LOOK at the list of stocks offered by CFD providers and you’ll see the size of the task. How do you pick the best ones to trade using the leverage of contracts for difference (CFDs)?

For professional traders, scanning software is the only answer, but for beginners there are some 700 or more stocks to choose from. Where to start?

Scanning software is for advanced traders. It looks at the price feeds from the stocks they’re interested in and checks the price and volume statistics to find those throwing up potential entry and exit signals on price charts.

The trader then looks at the charts to see if any stocks meet the predetermined entry criteria. These would include a requirement that the stock must be liquid enough to trade readily (which may change over time for a particular stock).

But the use of scanning software, and a deep knowledge of the full suite of technical analysis tools that this implies, is not for the CFD trader first starting out, says Chris Conway, senior research analyst at trading advisory group Australian Stock Report, and a trader himself.

Conway suggests there may not be a single easy answer to the question of which stocks are best for CFD trading. “CFDs are most suitable for short to medium term trading. There is a financial cost for holding a long (bought) position and an opportunity cost if the short (sold) positions you hold are not moving.

“So you’re looking for stocks capable of a 5 to 15 per cent move (up or down) over a two-week to three-month time frame. Ideally you would use scanning software like Metastock to find those displaying a suitable average true range for this purpose,” he says.

Average true range is a measure of how far a stock has been moving day to day fairly recently – usually over the past 14 or 20 days.

Alternatively, Conway says, “Traders can eyeball charts. I wouldn’t buy or sell a stock that moves a small amount. But you have to find a balance with your skill set. Not everyone has the capability of using technical analysis and scanning programs.

“The other qualities you could look for include the quality of the trend. In an uptrend, is there a series of higher and higher lows defining a solid uptrend line? Are the moving averages displaying positive momentum?” Momentum is the strength of a trend, measured by the ratio of the size of rises to that of falls.

Traders should also be looking for key support and resistance areas, Conway says. Support is where, in the past, a downward moving price has met fresh buying, halting the slide and leading to an upward bounce. If this happens more than twice at the same price, a support line has been formed and the stock is likely to have trouble moving down through that price in future.

Conversely, resistance occurs in an upward moving market when fresh selling is encountered, and the price dips, returning to reach the resistance level more than twice.

“For long positions, place your stop-loss order (to get out of the trade) just below the support level,” Conway reminds traders. “This will decrease the number of bad hits.” This is when a trade is exited on a minor price drop and the profit is missed when the stock soars.

“If all these factors line up, then the probability of the success of a trade increases,” Conway says.

Which stocks does a new trader start with? “In terms of psychology it’s best to start with stocks you know and are familiar with, then look to branch out to other stocks displaying the qualities just outlined,” Conway says.

He says he looks at some 200 different stock charts during the course of the trading day, but doesn’t spend more than a few seconds deciding whether each one is of interest and deserves closer scrutiny.

“That’s a skill set stgeloped over time, and unless you have software it will be a grind at the start. You can try and take short cuts, but at the end of the day you have to spend screen time eyeballing charts. There is no substitute for screen time,” Conway says.

But beginners can – in fact should – start with just a few stocks, and may find some clues in the list of most actively traded stocks this week (to 24 November 2010) among clients of CFD provider IG Markets.

The list, in descending order of popularity, is: BHP Billiton, Rio, Commonwealth Bank, Westpac, Telstra, ANZ Banking Group, Fortescue, OZ Minerals, Queensland Rail (QR, the newest listed public float) and Macquarie Group.

The perennially popular stocks among CFD traders include the big blue-chip resources such as BHP, Rio, Woodside and Santos; the big four banks and the second runner, Macquarie Group; big miners such as Fortescue, OZ and gold stock Newcrest, and the small-cap miners, most of which are best left to seasoned traders.

The small and medium-cap mining companies have been the front runners for most of this year in the best performing stakes, many of them having made gains of 50 to 100 per cent or more. The top ten performers among all ASX listed stocks in terms of price rise to mid-November 2010 are Lynas, Iluka, Sandfire, Sundance, Oceana, Medusa, Avoca, Perseus, Riversdale and White Energy.

Harley Salt, educator and trader at IG Markets, says most of his firm’s clients are converts to technical analysis. “There are not many fundamental traders using CFDs,” he says. “Since CFD trading is short-term most will look at short-term indicators.

“People are trading by charts; they don’t care what the company is. They’re just looking for the right patterns.”

He says patterns that traders look for include a price break through a long-term moving average (200 days) and stocks with a strong trend, as well as retracements based on Fibonacci numbers (a mathematical series), and moves between long and short moving averages.

David Taylor, senior analyst and a trader at CMC Markets, takes a more fundamental approach to choosing stocks, and warns traders not to trade stocks they don’t understand.

When choosing stocks to begin trading CFDs with, he says, “BHP and Rio and the big four banks would be a good start. Ask a friend with some knowledge or pick one of a range of institutions that offer trading advice,” he says.

“My personal approach is to make trading decisions based on fundamentals and then wait for the charts to confirm. There are technicians who use charts only, but the school of thought I was brought up in is to use them in conjunction with each other. If both [charts and fundamentals] agree, then there is a high probability of a good trade,” Taylor says.