Stocktake

CFDs invariably a money-losing game The Central Bank missed the point last week when it cautioned that contracts for difference (CFDs) are "unsuitable for investors with a low-risk appetite". The real problem is that, whatever your appetite for risk, leveraged CFD trading is almost invariably a losing game.

The Central Bank reported that 75 per cent of retail CFD traders lost money during 2013-2014, with the average punter losing €6,900. That’s bad, but the long-term figures are likely to be much worse. Some traders may get lucky in one year, but luck eventually runs out; one study of Taiwanese day traders found 13 per cent profited in an average year, but only one in 360 traders consistently outperformed.

In 2014, French regulators reported that in every year between 2009 and 2012, 83 to 84 per cent of CFD and foreign exchange traders lost money; at the end of the four years, 89 per cent had lost money. It found 722 clients lost more than €50,000, while only 121 clients gained more than €24,000. It also found that those who traded the most lost the most; the bigger the trade, the bigger the loss; and traders didn’t improve over time, “indicating there is no learning curve”.

In contrast, the Central Bank's press release was decidedly sparse in content and too gentle in its tone. To truly get a feel for the reality of CFD trading, seek out the French report, not the Irish one. Penny pain for short seller Talking of risky trading practices, spare a thought for Arizona business owner and occasional day trader Joe Campbell, who recently hit the headlines after asking for online donations to help cover his losses following a disastrous trade.

Campbell took a short position against biotech penny stock KaloBios, which was on the verge of filing for bankruptcy before controversial pharmaceutical executive Martin Shkreli announced he was investing in the firm. The price shot up overnight, from $2 to $16; not only was Campbell's $37,000 account wiped out, he woke up to discover he owed a further $106,000 to his broker, eTrade.

Many people hate short selling, seeing it as immoral and manipulative. Both accusations are untrue. It is, however, very risky, for two reasons. Firstly, shorting is an asymmetrical bet – the most you can gain is 100 per cent, but losses are potentially unlimited. Secondly, prices can be driven to unjustifiable heights during a so-called short squeeze. This was the case with KaloBios, which soared 4,000 per cent in just six days.

No doubt Campbell can relate to the words of legendary 1920s speculator Jesse Livermore. "The game taught me the game", said Livermore. "And it didn't spare the rod while teaching." 'Financial patriotism' and Paris The calm reaction of financial markets to the recent Paris attacks has attracted no shortage of ill-informed commentary.

Time magazine, noting the strong stock gains in the days following the attacks, asked if this was a case of “financial patriotism” or whether investors were anticipating supportive stimulus from central banks. In contrast, Barron’s suggested investors had “grown a lot more callous”. Others argued it was proof that nothing would derail this irrational bull market.

Two points are worth making. Firstly, terror attacks tend not to impact on stocks. Secondly, Wall Street’s 3.6 per cent decline the previous week was one of the worst weeks of 2015, setting the scene for a market rebound.

Stocktake has quoted author and trader Victor Niederhoffer on this point before: stocks "tend to go down after there has been excessive optimism over the previous several days, and they tend to go up after there has been excessive pessimism". Sometimes, the simplest explanation is the best one. Another flat year for stocks? Despite the volatility of recent months, stocks have ultimately gone nowhere in 2015. Goldman Sachs cautioned last week that another flat year is in store for 2016, but history indicates otherwise.

The only time the S&P 500 recorded two consecutive flat years (defined as gains or losses of less than 3 per cent) was in 1948, according to S&P Capital IQ’s Sam Stovall. There have been 10 flat years since 1945, says Stovall. The following year, stocks rose on eight occasions, enjoying above-average gains of 12.8 per cent. History, says Stovall, suggests that “while two flattish years in a row are possible, they are not likely”.