Funds & Day trading
Information about risks
Trading in securities (funds and day trading)
Risks mean that it is possible that the future profits from an investment differ from the value, which capital investors expect on the basis of the information that they have available. Risks are therefore a measure of the certainty that particular profits will ensue. A difference is made here between specific and non-specific risks.
Non-specific risks
Non-specific risks only relate to one investment. Depending on the type of fund, the following risks mentioned below may occur.
Specific risks
The specific risk not only concerns the individual security, but always a complete category of investments (e.g. shares, bonds). Depending on the type of fund, the following risks may occur:
The market value and yields from securities forming the basis for an ETF may fall and rise – and therefore the value and yields from an ETF may do the same. It is therefore possible that investments do not receive back the complete amount of their investment in ETFs when selling them. The performance of the ETF may also be negatively affected by different outside factors, for example, through changes in the economic and market-induced conditions, uncertain political developments, changes in government strategies and legal, tax or supervisory requirements. The performance of an index in the past does not necessarily dictate its future development.
Risk information for funds / ETFs (Exchange Traded Funds) traded on the stock exchange
Share and pension funds
- Economic risks: They are mainly of a macro-economic nature and cannot be analysed in isolation from political risks. They particularly result from the structure of the economy in question and its type of involvement in the international economy. They are particularly felt from a financial point of view in exchange rate risks and transfer risks, which may hinder the international payments and the movement of capital or completely paralyse them. The latter are confronted by foreign exchange controls, restrictions on the movement of capital and in extreme cases by the “freezing” of accounts by foreign business partners.
- Liquidity risks: It is possible that, at the time when a share or a bond are to be sold, there is no demand for any purchases in the market. The sale may not take place at all or involve major markdowns. This risk can be neglected in markets with a huge market volume; but it may exist in small markets or in the case of exotic bonds.
- Event risks: The event risk is a possible change in the debtor’s risk profile because of unforeseen events. They include e.g. company takeovers or credit defaults by debtors. Event risks may affect the credit rating of a company either negatively or positively.
Pension funds
- Credit worthiness risk: The risk of insolvency or a lack of liquidity by the debtor (issuer). This may involve a temporary or final inability to meet interest and/or repayment obligations at the right time. Alternative terms for the credit worthiness risk are the debtor or issuer risk
- Termination risk: The issue conditions, which are contained in the issue prospectus (sales prospectus), the debtor of a bond may reserve a premature right of termination. Bonds often attract high interest phases with this kind of termination right. If the market interest rate drops, the risk for the investor increases that the issuer may make use of his or her right of termination.
- Premature redemption risk: Redemption bonds, which are paid back according to a redemption procedure, are associated with particular risks. Particularly the uncertainty about their mathematical term in the case of these redemption bonds can lead to changes in profit levels. If investors buy a bond at a market rate of 100 percent and the redemption of the securities takes place at part at an unexpectedly early time because of premature redemption, the earnings decline for the investor as a result of this reduction in the term.
- Interest change risk: This risk is the result of the uncertainty about future changes in the market interest rate. The purchaser of a security with a fixed interest rate is exposed to an interest change risk in the form of a price loss if the market interest rate increases. The non-specific risks can be minimised by investing in ETFs, which contain many different securities. The specific risk particularly with national or sector ETFs, still remains, however.
- Specific risk: The specific risk not only concerns an individual security, but also a complete category of investments to the same degree (e.g. shares, bonds). Depending on the type of fund, the following risks may occur: a general market risk – the market value and yields of securities forming the basis of an ETF. It is therefore possible that investors do not receive back the complete amount of their investment when selling it. The performance of the ETF may also be negatively affected by changes in the economic and market-induced conditions or because of uncertain political developments, changes in government strategies, legal, tax and supervisory law requirements. The performance of an index in the past does not dictate its future development.
- Country risk: These are risks which arise from uncertain political, economic and social circumstances in a different country. Political risks arise from the domestic and foreign policy situation in the country concerned. Domestic political risks are the results of ideological disputes by the country’s parties, social unease, state administrative bodies that are incapable of operating and weak governments. On the other hand, foreign policy risks arise from membership of political alliances and/or the hostile/unfriendly behaviour of other countries towards the country in question
- Specific country tax treatment: The tax treatment of the investment in ETFs may be different from one country to another. Investors are recommended to obtain information from their own independent tax advisors.
- Exchange rate risks: Exchange rate risks arise for investors with a different national currency to the euro and in those cases where investments were acquired in other currencies than the euro.
- Risks in the development of the secondary market: Permanent listing on a stock exchange is not guaranteed.
- Investment goal risk: There can be no guarantees that the investment goal, which is the exact 1:1 imitation of the index in question, will be achieved. Firstly, management fees may cost a few base points and can therefore have a negative effect on the market price of the ETF. Secondly, the change that the index will differ is greater than when investing the complete mapping when using the random sample method for index mapping.
- Index risk: The index risk consists of two components: firstly, there are no guarantees that the mapped indices will be computed in the same way in future too. Secondly, the pooling of the index may pose a risk too. This could concern the selection of individual securities and the weighting of some sectors. On some indices, the companies involved are weighted according to market capitalisation; on others, the weighting is the same. The former is risky because of pro-cyclic behaviour by the index fund. Before a security is accepted into an index, it must have achieved a certain level of market capitalisation, which is a consequence of a company’s successful work. Success can therefore only be assessed when looking to the past and it is possible that the share’s high price will soon come to an end.
- Correlation with sector ETFs: All the companies in a sector ETF are active in the same sector at the time when they are accepted. The share prices of these companies my therefore be more highly related than those of companies, which are selected according to a different investment strategy – e.g. according to their geographical region or a more widely spread division of sectors. The question about the correlation of sector indices plays a role that should not be underestimated. Because the range of investments is more restricted and therefore more volatile, the opportunities for yields – but also the risks – may be considerably greater. The diversification effect is largely neutralised by focusing on just one sector. This effect increases, if some companies have a strong market position within one sector and their weighting within the index is therefore very high. For example, the weighting of the Finnish mobile phone giant Nokia accounted for more than 35 percent of just 23 securities in the DJ STOXX®600 Technology Index (in August 2007). The correlation would then have a negative effect if the Nokia shares gave ground by several percentage points for individual reasons. This change in market prices would have a negative effect on the whole index because of the strong weighting.
- Risk of ETF closures: As has already been mentioned, it is possible that an ETF may not be permanently listed on a stock exchange. It is possible that too few funds flow into an ETF. If the costs of the issuing company are no longer covered by the management fee, e.g. for marketing, administration and licence fees, it is possible that the issuer will close these ETFs. If a fund is closed, the capital, however, is in no way lost. Either the ETF is purchased back at its net inventory value and the current value is paid out in cash, or the invested amount is transferred to a different ETF in the same company at the request of the investor free of charge.
Risk information for trading in shares, particularly in the case of so-called “second-line stocks”
Principle: A share investment is a speculative risk investment with significant risks of making losses. A share investment provides a holding in a company. A shareholder is not the company’s creditor, but has a holding in it. He or she therefore has rights, but also risks. The value of the share depends on the company’s development (risk of company holdings). The company’s risks lie in the general development of the company (economy) and the special situation faced by the company, which has to assert itself in the market place. The company’s success affects the value of the share. If the company develops in a very negative manner (insolvency), the risk exists of making a complete loss.
In the case of specific values and innovative values, the company is often only working in a very narrow area, is new in the market place and risk of taking a holding is greater. It is hard to predict whether success will ensue or not and this depends on many factors. The companies often do not have any history or successes in the past. The issuer risk is therefore higher.
In the case of second-line stocks and open-market securities, there are additional considerable risks:
- Restricted trading capacity: the market liquidity of second-line stocks is often so low that it is impossible to sell shares or only very difficult to do so.
- Risk of price formation and market prices: In the case of second-line stocks, the market situation is often tight and there is little liquidity. Prices here are often only set and no actual market agreements exist, i.e. based on bidding and asking. The spread between the purchase price (the so-called bid or bid price) and the sale price (the so-called ask or ask price) is often very high with these securities and is arbitrarily set by the so-called market makers. The spread represents an automatic loss. No fair price formation is guaranteed. The investor risks acquiring second-line stocks at high arbitrary prices, even if they are purchased through a stock exchange (the SWB Stuttgart and FWB Frankfurt pseudo-stock exchanges) – however as soon as the interest by the person responsible for the issue or their sale declines, the prices will collapse and there is no possibility of selling them any longer.
- Risk of abuse/manipulation: The over-the-counter-markets (OTC/Pink sheet/Stuttgart etc.) have one thing in common: the price formation is strongly dependent on just a few special participants. Their behaviour determines the market events. The lack of any normal bid and ask situation or any general interest and the influence on the prices of just a few people as a result provides an opportunity and increases the probability that prices will be manipulated to the detriment of investors.
- A lack of information and a monopoly on information: Second-line stocks are often unknown and are rarely considered in the stock exchange press. It is often extremely difficult to assess the share and obtain information. You are largely dependent on the company itself.
- High market price fluctuations: In the case of second-line stocks, there are often high market price fluctuations and sudden slumps in prices
- Inflow of funds: The purchase price goes to the seller, not the company. It does not increase the value of the company.
- Purchase outside the stock exchange: When orders to sell or buy shares are handled outside the stock exchange and not through one, they are traded outside the stock exchange by a financial services provider, who brings together the purchaser and seller. These orders cannot therefore be considered by stock exchange participants setting the price at a stock exchange.
The investor therefore has no opportunity of achieving a better price by conducting the order through the stock exchange. He or she may not benefit from the protective measures either, which would come into play with a stock exchange trade. These points apply, regardless of whether the order is traded at the market prices listed at the stock exchange or not. The investor must also ensure that he or she affects the stock exchange prices through any order, particularly with shares that are in short supply, and may possibly trigger a movement in the market prices to their detriment. The investor must therefore carefully consider, whether they wish to trade at a stock exchange or away from one.
Day trading
Particular risks with frequent account movements, so-called “day trading”
The trading intention that is mentioned above may contain the possibility of performing futures transactions (options and/or futures) by using a trading system, which enables market participation in the form of day trades or overnight trades. It is possible that several purchases and sales take place in the same market during one trading day. This kind of process contains considerable risks, which you need to be aware of once again.
In the case of day trades, customers often hold market position for a very short time. A position opened is closed on the same day with so-called day trades. It is possible here that a corresponding position is opened again on the same day and traded several times during the day in this market. In the case of overnight trades customer close purchased positions on the next day again. The key feature of this kind of trading is that the customer is only active in the market for a short time. Day trades or overnight trades, however, are not any less risky than futures transactions, which customers leave in the market place for longer.
If this type of process involves short-term trading, it entails a number of transactions. The commission charged is incurred for each transaction.
If a number of transactions are traded (and this is usually the case with short-term trading), there is a high degree of costs compared to the capital that is invested.
This level of costs may cause the customer’s capital to be eaten up by the commission incurred (trading commission, transaction costs). This is particularly the case if the market does not provide any or only slight fluctuations in market prices so that the yields achieved do not cover the commission when realising a position. If you do not just conduct day trading transactions with your own capital, but take out loans to do so, please note that the obligation to repay the loans still exists for day trading, regardless of how successful you are.
When conducting these kinds of transactions, please note that day trading may lead to immediate losses, if surprising development create a situation where the value of the financial instruments that you have bought fall on the same day and you are forced to sell the security that you have bought at a price below the purchase price before the end of the trading day. This risk increases if you invest in securities which are expected to be subject to major fluctuations within a trading day. In certain circumstances, the complete capital that you have invested in day trading may be lost.
Otherwise, you are competing with professional and financially strong market participants in attempting to make gains using day trading. You should therefore have an in-depth knowledge of securities markets, securities trading techniques, securities trading strategies and derivative financial instruments. In the case of futures transactions, there is also the risk that you will have to obtain additional capital or securities. This is the case if losses are incurred on the same day, which go beyond the invested capital or the securities that you put aside.
The customer should be particularly clear about this if they allow a business agent, i.e. a portfolio or administrative manager, to conduct these kinds of transactions and need to pay them for this service. In the case of short-term trading, a conflict of interests can easily arise between the portfolio or administration manager and the customer. This occurs if the remuneration for the portfolio or administration manager depends on the turnover. The so-called round turn commission is incurred with each transaction. The portfolio or administration manager may be interested in conducting as many transactions as possible – and the round turn commission is liable for payment for each of them. Our remuneration too (cf. trading fees) depends on the number of traded positions, so that what is mentioned above is true of us too, even if we do not have any influence on your trading activities.
The risk regarding the portfolio or administration manager is particularly present if you give your portfolio or administration manager a free hand in managing your investment and/or grant him or her authority to use their discretion (externally administered account), as they can then act as they see fit and can only explain the transactions with hindsight.
A similar problem can occur with stop orders that are too tight, if the position is automatically evened up when a particular price has been reached, which is always reached in normal day trading.
You should therefore regularly check your account with regard to the ratio between transaction costs and the capital being invested and the type of transactions being performed. You should take note of whether the results in your account are mainly determined by market results or the cost of commission.
If special premises are made available to handle day trading business, the close proximity to other investors in these trading rooms may influence your behaviour.