SHAREMAESTRO FTSE 250 SPREAD TRADING STRATEGY
Outstanding long-term returns
This strategy combines investment in cash deposits with investment in FTSE 250 spread trades (also known as "spread bets") to target outstanding long-term returns. Providing that the FTSE 250 price is not too expensive, you invest in FTSE 250 spread trade contracts during the months which historically have delivered the largest FTSE 250 price gains. You are fully invested in cash deposits for the other months.
Spread trading multiplies the gains (and losses) of market price changes, according to the number of pounds per point which you bet in relation to your total investment sum. This is known as gearing - see the section What are financial spread trades? below. For example, a gearing of 3 will triple the percentage market price changes.
If you had invested at the maximum feasible gearing level of 6.3 from November 1986, you could in theory have turned £1000 into £305,000,000 at June 2016 by using this strategy. This maximum gearing would have involved extreme short-term risk. A higher gearing than 6.4 would have wiped out all your capital. However, even a more modest gearing level of 2.0 would have transformed £1000 into over £154,000 by June 2016. You can verify these results by using the spreadsheet simulator which is embedded on the last page of this paper.
Under current tax rules, all profits on spread trading are free capital gains and income tax. Interest earned on the cash deposit account is subject to higher rate tax, if applicable.
The strategy in a nutshell
More detail is given in the section below entitled The detailed steps to execute the strategy.
· By the end of October, you place your chosen investment sum in a competitive interest-earning instant-access cash deposit account.
· At the start of November, unless ShareMaestro shows the FTSE 250 price to be too expensive (see below), you buy a FTSE 250 spread trade contract. You set a stop-loss level to limit any loss to the maximum which you are prepared to incur and to make it very unlikely that the stop-loss will be triggered, taking into account your chosen gearing level. The calculations for establishing your spread trading position, to reflect your appetite for risk/ reward, are explained below in the detailed steps section.
· You cover your maximum potential loss with part of your cash deposit.
· At the beginning of June, assuming the stop-loss has not been triggered, you sell the FTSE 250 contract. You then transfer all of the funds on your spread trading account, including profits or losses, back to your cash deposit account.
· The following November you start the cycle again.
In normal circumstances, this strategy will require actions only three times per year: at the end of October, at the start of November and at the start of June.
Key success factors
There are three key success factors to this strategy:
1. The spread trades are contracted in an index which has a history of strong capital growth. The FTSE 250 comprises 250 mid-sized UK companies. These are nimbler than the behemoths in the FTSE 100 and tend to grow much more rapidly. When it was launched in 1986, the FTSE 250 index was nearly the same value as the FTSE 100. Now the FTSE 250 is nearly triple the value of the FTSE 100.
2. The spread trades are contracted during the season which has, historically, delivered the highest capital growth for the FTSE 250. This strategy exploits the old adage - "Sell in May and go away" by investing in spread trades between the start of November and the start of the following June each year. Only three times in the history of the FTSE 250 (up to 1 June 2016) has the market price fallen between the start of November and the start of following June. In fact the average price increase has been 11.0% over this 7 month period, more than the average increase for the whole of the year.
3. No spread trades are contracted if the FTSE 250 price at the beginning of November is shown by ShareMaestro, a proven market valuation system, to be poor value. ShareMaestro has a strong track record of valuing UK indices and individual UK shares. ShareMaestro produces intrinsic valuations and expresses these as a percentage of the market prices. 100% is fair value, over 100% is good value and below 100% is poor value. As stated above, there have been only 3 (out of 30) years when the FTSE 250 price fell between the start of November and the start of the following June. On the first occasion the fall was only 1.3%. On the second occasion, the fall was 13.9% but, under the rules of this strategy, you would have stayed invested in cash because the ShareMaestro FTSE 250 valuation was below 100% (in fact 83%) at the start of November. On the last occasion the fall was 0.6%.
Long-term returns from this strategy for different gearing levels
This table shows the long-term results from this strategy for different gearing levels. These returns exclude the benefit of interest earned on the cash deposits and are based on IG's FTSE 250 spread trade costs current in January 2016. The accumulated fund shows the growth to the start of June 2016 from an initial investment of £1,000 at the start of November 1986.
Returns from start November 1986 to start June 2016Gearing / Stop-loss % / Largest annual loss % / Compound annual return % / Accumulated fund from £1,000 investment
1 / 16 / 2.8 / 9.4 / 14,936
2 / 32 / 5.5 / 18.3 / 154,870
3 / 48 / 8.3 / 26.7 / 1,223,689
4 / 64 / 11.0 / 34.8 / 7,823,023
5 / 80 / 13.8 / 42.6 / 42,129,228
6 / 96 / 16.5 / 50.0 / 196,844,852
What are financial spread trades?
Financial spread trades are available for a wide range of financial instruments (e.g. equities, currencies, bonds). A spread trade is an agreement between a client and a spread trade provider to exchange the difference between the opening contract buy or sell price and the subsequent sell or buy price. If a spread trade contract is held to expiry, the closing price will be the price of the underlying futures market. The way spread trades work is best shown by way of an example:
A quarterly spread trade on the FTSE 250 is used in this example.
On 22 January 2016, the FTSE 250 cash price is 16128. You think that the FTSE 250 price is going to rise over the next few months.
You get a spread trade quote for the June 2016 FTSE 250 contract, expiring on 14 June 2016. The quote is 16248-16135. The higher price is the buy price and the lower price is the sell price. The difference between the two prices is the spread. The spread is the profit margin of the spread trade provider.
You decide to buy £5 per point at the price of 16248.
Fast forward to say 20 May 2016. Let's say the FTSE 250 cash price has risen to 16510. The current quote for the FTSE 250 June 2016 contract is now 16570-16470. You decide to sell your open trade at the price of 16470. So you realise a profit of £5 x (16470-16248) = £5 x 222 = £1100.
Spread trades enable you to magnify the price movement in a contract price according to the number £s per point of price movement you choose to trade. This is known as gearing. To limit any losses, it is essential to specify a price at which your contract should be automatically sold if the price falls to that level. This is known as a stop-loss.
The detailed steps to execute the strategy
1. Decide the initial sum which you wish to invest in this strategy. This sum is likely to be influenced by the maximum percentage loss which you are prepared to incur in any year on your accumulated investment sum.
The best returns from the strategy are achieved by avoiding having your position closed out before the beginning of June because of a high interim loss. Most interim losses have turned into profits by the start of June. The highest ungeared interim loss since the inception of the FTSE 250 has been 15.7%, excluding the year when you would have remained in cash because the ShareMaestro FTSE 250 valuation at the beginning of November was below 100%. Rounding this highest interim loss to 16.0%, based on past experience this is the minimum loss, before gearing, which you should be prepared to incur in any year. If you are not comfortable with this potential level of short-term loss, this strategy is not for you. Gearing will increase any potential loss. For example, a gearing of 2 would double the highest interim potential loss to 32%.
2. Deposit your investment sum before the end of October in a competitive interest-earning instant-access deposit account and open a spread trading account.
3. Decide the level of gearing which you wish to use for this strategy. Higher gearing increases the potential long-term returns from the strategy but also increases the potential for short-term losses. If, for example, you decide that the maximum potential loss which you are prepared to incur in any year is 30% of your accumulated investment sum at the start of November, then a gearing of 1.875 is indicated i.e. 30/16 (16 being maximum historic interim loss % in 1. above).
4. Transfer cash from your cash deposit account so that it reaches your spread trading account by the first trading day in November. The cash should be sufficient to cover the maximum potential loss on your investment plus any additional margin (cash collateral) required by your spread trading firm. Margin requirements vary between firms and you need to understand fully those of the firm which you select. For example, if your investment sum were £10,000 and your maximum potential loss were 30%, you would transfer £3000 to your spread trading account plus any margin required by the spread trading firm.
5. On the first trading day of November, unless the ShareMaestro FTSE 250 valuation is below 100%, buy a FTSE 250 contract expiring next March. Determine the number of £s per point by the following formula: (your total investment sum x your chosen gearing level)/the current buy price of the contract. For example, if your investment sum were £10,000, your chosen gearing level were 1.875 and the current contract buy price were 16,500, the £s per point would be: (10,000 x 1.875)/16,500 = 1.14. Note: spread trading firms operate a minimum number of pounds per point e.g. 50p.
6. When buying a contract, it is critical to establish your stop-loss position. This is determined by establishing a price which is a number of points below the current contract buy price. The number of points is determined as follows: the maximum potential loss which you have decided to tolerate on your investment sum/number of pounds per point which you are trading. So, following the previous examples, where the contract buy price is 16,500, the number of pounds per point is 1.14 and the maximum sustainable loss is £3000, the number of points would be 3000/1.14 = 2632. So the contract sell price would have to fall to 16,500 less 2632, or to 13,868, for your position to be automatically sold. In fast markets, or when market sentiment falls during the market close period, your position may be sold below your stop price, thereby creating a greater loss. You can avoid this risk by taking out a guaranteed stop-loss when buying the contract. Charges for this guarantee vary between spread trading firms and have not been included in the simulator. Currently IG widen the spread by 49 points to charge for the guarantee.
7. Either online or by talking to your spread trading firm, ensure that the March contract, on expiry, will automatically be rolled over into the June contract for the same number of pounds per point.
8. If the ShareMaestro FTSE 250 valuation is below 100% on the first trading day of November, return all the cash on your spread trading account to your cash deposit account. This has happened only once in the last 29 years. Do not buy any spread trade contract until the following November (when you should check the prevailing FTSE 250 valuation), even if the FTSE 250 valuation subsequently rises above 100% before then.
9. If your position is closed automatically by a stop-loss, transfer the remaining cash on your spread trading account to your cash deposit account and wait until next November before commencing a new trade. If you follow the rules described in this section, especially with regard to your risk appetite and the associated gearing level to use, it should be rare, based on past experience, for your position to be closed out before the start of June.
10. At the start of June, assuming your position has not been closed automatically by a stop-loss, sell your position and transfer all the cash on your spread trading account back to your cash deposit account.
11. At the end of the October repeat the above cycle. Your new investment sum, and the associated rules for establishing gearing and stop-loss levels, should include any profits/losses made on the previous trade together with any interest credited to the cash deposit account.
Risks
· Although this strategy uses short-term instruments, it is designed for long-term investment (minimum five years) because of the large fluctuations in performance for individual years.
· This is a high-risk, potentially high-reward strategy and is not for the fainthearted. You should take appropriate professional advice before making any investment. ShareMaestro Limited and the author take no responsibility for any losses which you may incur. ShareMaestro valuations do not constitute investment advice from ShareMaestro Limited.