Ask Colin

I am a beginner at share trading and starting out with small capital. Therefore, I was thinking of either taking a margin loan or trading in CFDs. Do you have an opinion for or against either?

I have learned the hard way to be a conservative trader and investor. I have found that it takes most of us at least ten years to become a good trader or investor. This is the same time rule that applies to most professions. The name of the game is to try not to lose too much while you are learning.

 

The most dangerous gambler is the guy who bets on the first race he attends and wins. He then thinks it is easy and is hooked. Usually he then learns the hard way that it is not easy and loses as he learns. A similar thing applies in trading. In a strong bull market it is not too hard to make some money quite quickly and the new trader thinks it is easy. Wall Street notoriously calls this mistaking the bull market for brains. Then the market gets a bit tougher – either by ranging for a while or even falling in a correction. Then the beginner finds out how hard it is to make money except in a strong bull market. And even in a strong bull market, many beginners can lose money.

 

Both margin loans and CFDs involve borrowing money, which increases financial risk. All my experience suggests that while learning the craft, we should avoid borrowing money. Once we have a good track record of making consistent profits for a few years in different types of markets, then we can consider using borrowed money, also called using leverage.

 

My view of the way to come into trading is this:

1. Go to school and learn the knowledge. The best place for this in Australia is Kaplan.

2. Develop a trading plan and paper trade it until you have established that it works. You can also test it on past data, which is good, but not a substitute for paper trading in real time going forward.

3. Start to trade real money that you own and could afford to lose. Ideally do one trade at a time (you only need limited capital to do this). Close that trade before you do another one. Continue one trade at a time until you rack up a series of profitable months.

4. Then start to trade more than one position at a time and again rack up a track record before you think of borrowing any money.

5. Once you have a couple of profitable years, then and only then, think of borrowing some money to trade with. Don’t borrow too much in relation to your own capital. Then try to run up a profitable year before borrowing greater sums.

6. Use CFDs to borrow money if you must, but use stops. Before you start CFDs, make sure you understand how the CFD provider and their web site works. Know all the rules in all the situations. Give preference to a CFD provider who has a facility for you to paper trade on their system for a few months before you start. If you don’t learn the ropes before you use real money, the market will teach you the ropes the hard and expensive way.

There is one other caveat I would make. You say you have small capital. I am not sure what you mean by small. Most experienced traders will tell you that if you try trading with less than $50,000, you will tend to be taking risks that make it highly probable you will lose money. Some people put the amount of capital required higher than this at $70,000 or $100,000. The key point is that the more capital you have the lower your risk level. Big experienced traders take smaller risks than beginners with small capital. That is why they are successful. If you do not yet have enough capital to trade safely, I suggest that you start saving while you are learning. You have quite a few years to save the required amount. Borrowing money is not really solving the problem of insufficient capital. It is actually increasing the pressure on you and will magnify losses, just as it magnifies profits.

I know this is not what you want to hear and that there are lots of people out there in the market place telling beginners what they want to hear. I am trying to tell you how it is in the real world, not a wishful paradise. Just remember that you will be competing in the market with highly intelligent, highly educated and experienced people. If you come in as neophyte with no knowledge and experience, they will eat your lunch.

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