DIY investors who dabble in online trading risk getting burned

WORDS ON WEALTH:

There has been a Covid-related surge worldwide in online share, derivative and forex trading by consumers, which warrants a grave reminder about the risks of such activities.

Evan Giannakis, the head of derivatives at Momentum Securities, says that current data indicates that more than 2% of equity trades in the US are trades of $2 000 (R33 469) or less – in other words, by small-time “consumer” traders.

Giannakis says there are a number of factors driving this phenomenon.

“Firstly, the US Federal Reserve has flooded the market with unprecedented levels of liquidity. Secondly, low-cost platforms such as Robinhood have opened up equity and derivative investing to a whole new segment of the population. Combine these with the fact that we are in an environment where sporting events have been cancelled, entertainment businesses are running at reduced capacity and people are sitting at home receiving government stimulus cheques,” he says.

Giannakis points out that half of Robinhood’s new customers this year said they were first-time investors, according to the company, and more than two million new accounts were opened in the first quarter.

I wonder how many of these first-time “investors” were fully aware of the risks before committing their money.

Take the tragic case of 20-year-old Alex Kearns. A few weeks ago, Personal Finance briefly reported on his suicide after he lost $730 000 trading on Robinhood. What has emerged since, making the case doubly heartbreaking, is that he had not lost that amount: the Robinhood app temporarily showed he was in the red, but the other side of the trade had not been settled.

If you are thinking of trading using one of these online platforms (it’s not investing if you’re speculating in the short term), you need go into it with your eyes wide open: you should only trade with money you are prepared to lose and be fully acquainted with each instrument’s characteristics and associated risks.

Equities (shares)

When you buy shares in a company, you become a part-owner of the company and share in its profits in the form of dividends. If the company goes belly up, you may, at worst, lose your entire investment, but that’s all you can lose. To limit your losses, you can make use of a stop-loss order, which directs the broker to sell at a certain point if the share price falls.

Some brokerage sites offer fractional shares – expensive shares are divided into smaller units to make them affordable to the consumer.

Derivatives

Although derivatives have the advantage that you can profit from a falling asset price, they are more risky than shares, because you don’t own the underlying assets and you can lose more than you invest. The most common derivatives on trading platforms are single-stock futures (SSFs), contracts for difference (CFDs) and options.

– SSFs: These are contracts that let you buy or sell shares at a fixed price on a future date. Standardised stock exchange contracts are for 100 shares in a particular company and they trade on a secondary market. Investors must deposit what is known as a margin, which should cover the maximum loss that may occur in a single day’s trade. At the end of each day, the exchange determines the closing price of its contracts and revalues your position. Any gains or losses are added to or subtracted from your account.

You don’t have to hold an SSF until its expiry date – you can “close out” your position at any stage, at which point you will be paid out the current value of the SSF less costs. The danger is that you can make (or lose) a large amount of money by committing a small amount (the margin), and thereby lose more than your original capital.

– CFDs: These are a related, newer type of share-based derivative that became popular in the early 2000s. A CFD is an agreement to exchange the difference in value of a particular share in the period between the opening and closing of the contract. As with SSFs, you put down an initial margin and a variation margin is added or subtracted daily. They carry the same risk that you can lose more than your capital.

– Options: These give you the option to buy or sell an asset on a certain date for a certain price. You are not locked in, as you would be with a futures contract, and can exercise the option, or not, depending on whether the price of the asset has gone your way or not. The counterparty in the transaction (the seller in the case of a trader who is buying, and the buyer in the case of a trader who is selling), however, is obliged to honour the contract.

You take out a “put” option if you expect the price of the underlying asset to fall, or a “call” option if you expect it to rise. Instead of depositing a margin you pay what is known as a premium, which is not refunded.

Forex

Forex trading sites offer CFDs, not on equities but on currencies, including cryptocurrencies, such as Bitcoin. Not only do you take on the risk inherent in the derivative instruments themselves, but also that of the notoriously volatile foreign exchange market. Remember, you are not buying the underlying asset; you are only entering into a contract based on what the price of the asset will be in the future.

Forex trading sites promote the idea that experienced traders can somehow read the forex markets. I suggest that such an idea is absurd – highly qualified, seasoned investment professionals find it almost impossible to predict the movements of equities, let alone currencies.

Final word

Some final advice from Giannakis: “Stay away from trading derivatives or using margin unless you’re an expert investor – or get help. Our advice to clients is to first and foremost fully understand the associated risks when trading derivatives on margin. Be clear on what you are trying to achieve, what your end goal is and, importantly, do not invest more than 15% of your portfolio in derivatives.”

PERSONAL FINANCE

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