ELAN CORP & THE CFD PROBLEM

Uproar this last month from the Irish Stock Exchange and Regulators over the losses that some private clients suffered in the wake of the Elan shareprice crash, down around 70% in one day after some sort of profits warning.

Elan 6 Month Price Chart

The reason for the outcry is that many punters were using Contracts for Difference (CFDs) to leverage up long positions. But whereas sympathy must be given to anyone that suffers large losses it's a little bit rich to complain when CFDs are marketed to so called sophisticated investors who should know the risks involved with these financial products.

In the January 2005 newsletter we promoted the 3 foundations to successful trading/investing

Foundation 1 & 2 are clearly at play with the Elan debacle. How can people protest after the fact when they were clearly dealing in financial instruments that 'could' inflict massive losses if wrong, as was the case. Note that CFDs also have the power to create massive profits (as the shorts found out in this situation) if right on the market direction.

Also as in Rule 2 there was a lot of risk trading the long side in this company. It has had a history of hitting the market with dreadful news going back many years. And market history proves without a doubt that companies that issue profits warnings or dire bad news are likely to do so again and again.

Elan 3 Year Price Chart

What If the Move Had Been The Other Way?

Why does nobody ever offer to help the evil short sellers? Imagine the delight on the bigwigs faces at the Irish stock Exchange if the Elan share price had shot up 70% in a day on the back of a surprise takeover! The shorts in the stock would have been annihilated but it would have been their own fault 'for backing against price rises combined with using leveraged products'.

In a situation like this the shorts would do what they've always done, taken their losses on the chin.

So What Can We Learn?

There are a number of important points we can learn from the Elan share price destruction

• Make sure that the 3 foundations of successful trading/investing are fully understood, including the risks involved when utilising leverage
• Understand that when companies announce bad news, more bad news is very likely to follow. As we've all seen so many times the first profits warning is never usually the last
• When a company's share price is very low by historical standards and that company is in a traditionally volatile sector (tech, drugs, finance etc) expect share price surprises in both directions
• Pay special attention to rule 2 if the share price in question gets very low. Yes, the Reward potential goes up but then so does the associated risk and the best traders and investors always pay far more attention to risk

• For more information on CFDs, check out the LearnMoney CFD section - Click Here

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