable are determined by the bond covenants hence the investors are aware of the timing of future cash incomes from the bond. This is useful for liability and expense management i.e. can be used to pay mortgage and tax expenses.

Let’s assume two bond portfolios worth £100,000 Portfolio A paying 6% and B 7%.

END OF YEAR YR1 YR2 YR3 YR4 YR5

Portfolio A 106,000 112,360 119,101 126,247 133,821

Portfolio B 107,000 114,490 122,504 131,079 140,255

The example demonstrates that over a number of years, assuming the coupons can be reinvested at the same rate, a bond portfolio would experience the “compounding effect” of capitalised interest. Hence if an investor can commit to a 5 year holding period and “lock in” high bond yields then the returns are forthcoming.

Bonds should be considered as providing diversification and income benefits for portfolios.

Bond interest income is a major element of portfolio return. Our advice seeks to maximise portfolio efficiency by securing improved yields via the bond market as an alternative to cash.

We have provided here a “Bond Guide”, should you wish to discuss its contents please contact us for further details.

Behavioural and Psychological Aspects to Investment Markets

“Conventional theory” and the psychological element to investingLooking at historical precedents, it is clear from the many “manias” (“Tulip mania”) and “bubbles” (“South Sea/ 1929/ internet”) that there are periods when the investing public gets a bit too exuberant about share investing. This aspect to investing i.e. when the public gets too involved creates a problem for central bankers.

“The central bankers’ job has always been to take away the punchbowl just when the party gets going”; Federal Reserve Chairman William McChesney Martin.

The challenge for the investing public is the ability to recognise and respond to investment biases. This is particularly relevant when bias creates crowd or herd like behaviour that impacts investment returns - a good thing if you are ahead of the crowd, a bad thing if you are last in the queue! We need to recognise and understand bias at both individual and crowd level and be armed with the tools we need to avoid being affected by bias.

Conventional theory holds that markets are “efficient” i.e. they move to price in good and bad news when it occurs, that market returns “revert to the mean” i.e. 8% return per annum. “Efficient market hypothesis” still holds up to a point, but its underlying assumption that markets move quickly to price in information has taken a knock in recent years with the frequent appearance of “black swan” events. This describes a high impact (negative) event that was thought (before it happened) to have such a tiny chance of occurring that it was discounted in decision making models. A “black swan” disproves earlier assumptions.

“Human nature attempts to concoct explanations for “black swan” events after the fact i.e. with hindsight making it explainable and predictable”.Nassim Taleb; “The Black Swan” 2010

A “black swan” was presumed to not exist and was undocumented until 18th century

Both the US subprime crisis and its consequent development into a global financial crisis in (2008/2009) and the Japanese earthquake and tsunami (March 2011) have been cited as Black Swan events. By their nature the impact of big events are unpredictable, difficult to grasp and have behavioural implications. What thought processes can be used to guide investors through the maze?

Behavioural finance tries to explain how emotions and cognitive errors influence investors and decision making. It is easy to notice the emotional impact of investment decision making. Indeed I have observed individuals go from elation to depression in seconds as a result of small share price movements. This is partly because people respond to uncertainty in different ways. Behavioural finance seeks to pinpoint patterns of behaviour that are relevant to investment decision making.

The human brain uses short-cuts and emotional filters to categorise information and save time. Having bought an asset, investors will focus on good news that supports that decision and filter out “bad” news that questions that decision. These are called psychological biases and may result from the need to seek comfort and order where it does not exist and attribute success to personal skill and failure as “someone else’s fault”.

CSS Investments, Behavioural and Psychological Aspects to Investment Markets – 04.06.2013

Behavioural finance draws heavily on a) Mental accounting and b) Prospect theory. We would suggest that a majority of people would have some psychological bias.

a) Mental accounting refers to the treatment we accord to different “accounts” hence we are more liberal with spending £100 of holiday money than £100 in an ISA. We attribute spending and investing decisions according to how we categorise the money i.e. we are more willing to spend a lottery windfall than payroll income because we view funds with varying degrees of merit, even though the source of the money should be irrelevant to the decision as to whether or not to spend it.

We are more willing to gamble with a lottery windfall; i.e. the illusion of the gambler’s “lucky streak”. This works in reverse as the “snake bite” effect. After taking a loss an investor will reduce position size and be less inclined to take risks.

Mental accounting also categorises expenses. Credit card pounds are cheaper than cash in the bank because you can defer payment, what is known as the “never never”. In fact the APR’s charged on credit cards make using plastic far more expensive than a debit card.

Solutions for mental accounting issues include; i) waiting before spending windfalls ii) imagine all income is “earned” income iii) imagine a world without credit, “how much would you pay in cold hard cash?”

b) “Prospect theory” – how do we emotionally treat gains and losses? Are we more distressed by prospective losses than we are happy by equivalent gains? If so then we will take more risks to avoid losses than to monetise gains.

According to Gerald Butrimovitz “the pain of loss is 2.5x stronger than the joy of gains”. This is because investors are emotionally motivated by whether the sale transaction will generate a profit or loss. A loss can cause embarrassment when it is reported to third parties hence contributing to a tendency to avoid selling losers. This approach explains “herd mentality”, the relative safety of “following the crowd” so that if individual decisions prove incorrect the decision maker has the defence of saying that everyone else was making the same decision. This is often a costly approach, as the adverse price movement may be due to a change in the business.

The “disposition effect” is related to loss aversion, in that portfolio choices are made on the basis of the profit/loss account and not the underlying business.

Example; you have a 2 stock portfolio comprising BP (+20%) and Marks & Spencer (-20%) and no cash. You want to buy Barclays but you will need to sell either BP or Marks. The disposition effect predicts you will sell BP as the sale will trigger “pride” and avoid the “regret” of triggering a loss.

Joy/Pain

150

100

50

-50

-100

-150

-200

-250

-6 -4 -2 0 2 4 6

Weber’s Law & Loss Aversion (Kahneman & Tversky 1979)

Prospect Theory Solutions i) Work out a stop loss level before committing to the trade and put in a stop loss at the time of entry AND

learn to love to take the losses (because you are avoiding bigger losses) and hate to take the profits.

ii) Evaluate risk tolerance; what losses are you prepared to tolerate at the level of individual stock selection and at portfolio level?

iii) Diversification; write down your investment strategy, justify all investments in the context of achieving portfolio goals. This will reduce your emotional turmoil and impulsiveness.

iv) “Forget the past” – what you paid for the investment may have no bearing at all on the long term value of the asset. Consider the movement in UK property values since the 1960s!

v) Pay less attention to investments (admittedly this has been more difficult in recent years).

One example might be to focus on monthly returns, i.e. how much cash does the portfolio generate per month? Does an additional investment augment or reduce monthly cash returns?

In adopting prospect theory solutions, and essentially becoming a more passive investor, we need to be mindful of psychological effects of adopting solutions to prospect theory. Broadly this encompasses the risk of “decision paralysis” which may manifest itself in three different biases:-

a) “Endowment effect”; owners tend to place a higher value on their portfolio assets than assets outside their portfolio. They tend to demand more to sell assets than they would be willing to pay for them. This frequently manifests itself if the asset is inherited and there is emotional attachment to giving it up - “selling the family silver”.

b) “Status Quo Bias”; owners have a preference towards “doing nothing rather than doing something”.

c) “Attachment Bias”; willingness to hold onto something due to familiarity. This is a problem especially when investing in companies that are also household names. It is important to remember that whilst you personally might like to shop at, and own shares in the company, your attachment might cause you to overlook that companies’ investment performance.

Overcome these biases by asking “if I only have cash would I buy this asset?”

The role of Confidence and Overconfidence; (Govt health warning: there is a sexist element to this!)

Bear in mind other psychological effects, in particular the “Illusion of Knowledge”. Studies have shown this applies far more to men than women. Men tend to have narcissistic tendencies leading to overestimating their athletic abilities, leadership skills, investing and analytical insightfulness, and likeability/charisma. They want to believe they know what they are doing and that others appreciate and love them for it!

As a result the individual tends to search for confirmation of previously held beliefs, and ignore or turn a blind eye to bad news, hence “confirmation bias”. The arrival of the internet and the financial news gives greater access to information and makes it easier to tick boxes. However information overdose makes it harder to arrive at a relevant interpretation of that information. The more “confirmation” the decision maker gets the more confidence grows.

This overconfidence impacts decision making as it results in an exaggerated belief in an ability to control events, the “Illusion of Control”. This develops over time, as you become more familiar with investment markets. It is typified by the remark; “I’ve been in the markets for over 20 years.... this sort of thing does not happen”. The more active the participation the greater the illusion of control. This leads to the risk of over trading, an expensive activity that is a major cause of trading losses.

Studies into trade frequency suggest that men trade more frequently and have higher portfolio turnover (total value of bargains per annum/net portfolio asset value) but women are more careful in their approach.

According to the above study, men have higher risk portfolios, trade more frequently and prefer volatile, high beta and small cap investments. This suggests overconfidence. An overconfident investor needs a second opinion, on the investment and its impact on the portfolio and the precise process he has undertaken to arrive at a decision to buy/sell. An overconfident investor should also monitor his own performance or have it monitored to judge investment selection skills more accurately.

A rational investor is one that does not suffer from overconfidence, undertakes research prior to making decisions and is knowledgeable about the portfolio’s overall rate of return.

“Cognitive dissonance”, “Can you sleep well at night?”Portfolio management can create issues if it causes stress and anxiety which tends to migrate from work to the home. “Cognitive dissonance” occurs because of the need or desire to mentally justify previous decisions. This is true when that decision was controversial or finely balanced or appears with hindsight to have been wrong. Then the decision maker is likely to seek “additional justifications” to reduce anxiety or dissonance. At its worst dissonance happens immediately with relatively small asset price movements.

“Solutions” to stress and pressure needs to be tailored to the individual’s mental condition. It helps to identify its different elements. Broadly stress is caused by one or all of the following:-

a) Performance Anxiety (excessive scrutiny and fear of a negative outcome).

b) Perfectionism (the wrong assumption that you can get in at the bottom and out at the top).

c) Positive and negative self talk (talking excessively about the subject matter usually with people who share your views).

Responses may be to do one or more of the following:-

a) Remain calm and focused on portfolio returns.

b) Eliminate perfectionist expectations by setting reasonable goals.

c) Ignore arguments or statements to the effect of what we “could have done” focus on what you are “going to do”.

d) Broaden other life interests – do not focus your entire energies on the pound note.

e) Conduct “a mental rehearsal” i.e. practise facing pretend situations to rehearse how you would like to respond.

9080706050403020100

Annual Portfolio Turnover by Gender and Marital Status

single women married women married men single men

Brad Barber and Terrance Odean study

SummaryLet’s start with a health warning, our sermonising might be in your best interest!

Investment management, understanding how companies work is a long and involved process that takes time. Many investors expect to obtain that expertise in a few weeks, but in reality it can take many years.

Few athletes win every single race, and many have long periods during their career without winning anything. The same holds in portfolio investment, you need to be mentally prepared for low return periods. This sort of thinking might help; “you will lose some battles, on the way to winning the war”.

“Black swan” events have challenged conventional wisdom that prices respond quickly to big events. There may be shock or a delayed reaction over a period of time that will depress returns. On the flip side, evidence has shown that crises, by causing disruption, panic and over reaction brings opportunities for the patient.

Frequent trading is often unprofitable, expensive and brings stresses and pressures that can apply to very experienced people. It is worth understanding different factors and influences and how these trigger behaviours that may be out of proportion. Often the biggest investment returns occur by holding high quality companies over a long period. Try to stand back from the rush.

It is vital to have the right expectations and sufficient faith in one’s own investment processes as well as appreciating that investment biases exist that may impact your investment performance. If the investor is targeting a portfolio rate of return, this will eliminate disproportionate concern over individual positions.

Do not let it stress you out; “make it your slave not your master”, try de-stressing.

Enjoy your returns and be at peace with your results.

Author: Ravi Lockyer MSc Llb 16th May 2013.

Risk Warnings

No RecommendationsCollins Sarri Statham Investments Ltd (CSS) does not in any of its Publications take into account any particular recipient’s investment objectives, special investment goals, financial situation, and specific needs and demands. Therefore, all CSS Publications are, unless otherwise specifically stated, intended for informational and/or marketing purposes only and should not be construed as:

business, financial, investment, hedging, legal, regulatory, tax or accounting advice,

a recommendation or trading idea, or

any other type of encouragement to act, invest or divest in a particular manner (collectively “Recommendations”).

CSS shall not be responsible for any loss arising from any investment based on a perceived Recommendation.

Notwithstanding anything to the contrary (not even if specifically stated), no Publication (including possible “Recommendations”) shall be construed as a representation or warranty (neither express nor implied) that the recipient will profit from trading in accordance with a trading strategy set forth in a Publication or that the recipient will not sustain losses from trading in accordance with a trading strategy set forth in a Publication.

Risk warningTrading in the products and services offered by Collins Sarri Statham Investments Ltd (CSS) may, even if made in accordance with a Recommendation, result in losses as well as profits as the value of investments may rise or fall due to the volatility of world markets, interest rates and capital values. In addition, you may not get back the original amount that you invest because of, for investments held in overseas markets, the effect of changes in currency rates of exchange and, for leveraged products such as Contracts for Difference (CFDs), derivatives, commodities & Foreign Exchange (FX), the high risk to your capital by losing rapidly & substantially more than your initial investment. Speculative trading is not suitable for all investors.

Any mention, if any, in a Publication of the risks pertaining to a particular product or service may not and should not be construed as a comprehensive disclosure nor full description of all risks pertaining to such product or service and CSS strongly encourages any recipient considering trading in its products and services to employ and continuously consult suitable financial advisors prior to the conclusion of any investment/transaction.

General risk warningThe market information relating to past performance of an investment is not necessarily a guide to its performance in the future. The value of the investments or income from them may go down as well as up. As stocks and shares are valued from second to second, their bid and offer value fluctuates sometimes widely. The value of investments may rise or fall due to volatility of world markets, interest rates and capital values or, for investments held in overseas markets, changes in the rate of exchange in the currency in which the investments are denominated. You may not necessarily get back the amount you invested.

Please note that Small caps carry higher investment risk than established companies. These types of Shares may be suitable for some investors but they are not for everyone. Please also note that there can be a big difference between how much you pay for the Shares and how much you can sell them for and if you want to sell them, it can sometimes be difficult to find a buyer. Also, Shareholder influence can sometimes be limited because the majority of the Shares may be closely held (e.g. – company directors). Publicly available information may be less comprehensive than that provided by listed companies, so you may be unable to assess the business and its finances in any great depth. Finally, there is increased risk of losing some or all of the money invested.

CSS Investments, Risk Warnings – 04.06.2013

Bonds/Fixed Income Risk warningFixed income securities are subject to the risk of an issuer’s ability to meet principal and interest payments on the obligation (credit risk). It may also be subject to price volatility due to such factors as interest rate sensitivity (interest rate risk), market perception of the creditworthiness of the issuer and general market liquidity (market/liquidity risks). Liquidity/marketability risk is the risk that your security or asset may not readily be convertible into cash or bought or sold in the market quickly without affecting the price. Fixed income securities are interest rate sensitive. An increase in interest rates will generally reduce the value of fixed income securities, while a decline in interest rates will generally increase the value of fixed income securities.

ETFs risk warningETFs are highly complex financial instruments that carry significant risks. They are suitable for investors who understand their strategy, characteristics and risks. You should ensure that the ETF meets your own objectives and circumstances, and consider the possible risks and benefits of purchasing the ETF before investing. ETFs are more complex in structure and carry a much increased level of risk. It is essential you understand the risks involved. If you are unsure about the suitability of ETFs for your own investment needs you should contact your broker for advice and further information.

Before making a decision to invest in ETFs, you should discuss the product with your broker and read the ETF Prospectus carefully to ensure that you fully understand the ETF you are intending to purchase. The Prospectus will detail how the ETF aims to meet its investment objectives. Whilst most ETFs can achieve their objectives by purchasing a diversified pool of assets, some achieve their objectives through the use of derivatives, typically swaps, which carry counterparty risk. If the counterparty does not pay the sums due, the investor will see a reduced return regardless of the performance of the underlying assets.

ETFs can often have unique compounding, daily reset and leverage features that may significantly amplify risk, particularly for medium and long-term investors, and in periods of high market volatility. The value of an ETF may be affected by market values, interest rates, exchange rates, volatility, dividend yields and issuer credit ratings. These factors are interrelated in complex ways, and as a result, any losses or gains could be magnified.

Emerging Markets risk warningInvesting in emerging markets carry higher levels of risk due to the nature of these investments. These investments are more volatile than investments in established markets.

Please note that this strategy might invest in predominantly one geographic area. As a result of this, the value and prices of the underlying assets may be affected by any type of decline in the economy of this area.

Also, the currency exchange rate may cause the value of investments to go down as well as up where overseas investments are held. The governance, including supervision and accounting may not be the same as those in established markets which could result in lower shareholder protection. Additional risks associated with investing in emerging markets include systems and standards affecting trading, settlement, registration and custody of securities, which could be lower than in established markets. Please note that emerging markets can often be more illiquid than established markets and this can lead to greater price fluctuation.

Our Fees and Charges (including Commission) for Advisory Clients and Execution (Online) Clients:

It is important that all CSS Clients understand that they will attract fees and charges for each and every single trade that they place, whether it be to open or close a position, and they ensure their understanding of the fees and charges that will apply to their account before trading is correct and current. This includes that certain American/European stocks and CFDs can attract other additional costs/charges plus that there is a £15.00 internal compliance charge (Advisory Clients) or £3.00 (Execution/Online Clients) per trade as listed above.

Please note that any performance figures / data / results / projections / graphs shown do NOT take into account any reduction in value of the investment (s) resulting from the remuneration* received by CSS or charges such as Stamp Duty (i.e. a ‘gross basis’). CSS believe this approach gives continuity with how we have shown such information during 2012 and reduces the possibility of clients finding comparisons of 2012 & 2013 data to be misleading or confusing, which could be the case if in 2013 CSS changed to showing such information on a ‘net basis’.

*remuneration covers any fees, commission, charges received by CSS.

Notes

Collins Sarri Statham Investments Ltd. is authorised and regulated by the Financial Conduct Authority (Registration No 483868).

Registered in England and Wales (Company No 6539190).

Collins Sarri Statham Investments Ltd.6th Floor 5 Lloyds Avenue London EC3N 3AE

Tel: +44 (0)20 7264 2360 Fax: +44 (0)20 7264 2361

Web: www.css-investments.com Email: info@css-investments.com