Increasingly unsatisfied with long exposure through the stock market, more investors are using a diversified mix of CFD’s to add leverage and flexibility to their investment portfolio. But regardless of which CFD instruments are traded, the overarching goal is to make money, despite what markets are doing.
And irrespective of whether investors choose to use CFDs over currencies, shares or commodities, Julian Allen sales manager with First Prudential Markets says similar strategies can be deployed. Given that CFD trading duration is significantly shorter than traditional investing, he says it lends itself to technical analysis – the study of price and volume to identify trading opportunities.
For starters, Allen says all successful traders stgelop a money management strategy that allocates a set amount of capital for CFD trading and determines a percentage amount to risk on each trade. While a good starting point is 2 percent, he says this may be adjusted due to perceived risk or market volatility.
Within highly volatile markets, Allen says the risk per trade (RPT) may need to be dialled down to 0.5 percent. “This percentage RPT becomes a self-regulating mechanism, if you’re profitable and your capital increases so will the dollar value of your RPT, and vice versa,” says Allen.
Once the dollar amount for RPT is established, the next step is figuring out how many CFDs to buy and at what level the trade will be exited – which helps determine a stop price.
An example of a technical stop would be an area of resistance that the stock rarely trades below. Allen encourages all traders to plan their exit prior to trading to ensure they cut losses short and let profits run. “However, trailing stop losses will let your profits run and exit you out of the trade once the stock declines by the amount specified,” says Allen.
Example of CFD money management strategy
The trader has a total of $100,000 to invest and decides to expose no more than 2% to any trade.
2% exposure = $2,000/trade with predetermined exit point or stop loss of 40c.
$2000 divided by 40c = position size of 5,000 CFDs
Example trailing stop strategy
You buy BHP at $39.50 with a view to taking profits around $45.00.
By deploying a trailing stop you don’t have to adjust your stop to lock in profits along the way.
In this case you want your stop to trail the market price by $1.00 initially (distance) and want the stop to be lifted when the price rises in increments of 50c (step).
The initial trade: Long BHP – Stop loss at $38.50 and Step 50 points (50c)
The price moves in your favour and rallies to $40.00 the number you instructed as the ‘step’, your stop automatically goes to $39.00.
If the price falls however your stop will obviously not move and will protect you on the downside.
Successful CFD Strategies
Simplicity is the backbone of any good CFD strategy, and Allen cites one client who used a ‘golden crossover’ – where a longer period moving average (MA) crosses over a much shorter one – as a primary filter for stock selection. After eight weeks trading Australian shares she turned $10,000 into $100,000.
1. Example of a ‘golden crossover’
14 July the five day MA moved up through the 21 day MA and coincided with an increase in the volume oscillator showing an increase in average volumes traded.
Closing the position on a technical stop when the five day crossed below the 21 day MA was signaled on the 29 Sept at $4.70.
In this example we have $10,000 allocated to CFD trading and we are starting with a risk per trade (RPT) of 2 percent.
$10,000 x 2 percent = $200 RPT
To find a stop we divide the Bollinger Bands range by 2 to get an outer point where on average 95 percent of the prices have occurred over the period.
Bollinger Bands range 272.26 – 237.64 = 34.62/2 = 17.31 distance till stop price Now calculate how many units will be taken up by dividing RPT of $200 by our distance to stop of 17.31c (ensuring to put a stop at these levels) 200/0.173 = 1155.40 CFDs
On 30 Sept the trade has not been stopped out and the initial technical indicator has reversed so the trade is closed at $4.70
$2.11 has been made on each CFD, multiplied by the 1155 contracts, minus any interest and transactions costs.
Given that it eliminates currency risk, another top CFD strategy currently gaining popularity is trading overseas shares or commodities with CFDs.
Goran Drapac CEO of AxisODL says trading shares overseas with CFDs means taking full advantage of price activity, without any currency risk on the purchase or sale of the full underlying asset price.
He estimates that 99 percent of CFD traders remain unaware that trading overseas markets using CFDs means not having to send money overseas to fund the initial purchase and then repatriating funds after a sale. “Nothing can be more frustrating than correctly predicting the movement in a market, then losing any benefits to the currency moving against you,” says Drapac.
2. Example Trading Offshore Shares: Cash vs CFD
Purchase 100,000 US shares at US$10.00 = US$1 million
Physical share purchase CFD Purchase
Conversion rate 0.905 Conversion rate 0.905
A$ value of purchase 1,104,972 Not required – deposit in A$Sale three weeks later: Total US Dollar Sale Return – US$1,080,000 Convert Sale proceeds back to AUS Dollars Convert Profit back to AUS DollarsConvn rate 0.925 (currency moved against you) Convn rate 0.925 A$ value of sale 1,167,568 A$ net value of sale 86,486 A$ net return 86,486 Net profit in US$ 80,000 A$ return 62,595 ComparisonShares profit 62,595 CFD 86,486 Net benefit from trading with CFDs 23,891
While a pairs trading strategy is only deployed by around 20 percent of his clients, Tamas Szabo CEO with IG Markets says they tend to be the most successful CFD traders. What these more savvy clients realise, adds Szabo is that pairs trading reduces exposure to the market going in just one direction.
He says pairs traders make money regardless of how the stocks perform as long the relationship between the two moves as expected. That’s because investors aren’t taking a view against the market, they’re trading the relative outperformance. “With less risk than a one dimensional ‘buy and hold’ trade or stop loss position, pairs trading removes the noise from the strategy by limiting the downside risk,” says Szabo.
While they can be traded over many different asset classes and products, Szabo advises that pairs by definition should trade within the same sector.
3. Two examples of pairs trades
Woolworths/Wesfarmers: Woolworths has underperformed Wesfarmers this year by 44 percent and due to prevailing headwinds and strong mining numbers, you feel this outperformance may continue.
Traditionally, in pairs trading you may look at valuations which could also offer upside potential. For 2011 earnings Wesfarmers is trading at a 1.7 point discount (according to Deutsche calculation Wesfarmers 15.1x and Woolworths 16.8X).
Having concluded that Wesfarmers will outperform Woolworths with a short to medium-term view, you buy Wesfarmers and short Woolworths. It’s critical you ‘net off’ you’re A$ exposure – ie same dollar amount in each stock – to avoid a directional bias.
Woolworths: Currently trading $29.85. To calculate the number of shares-divide 10000/29.85 = sell 335 shares
Wesfarmers: Currently trading at $26.44. To calculate the number of shares, divide 10000/26.44 = Buy 378 shares
Your analysis pays off and Woolworths trades up to $30.00 and WES trades to $28.50.
Woolworths – 335 * 30 = 10050Wesfarmers – 378 * 28.50 = 10773, subtract the difference.
Gold: Trading to a new high of US$1070, it looks as if there’s consolation within an uptrend – in which case gold could conceivably underperform other $ based commodities in the short term.
Crude: Having broken the range it’s been in since May ($68- $75), money could flow into this asset class as the $ continues to weaken.
Rationale: Crude can continue to run as it has formed a new range and could outperform gold in the short term. Oil Search (OSH) to outperform Newcrest Mining (NCM) in the short term.
Using equity of A$10,000, both these stocks are a 5 percent margin so an initial deposit of $500 is required.
OSH -10,000/price of $6.25 = BUY 1600 Shares NCM – 10,000/$35.85 = SELL 278 Shares
Result: This analysis proves correct and Oil Search rallies to $7.00, Newcrest trades down as money flows out of gold to $35.50.
You make $1331
Here you make money on both legs:
OSH buy 1600 shares @ $7 = 11200,
NCM Sell 278 shares @ $35.50 = 9869. Subtract the difference.
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