Have you “Stress Tested” your Spreadbet Portfolio?

In this article I’d like to encourage you to stress test your spread bet portfolio, to discover how you would cope in the event of a market meltdown.

I’ve talked before about stop orders as a form of insurance on your spread bet portfolio, which when triggered will protect your portfolio against further falls. With a stop order at 20 points below your buying price on a £1-per-point bet, the most you can lose is £20 even if the 100p-per-share equity falls a further 80 points to zero.

That’s only strictly true, of course, if your stop orders are guaranteed. Otherwise you have to assume that all your positions could theoretically become worthless, and therefore you should size those positions accordingly. Don’t go placing a £10-per-point bet on 1000p-per-share stock with a non-guaranteed stop order if you can’t afford the £10,000 worst case hit.

Having non-guaranteed stop orders should be better than none at all, if you spread spread your £10,000 worth of risk (in this example) across several diverse positions in order to reduce the risk of losing the lot on a single adverse event!

This brings me to the idea of “stress testing” your spread bet portfolio to discover how well it would cope (another way of saying “how much you will lose”) in the event of a market meltdown.

Stress Test Your Spread Bet Portfolio

By “stress test” I mean calculate what effect it would have on your portfolio account balance if all of your positions fell to zero in some catastrophic market crash. This will tell you what would happen if you had no stop orders in place, and what could happen if your stop orders are not guaranteed. Here’s a concrete example:

• If you have two £1-per-point positions each priced at 500p, in the very worst case scenario you could end up £1000 down in the event of a total catastrophe.

Obviously if any of your positions have the benefit of a guaranteed stop order, your loss on those positions will be fixed absolutely at the stop level so that the true worst case scenario won’t be so bad. Here’s a concrete example:

• If one of the aforementioned positions has a guaranteed stop order at 450p then in the true worst case scenario you would end up £550 down across both positions.

Those are the worst of the worse-case scenarios, but you would hope that in the event of a gradually unfolding crisis most if not all of your stop orders would stop you out as expected — even if they are not guaranteed. Here’s a concrete example:

• In the best worst case scenario, in which the other position also has a stop order at 450p which — despite not being guaranteed — executes at the required level, you would end up a more manageable £100 down.

The Trade-Off

In the very worst case of having no stop orders in place, you could be taking £1000 worth of risk using the mere £250 (for example) that the spread betting company required you to deposit to take on that risk. But you’d have to cough up the additional £750 when you got the dreaded ‘margin call’.

In the true worst case of having some of your positions guaranteed, you lesser loss comes at the cost of those guaranteed stop orders.

In the best worst case, the presence of non-guarantee stop orders reduces your notional loss to a much more manageable level, but it’s only notionally less risky. Which brings me to…

Trading Within Your Means

Your spread betting provider gives you an idea of how much money you would be left with in a worst case scenario, by providing you with a Trading Resources figure that gets lower and lower as you take on more and more risk.

As you reduce your risk by applying stop orders to your positions, you may find that this Trading Resources figure (the amount you are allowed to spend on new positions) increases to reflect the reduced risks you are taking. So you get more “paper” — well, electronic — money to play with, without you having to deposit any more cash.

Sounds good, but you need to be aware that different spread betting companies calculate your Trading Resources in different ways. Some will only let you trade within your means, by basing your free Trading Resources on the true worst case scenario that is yields a guaranteed liquidation value for your portfolio. Other spread betting companies will give you extra benefit for the risk reduction implied by your non-guaranteed stop orders and the increasing values of your profitable positions, such that they could be allowing you to trade beyond your means using money that you are not guaranteed to walk away with in the event of a meltdown. This will benefit you on the way up, but could destroy you on the way back down, which now brings me to…

Risk and Reward

All this talk of worst case scenarios may leave you thinking that maybe this spread betting lark really is as dangerous as some people portray it to be.

I don’t think that spread betting need be any more dangerous than traditional share dealing — if you understand the risks and how to measure and manage them. To my mind, it’s better to teach the kids “safer sex” (it’s an analogy) than pretend that they won’t do it.

And of course, there’s a flip-side to the risky spread betting coin. You have to speculate to accumulate, and you won’t get any reward if you don’t take any risk.

Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.