How a Sure Profit Can Lead to Ruin

What did you want be when you grew up?

Kids have a knack for dreaming up jobs they’ll do in the future. A few go on to fulfil these early ambitions. But if you’re like me, your ideas gradually shift in a different direction.

My first love was flying. Nothing else came close.

I remember gazing out a plane window as a five year old. I was amazed how the cars and buildings below looked like toys. It’s one of my most vivid early memories.

I was hooked. There was only one job for me…a pilot.

For years I built model planes and read aviation books. I’d also pester my dad to arrange a cockpit visit every time we flew. I couldn’t get enough.

Eventually things changed. By senior school the stock market had my attention. My passion for flying was still strong. But the buzz of the trading floor was nudging ahead.

The cockpit was destined to remain a childhood dream…or so I thought.

I recently had the chance to step back in time. You see, my son’s Scouts group had an excursion to a flying school. And I couldn’t volunteer to help fast enough.

The day involved introductory briefings and a walk around the hangers. But the highlight was a 30 minute flight in a single engine Cessna. I was back in a cockpit for the first time in years.

So did I recapture the flying bug?

Well, my mind was racing listening to the instructor talk about flying. I thought maybe I could still do this. Perhaps I could still be a pilot.

But the flight put an end to that idea. As fun as it was, I knew I wouldn’t take the next step. My enthusiasm for being in a hot noisy cabin just isn’t what it once was.

The day was a snapshot of how my career could have easily begun. It was the closest I’ll get to going back in time — even if it was just for a few hours.

A glimpse of the future

Unfortunately, time travel is the stuff of science fiction. But let’s pretend for a moment. Rather than winding the clock back, we’re going to look forward three years.

Suppose we knew for certain that the gold price would rise 90% by 2018. How would you use this information to make the most money possible?

Now, there are many ways you could trade this knowledge. But let me narrow it down to just two choices. You can buy gold outright, or you can use a CFD to give yourself leverage.

Have a look at the next chart…

Click to enlarge

This is our hypothetical graph of gold’s future. The current price is $1,000, and the future price is $1,900. I’ve blocked out intervening period. We don’t have this information.

CFD provider IG has a product that will give you leverage of 100 to 1. This means for every dollar gold moves, your account’s value changes by $100. So if you buy one CFD when gold is $1,000, and sell when it’s at $1,900, you’ll pocket $90,000. That’s the power of leverage.

Think for a moment. The price rise is a certainty. Do you play it safe or leverage yourself to the hilt?

Just for fun, work out a hypothetical trade. Use your actual capital base to do the sums. It will be interesting to see how this sure thing plays out for you.


$1,900 or bust

Okay, let’s see how the trade goes…

Click to enlarge

There’s no surprise with the end result. Gold rises from $1,000 to $1,900. If you bought gold outright, your account is up 90% — well done.

But what if you chose the CFDs?

Well, you’re potentially up $90,000 per contract. There’s just one question…were you able to hang on?

Yes, we knew gold would hit $1,900. But we didn’t know the course it would take. Look at the decline following our entry point. Gold falls by over $300 per ounce.

Now, this isn’t an issue if you bought gold with capital sitting in your account. You know the fall is temporary. So you just ride it out and wait to collect.

But it’s not so simple if you’re using leverage. You see, the CFD provider adjusts your account daily. It adds money when the price rises, and makes withdrawals when it falls.

Do you remember the amount of leverage on the gold CFD? Let me remind you — it’s 100 to 1.

Let’s do the sums on one contract…

Every dollar gold moves creates a $100 adjustment to your account. If gold falls $10, the CFD provider withdraws $1,000. If it falls $100, the withdrawal is $10,000.

In our example, gold drops to $681. That’s a fall of $319. Multiply that by 100 and you get a loss of $31,900. And that’s for just one CFD. How many contracts did you think of buying?

The CFD provider will allow you to keep the trade as long as you can cover the loss. If your account runs out of funds, it’s all over. The trade gets closed. All you get to keep is the loss.

Even knowing the future price doesn’t guarantee a profit when using leverage.

The simple fact is this. You can be the world’s best trader and have a heap of capital. But you still risk ruin if you use too much leverage.

Wealth creation isn’t something you can rush. A bit of leverage can give you a boost. But don’t hit the accelerator too hard. Things can quickly get out of control.

Until next week,

Jason McIntosh,

Editor, Quant Trader

Editor’s note: Blackmores [ASX:BKL] was the best performing ASX 200 stock in 2015. It began the year at $35…and finished at $217.98. That’s a gain of 522%.

Quant Trader got the entire move. Its algorithms identified BKL at $33.93. The system then rode the trend all the way. That’s the power of system trading.

You too can get gains like these. It’s all about having the right strategies.

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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