Diary of a CFD Trader

Smart Investor, December 2011

How should a novice approach contracts for difference? For speculation or for hedging? Quick gains or safety? To find out, Chris Wright took a trail of a CFD platform during the most volatile month since the GFC

Monday September 5

It’s been a characteristically miserable day in the markets: the ASX 200 down 2.2% at lunchtime, Asian markets faring worse. The market chat is about miserable US economic data while the fate of European sovereign debt lurks in the background like a hangover. It’s against this backdrop that I key in my password and login to IG Markets for a month-long trial. I’ve been given $20,000 of mock capital (“regrettably, it’s not real”, IG’s Chris Weston tells me as he sets up the account) and I will paper trade until I think I’ve figured it all out.

To see the article as it ran, click here: diary1 diary2 diary3

As I log in my first impression is of a data-heavy page with some regular flashing red and blue lights. Closer inspection shows the flashing is next to buy and sell prices on AUD/USD FX rates, the spot gold price, the FTSE 100 (it’s late in the day and London is in session) and crude oil. I look at the various menus and within seconds realise I need some training.

IG has also given me access to its TradeSense training modules, and I’ve decided my job for the first few days will be to get through this six-part series before trying even a paper trade. The modules, in PDF form, are well ordered and filled with examples; the early emphasis tends to be on unfamiliar things like short positions, which makes sense since most people using this will already have bought shares in the traditional manner beforehand.

In real life, you’d also be making a decision on whether to pay extra for live data fees, which depends on just how closely you want to follow the market.

Thursday September 8

I’ve gone through the six training modules in the TradeSense scheme. A lot of it is about risk management, and I like the bluntness of some of the advice: “Do not trade for fun. Do not trade because you are bored. Do not trade because you are scared of missing out.” And: “Leave your ego at the door and admit when you are wrong.” The CFD trading process seems straightforward: there is a lot of explanation around stop losses, and I’ve decided I will use them (or a limit order) on every single trade I make.

In the time I’ve been going through these, the world has gone through yet more tortuous ructions: the Swiss central bank has set a ceiling (or floor, depending on which way you’re looking at it) for the Swiss franc against the euro and the fear in world markets now is of a currency war. It doesn’t look good.

For various reasons tedious and unfortunate, I own a ton of bank stocks which are a mile underwater. Had I had a CFD account earlier, I could have taken a short position against banks in order to hedge. It’s too late to insulate those losses, but frankly it looks like things will get worse before they get better, so I decide to short Macquarie as a hedge. The way I see it, if I’m wrong, then at least my other bank shares will be rising. Part of me can’t help but feel that this is cutting off my nose to spite my face, and that I should just have the courage of my convictions; the other half of me thinks it’s prudent risk management and if I’d done this ages ago I’d be living in a larger house.

Conducting a trade is very simple: pop the code into the Finder window, do any research you want to do in another window (charts, Reuters info, etc), set the size of your trade, put a stop loss on if you want to, and press buy or sell. I decide to sell 100 Macquarie shares, which are worth $2,380, roughly 10% of my opening account.

But I’ve forgotten just how powerful leverage is in a CFD platform. You only need to put down a fairly modest amount in order to effect a major exposure. So having made what, to a usually long-only investor, appears a reasonably significant trade, I notice that I still have A$19,992 of funds left, and have spent just A$87.49. My initial reaction is: oh, I should make it a much bigger trade. And then I realise I’ve learned my first lesson about CFDs. The power of leverage is great, amplifying good and bad calls equally, and just because you have the ability to use it doesn’t automatically mean you should.

I leave Macquarie as it is but also decide to short the European market. Nothing in recent weeks has made me think anyone has the faintest idea how to fix the European sovereign debt problems and that things are going to get worse before they get better. Again, there’s a logical hedge here: while I don’t own many European stocks I do have lots of stocks that fall when there are global macro worries – indeed, it’s hard to think of any that don’t. So I find that, without really thinking about it, I’m using CFDs as a hedging tool rather than a money grabbing exercise.

So I go to the indices panel and pick the EU 50. I take a bigger position here, and now I’ve used a total of A$2,000 of margin. Once again I’ve used a stoploss so, if I’ve understood the system correctly, the trade will close out at a point where my maximum losses are about A$4,000. While I wouldn’t normally want to lose that in real life, I comfort myself with the fact that if it happens, then probably my other shares (the ones I really own in this bitter reality) have been going up.

Within seconds I’m down about $500. I log off and get some work done.

Friday, September 8

Next day, I find myself up about $2,000. Suitably galvanised, I decide it’s time to try FX.

Being only a share trader by background, this is new to me, and it takes me a little while to work out which way I ought to be betting (let’s be honest, with forex, it’s all betting) to express my view. I have a theory, you see, and want to try it out: Switzerland pegged of Swiss franc, to support its exporters, is another bit of news that’s not great for the euro. Also, people are going to be looking for another safe haven currency if the Swiss franc can’t move; everyone’s talking about the Singapore dollar, but why not the Aussie? What could be safer and more supported than our very own Aussie dollar? So I take a long position on the Aussie-euro cross-rate. I notice that just one lot requires more than A$1,000 of margin – that’s a reflection of the leverage involved in CFDs. I decide to put my stop loss in 30 pips below the trade, which means that if the exchange rate falls from the 76.30 cents where I’ve bought in to below 76, the trade will close. On reflection I realise that’s probably too close to be sensible in a volatile market – just 0.3 cents! But I’m a bit paranoid about the leverage and the potentially bottomless pit of getting my call wrong.

Watching the FX screen is like a 70s disco: all flashing red and blue lights moving around. All it needs is a mirrorball. The FX market moves so exceptionally fast I can see why most people leave it to the professionals.

Monday September 12

After I turn off my computer on Friday, the chief economist at the European Central Bank resigns; the European market reacts as it does to anything with a hint of negativity about it and plunges. When I turn my computer back on on Monday morning, my short position on European stocks is in profit to the tune of Eu13,000; I instantly close my position. To my astonishment my A$20,000 of equity now stands at A$36,240. Clearly I’m a genius.

After this initial moment of euphoria subsides (it is, after all, pretend money) I analyse why I’ve just acted as I have. My view that European markets are going to get worse is considered and, I think, well thought out. It’s a reasonably long term view. So why have I just closed my position barely two days after opening it? To preserve profits, sure, but if I believed in that position, why not let it run?

I realise I have brought some preconceptions to CFDs and am acting accordingly. I have read that most people who use CFDs have their positions open for only a couple of days, sometimes even hours, and so I’m behaving in the same way. But the truth is, if you’re really going to use a CFD platform for hedging, there’s no reason to do that.

The very next day, I will regret this: Greece defaults and European markets plunge. Pretty much every day for the rest of the week something utterly miserable happens in Europe, culminating with a rogue trader losing US$2 billion of UBS’s money at the end of the week. Had I stuck by my convictions I’d have made more than twice as much – but, then again, I’m still ahead.

What next? I’m not generally using the platform to buy stocks I hope will go up – it’s easy enough to do that with my usual online broker. The novelty of a CFD is to trade things I can’t normally trade. So next, I decide to take a look at oil. IG Markets hosts a range of different oil contracts (Brent, US light), in a variety of amounts and durations. I’ve decided that if the world is in a mess then probably demand for oil will decline, plus the Middle East seems to be getting a bit calmer, so I take a short position on US Light Crude. I think about doing something similar with other commodities but can’t decide what I actually think and so, lacking an intelligent reason to trade, I don’t.

Next day, I find that both my FX trade and oil trade moved too far against me and hit stop losses. I lost a bit, but not too much, and am still well ahead overall; I’ve decided I like stop losses. In CFDs, putting in a stop loss also reduces the amount of margin you have to commit.

I’ve been having a think about gold. It’s at an all time high and there is more and more talk of a bubble. But I don’t see any reason for a decline in the near future. So I go long the spot gold price. This, I promise myself, will be a longer trade. I also go long the Aussie dollar against the US dollar, since it has retreated a bit lately and I can’t really see why.

Friday September 16

Swamped by deadlines, I take my eye off the ball for a few days, and it costs me. Both my trades from Monday – long gold, and long Aussie dollars – go against me and hit their stop loss positions. Worse, I realise I’ve miscalculated the margin on the FX trade and lost twice as much as I thought I would – wiping out the gains on shorting the European stock markets. I’m back pretty much where I started. It’s an expensive mistake, except for the fact that it’s not a real trade – and I am reminded again just how important it is to try paper trading first. Next time, when trading with real money, I won’t make the same miscalculation.

The following week I have to go to America and will rarely be anywhere near the system during trading hours. The only sensible thing to do is to hedge existing positions – which, again, means going short stock markets.

Tuesday, September 27, 2011

My week in America, attending the World Bank/IMF annual meetings, is an apocalyptic series of press conferences and meetings among the leaders who are supposed to bring the world away from the threat of recession and Eurozone collapse. To say that they don’t inspire much confidence is like saying the Titanic had a slightly disappointing maiden voyage. The markets, unimpressed, crash; the Dow loses almost 400 points in a single day on the Thursday.

So with my short positions on world stock markets, I must have made a fortune, right? Wrong. Although my call on stock markets declining has been entirely correct, I manage instead to lose half my money because I have failed to take into account volatility. On the way down, markets bounce and wobble, and my stop losses are too close to the level I bought at – so I get wiped out, despite having actually been right. This happens twice.

Seeing this, I then go short again, with a wider stop loss, and this time eventually get it right. By the end of the month, and the end of my four week trial, I have ended up just short of where I started out.

It takes some kind of incompetence to go short during a market rout and still lose money. Still, I have learned some valuable lessons, and am newly convinced of the merits of CFDs. Were I to start from scratch with real money, having learned about the pitfalls involved, I think I’d do reasonably well.

Postscript

Since the money is not real, I don’t close out the trades on the day I stop trading to file this article; I see what they’re worth that day, take that as my closing balance, and leave them. Two weeks later, out of curiosity, I open the system again to see if the account is still active; markets have rallied and all the capital has been wiped out. Of course this isn’t real, since in reality I would have closed the positions when I wanted the money. But it’s a cautionary tale: never leave your positions unmonitored and forgotten!

So what have I learned?

1. Spend a month paper trading! You may think you know what you’re doing with a new system but you’re very likely to find a couple of areas along the way where you mis-step because you’re unfamiliar with the program and its processes. There’s no harm in taking a few weeks getting to know the ropes.
2. Know your strategy. It may be, for example, that you want CFDs in order to hedge your stock exposure, or to take a position on particular asset classes you can’t normally get exposed to. But don’t just dip in and out like it’s a sweet shop: know what you want to do and execute it calmly.
3. Stop losses are great. It would be rash to use CFDs without them.
4. BUT, be careful where exactly you put that stop loss. On three separate occasions I took a position, which within a week was correct, but instead lost money because my stop loss was hit in the volatility.
5. Be sure your understanding of leverage, margin and exposure is correct. This is another thing I got wrong to my (theoretical) cost, taking a much more leveraged exposure on a foreign exchange position than I had intended to. No harm done in paper trading – that’s what it’s for, to iron out these mistakes before they matter – but you wouldn’t want to make an error like that in real life. Leverage on FX contracts can be very, very high.