2
Jan
2017

The Pain Amplifier

One of my charming friends told me his favourite film quote of all time was from Dune.

“Remedy this situation! Restore the Spice production…or you will live out your life in a pain amplifier!”

A Pain Amplifier?  Hmmm.  Like many attractive and affable people, he probably has a dark side, just below the surface. But given it was the New Year and a party, and we all had hangovers from New Year’s Eve, we started discussing “The Pain Amplifier”. What would it look like? How would it work? How would you prevent someone being de-sensitised? Could you reverse it to be a Pleasure Amplifier?
Then I mentioned that while running round Richmond Park, the people who effortlessly overtook me, tended to run past chatting casually in groups, hardly seeming to break sweat, probably members of a running club. They actually seemed to be enjoying themselves.  In some sense, the discomfort is recreational. But the slower, dumpier people who I overtook, seemed to be really struggling, often listening to music on headphones on their own, in their own world. Using the music to block out the pain, or at least distract themselves.  So, if discomfort is recreational, and trying to block it out has the reverse effect, how would our Pain Amplifier work?

Amplifying your gains and losses

Not by coincidence (because it was the 1st January) I was also looking at my derivative trading record for the year. Derivatives amplify gains and losses. And often there is a tax break, but for a while I’ve been thinking that much of the time financial derivatives are being abused. And the way they are marketed looks horribly misleading to me. For most people, the amplification that derivatives offer means they lose.  The first step in avoiding a trap, is to know of its existence.
So I thought it would be a useful exercise to see how I’d done over the last 12 months. Where I’d made money, and how I’d lost it. I’ve been trading Contracts for Difference (CFDs) really because I was curious how they worked, psychologically.

Just out of curiosity.

Contracts for Difference have around for 20 years. They were originally meant for institutional investors. The idea was that market makers had to offer firm, continuous two way prices (ie 2 prices that the market maker was prepared to sell at (ask price) and a lower price they were prepared to buy at (bid price)). Most of the time market makers earn money on the difference between the two prices, but occasionally markets can turn chaotic (eg on the day of BREXIT vote) and this obligation to quote two prices can be very painful. So in exchange for this, they were allowed to avoid paying UK stamp duty and to borrow stock. The Contracts for Difference industry was born.
But what started off as a product for sophisticated investors has evolved into something that I find exploitative. The UK regulator, the FCA announced in December that they thought that CFDs might be being marketed at the wrong people. The FCA’s analysis found that 82% of clients lost money on these products. That is for every 5 customers, 4 lose money trading CFDs.  I’m not sure how that compares to Las Vegas, probably not quite as bad.  Do people expect to lose money in Las Vegas but still enjoy the experience?  With piercings and tattoos the pain is an integral part of the experience.
Meanwhile a look at the historic profit margins and return on capital reported by companies like IG Group and Plus500 suggests that the customers were losing, and the companies that offered the product were flourishing.

 

 

 

 

 

 

 

 

What does my scorecard for 2016 look like?

25 trades, of which 14 were successful (ie win / lose percentage of 56%)
But the trick is to remember your George Soros.

“It doesn’t matter if you are right or wrong. It is how much you make when you are right, and how much you lose when you are wrong.”

On this front I did better. My average money making trade made 3x more money than my average money losing trade. And you can see the distribution in this graph.  (Click on it to enlarge)

cfd-2016
But you study silence to learn the music. There is a lot that is unseen.

For instance,

  • My most profitable trade Indivior (which makes heroin substitutes for addicts, and was involved in a patent dispute) rose 28%. But actually this was a terrible trade, because the share price went on to treble by November this year. I took my profit far too early.
  • I lost money on several bank trades, as I cut my losses when the prices fell – but these all ended the year strongly and I perhaps should have held on.  
  • There were also many trades that didn’t get executed, because most of the time I was trading with limit orders. The price of what I wanted to buy did not fall far enough for me to have the order filled.

Also, the stock that was my most successful trade (Britvic, which makes soft drinks) was also my least successful trade. I bought Britvic on the day BREXIT vote was announced, and made a healthy turn. But in the second half of the year the same company fell by 27%, without announcing any disappointing news. Even companies that sell soft drinks, share prices behave as you don’t expect. And when that happens the leverage will amplify your losses, unless you act quickly.
So I was one of the few that made money trading CFDs. And it was fun.  Sort of. Enjoyable in the way that running the whole way round Richmond Park on a cold Sunday morning is enjoyable. Not trying to ignore or block out the pain of losses. But even when you know the rule of thumb: cut your losses, and run with your winners, it’s surprising how hard it is to do in practice.

I also realised something else.  I was open to losing thousands, but not tens of thousands, so I could cut my losses.  That meant my trading only worked because I knew if I got it wrong, the pain wouldn’t hurt me too much. Dealing with much larger sums would be more uncomfortable, perhaps exponentially more uncomfortable.   A real life pain amplifier.

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