How to implement an asymmetric payoff strategy: Part 3- Using margin lending, GSL & CFD

September 30th, 2007

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In our previous article, How to implement an asymmetric payoff strategy: Part 2- Using options, we mentioned about using options to profit from a possible stock market crash. Today, we will introduce to you another technique. It may sound complicated because of the 3-letter acronyms, but once you understand it, it is far more easily conceptually than using options. First, let us explain some of the elements used in this strategy:

  1. Margin lending – We assume that you know what margin lending is all about. Basically, you borrow money to buy stocks. At any point in time, the amount you borrowed must remain at or above a certain ratio relative to the total valuation of your stock.
  2. CFD – This is a leveraged derivative instrument called Contracts for Difference. It is an agreement between two parties to settle, at the close of the contract, the difference between the opening and closing prices of the contract, multiplied by the number of underlying shares specified in the contract. The usefulness of CFDs is that you can use it to bet on a falling stock price as well as on a rising stock price.
  3. GSL – This stands for Guaranteed Stop Loss. This is different from the ordinary stop-loss (see How to implement an asymmetric payoff strategy: Part 1- stop loss, the wrong way for the pitfalls of using stop-loss). The difference is that in the GSL you are guaranteed a selling price (or buying price when you go short) even if the prices gap down.

So, how do you implement this strategy? Below are the steps to do so (assuming that the everything is ideal in a perfect world):

  1. Long (or buy) the stock at a particular price, using margin lending for leverage.
  2. Use a GSL that will activate when the stock fall by a certain percentage.
  3. Use CFD to short the same stock at the same price that you go long.

When the stock market is behaving normally, profit (loss) from the long leg will offset the loss (profit) of the short leg, resulting in net profit/loss of zero. When an extraordinary event (i.e. a crash) occurs, falling market price will activate the GSL, thus terminating the long leg. The short leg is then allowed to run free, resulting in runaway profits.

This is the theory anyway. What are the possible pitfalls to watch out for this technique? They are:

  1. Interest charges – When you use margin lending to borrow money, you have to pay interests. When you use CFDs to go short, you are paid interests. However, the interest rates on these two legs are different and most likely against your favour.
  2. Percentage activation of GSL – When you set a GSL level, you have to specify the percentage of the fall in stock price before your GSL will activate. This is the tricky bit.
  3. GSL fees – Guaranteeing a stop-loss comes with a price to the stock broker who provide you with this service. The charges varies depending on the market volatility, the percentage level for which the GSL will activate, the length of time this GSL facility is active.

The concept of this technique is simple, but the devil is always in the detail.