DIY Investor Magazine
/
2015 Issue
12
CONTINUE... BOOST YOUR POTENTIAL RETURNS
WHILST LIMITING YOUR RISK
An illustrative example: Infinite Long on the FTSE
100 Index
EPIC
IT10
Type
Infinite long
Underlying Asset
FTSE 100 Index
Underlying Asset price 6,500.00
Ask price
£0.8000
Finance level
5,700.00
Knock out level
5,800.00
Parity
1,000
Gearing
8.13
To demonstrate how Infinite Turbos work,
suppose that the FTSE 100 Index is trading at
6,500.00, and you believe it is set to rise by at
least 5%. Having looked at the range, you select
IT10, an Infinite Long on the FTSE 100 Index with
a Finance Level of 5,700, a Knock Out Level of
5,800.00 and gearing of 8.13 times.
What this all means is that the price of IT10 will
rise or fall based on how far above 5,700 the
FTSE 100 Index is trading. 8.13 times gearing
means IT10 will move 8.13 times faster than the
FTSE 100 Index before costs. Plus, the Knock
Out level of 5,700.00 means that IT10 will expire
if this level is ever touched.
The cost of IT10 is £0.8000 per unit, which is
calculated by subtracting the Finance Level
(5,700.00) from the FTSE 100 level (6,500.00). In
this case we also have to apply a scaling factor
of 1,000 to reduce the trading size. We call this
Parity and without it IT10 would cost £800 per
unit. But dividing everything by 1000 makes IT
more palatable at £0.8000 per unit.
WHAT HAPPENS NEXT?
As the table below shows, there are three things
that could happen next. If we’re right and the
FTSE 100 Index rises 5% we would make a profit
of £0.3250 per unit, a 40.63% return on the initial
price of £0.8000. If we’re wrong, and the FTSE
100 Index fell 5%, IT10 would fall 40.63% to
£0.4750 per unit.
The worst case scenario however is that the FTSE
100 Index hits the Knock Out Level of 5,800.00.
If this was to occur IT10 would expire immediately
and some or all of your capital would be lost. The
amount repaid would depend on the level of the
FTSE 100 Index over the next three trading hours.
Performance of the FTSE 100 Index
RISES 5% FALLS 5% HITS 5,800
New Index
Level
6,825.00
(+5%)
6,175.00
(-5%)
Lowest level
in the next
3 hours of
trading
New price for
IT10
£1.1250
(6,825 –
5,700)/1,000
£0.4750
(6,175 –
5,700)/1,000
Dependent
on recorded
index level.
Profit per unit £0.3250
(+40.63%)
-£0.3250
(-40.63%)
Up to 100%
loss
‘For illustrative purposes only’
Taking a more conservative approach
Leverage doesn’t have to be used aggressively;
it can in fact be a tool for reducing risk. Assume
you have £2,000 to invest, the FTSE 100 Index
is trading at 6,500 and you think it will rise. If you
wanted to simply track the FTSE 100 Index you
may invest your money in an Exchange Traded
Fund, which will rise or fall in line with the index.
If you wanted to ‘Gear up’ and boost your potential
returns you could buy 2,500 units of our Infinite
Turbo from earlier - IT10. At £0.8000 per unit
it would cost a total of £2,000. With 8.13 times
gearing, this would be the equivalent of investing
£16,260 (£2,000 x 8.13 = £16,260) in the FTSE
100 Index ETF.
If however you are happy to replicate the same
performance as the FTSE 100 Index (before
costs), but want less capital at risk, you could
‘gear down’ your investment. This time you are
trying to buy £2,000.00 worth of exposure with
8.13 times less capital (£2,000 / 8.13 = £246). We
can’t buy £246 of IT10 precisely as £246 does not
divide perfectly by £0.8000 (£246 / £0.8000 =
307.5). The closest we can get is to buy 308 units
at £0.8000 for a total cost of £246.40. This gives
us a FTSE 100 Exposure of £2,003.23 (£246.40 x
8.13), but we have £1,753.60 left.
