Smart Investor: Strategies for trading CFDs

Smart Investor, June 2010 

 You will have read about the boom in contracts for difference, or CFDs. But if you join the crowd, what exactly should you do with these versatile and powerful investment tools? It’s all very well having the ability to leverage, to go long and short, and to take positions not just on stocks but indices, currencies and a host of other assets – but without a trading plan, you’re unlikely to get too far.

 “After 17 years trading financial markets I have learned that the one thing all consistently winning traders have in common is a strategy,” says Andy Richardson, founder of www.contracts-for-difference.com, a UK financial trading site that offers free advice on CFD trading. “They all stick to a strict set of rules, taking the emotion out of their decision-making.”

 LONG AND SHORT

In its simplest form, you can just use a CFD in the same way you would buy a share – by going long. Doing so means you benefit if the price of that share, or whatever other asset you have invested in, goes up.

 But one of the main reasons people choose to set up CFD accounts is they make it easy to do something that is otherwise quite tricky: going short. This means you benefit from a fall in the share price.

 This brings us to our first real trading strategy: how you use a short. Most obviously, you can use a short position to express a view that there is a fall coming in something’s value. If you were one of those bright people who took short positions on US bank stocks in 2008, or on an index representing them, then you are probably wealthy enough not to need to read on. In circumstances like that, there is just as much return to be made from something falling in value as rising.

 Many professional fund managers find the ability to go short enormously useful, and argue that being constrained to long-only positions is an illogical limitation of their skills. If they have a view on stocks that are going to go up, surely they should also have a view on stocks that are going to go down? And why shouldn’t they be able to take a position that reflects those views and make money if they’re right? CFDs allow you to do exactly that.

 But there are other uses for shorts too. The main one is hedging. This means you offset one position with an opposite one in order to reduce the risk you have. You can do this in varying degrees: you might take a modest short position that doesn’t complete balance out a long position but does provide a bit of insurance to dampen the blow if the share price falls. Or, in some circumstances, you might choose to negate your positions entirely – if, for example, you have acquired a lot of stock that you can’t sell (most commonly through a share option plan with your employer which requires you to hold the stock for a certain period of time), you could take a short position which means that no matter what happens to the share price you will not have lost or made money.

 “Recently, when we’ve seen activity in our market driven by what’s happening in Europe, clients have been adjusting their strategy a bit,” says James Leplaw at Macquarie. “We are seeing more people use CFDs to hedge their portfolios. If you’ve got 10,000 BHP and you don’t want to be exposed to potentially losing the stock, and what you really want to do is protect your investment, you can short or sell a CFD for the same number of units. You’re then not getting any downside risk, but are also losing any upside exposure to what BHP might do in the short term.”

 RULES TO LIVE BY

 But a trading strategy doesn’t just mean following a theme like this. When many traders talk about strategies, they mean a hard and fast set of rules they apply to themselves when trading as a form of risk management. This might include when to sell out of a losing position; when to sell out of a winning one; and how much leverage they are comfortable with.

 Vital in implementing these strategies are instruments like the stop loss.

 There are all sorts of variations of these conditional order tools, but the principle is simple. A stop loss defines a level at which your broker will sell out of your position if the market moves against you.

 The most obvious example of a stop loss is in a long position, when you’ve bought something in the hope that it will go up in value. If you set a stop loss sell order at, say, 10% below the market price when you place the order, then your broker will bail you out after your position has lost 10% of its value. Deciding exactly where to put the order is tricky: too close to the share price and you’re likely to trigger it in everyday volatility, too far below and you’re exposing yourself to a lot of risk.

 A variation on this theme is the stop entry: that means you’d like to buy a stock, but only if it falls a bit. By buying a stop entry position, your broker will automatically buy in if the stock falls to that level.

 With some providers you can also put a stop loss on a short position, meaning you get out of it if the share price rises too far.

 It’s important to understand a distinction between different stop loss products. “The mechanism for how it is triggered is important,” says Leplaw. “With a stop loss, if a stock trades at a certain price, the order will be executed – but in order for that to happen it has to trade at that exact price. What can happen is, in a falling market, a price step can be jumped” – going straight from $19.05 to $18.95 without hitting your stop loss level of $19, for example – “and with a normal stop loss that will mean the order is not triggered.”

 This is called gapping, and is particularly dangerous in the gap between the market closing and opening again, when the behaviour of other markets around the world will have a big impact on the share price in the meantime. It is quite common for a stock to close at one price and then open the next day much lower or higher.

 To get around gapping, many providers offer a guaranteed stop loss, meaning that even if the share price jumps over your stop loss level without hitting it, the broker takes on that risk and guarantees to get you out at that level. “Think of it as an insurance policy,” says Leplaw. Stop losses cost money and guaranteed stop losses cost more, but many traders swear by them for peace of mind.

 KNOWING YOUR LIMITS

 Another vital part of a trading strategy is to make sure you absolutely understand how leveraged you are, how much you can lose, and whether you are comfortable with that. If you are too highly leveraged, you can sell some of your position, or commit more money as margin against share price movements. But it is impossible to overstate the importance of understanding this simple fact: leverage allows you to make a lot of money, but it potentially loses you a lot too – perhaps more than you actually have. You must understand how to mitigate this risk, and be comfortable with it, before trading with CFDs.

 What do we know about how people really behave when it comes to these risk systems?

 A useful study is the 2009 CFD report by the consultants and researchers Investment Trends in Sydney. They got responses from 7,500 investors, including 2,000 current CFD traders, so their findings are quite representative.

 “Risk management plays an important role in current traders’ strategies, but they are unlikely to switch providers for improved risk management tools,” explains Pawel Rokicki, analyst at Investment Trends.

 58% of current traders in the survey said that contingent or stop loss orders would be important if they were choosing a CFD provider today, and of those respondents who aren’t yet traders but plan to do so, 42% said the availability of guaranteed stop losses was the single most important catalyst to prompt them to start using CFDs.

 More than anything the key with CFDs is to know what you can do and understand what tools you have at your disposal. “Traders should stack the odds in their favour before making a trade,” notes Richardson. “That means spending some time analysing their trading style and mindset, as well as the markets. Some CFD firms offer investors a free suite of tools and seminars designed to assist. Only once these crucial elements are conquered is an investor ready to trade.”

 BREAKOUT: STRATEGIES THE PROFESSIONALS USE

There are several other specific strategies that traders talk about. Here are a few examples:

• Index constituent changes. This involves trying to take positions when indexes are being reweighted in order to try to take advantage of movements in the share prices of companies that are added or removed from an index, or reweighted within it.
• Trading on news. Some CFD providers provide ready access to news about companies – directors selling shares, maybe, or corporate activity – that could affect the share price. Doing this, though, means taking on the professionals, who will be doing much the same thing but probably with faster news sources than you.
• Arbitrage means trying to make a profit from what you see as a price discrepancy – this might be a company trading out of line with its peer group, or even the same company’s stock appearing to trade at different levels on different exchanges. Some professional traders try to exploit these discrepancies by taking one long and one short position, hoping that the discrepancy will eventually resolve itself, making them money.
• An example of an arbitrage technique is pairs trading. This can take a number of forms. One could pair trade with companies in the same sector, such as buying Rio Tinto while selling BHP Billiton because you believe Rio Tinto will rise relative to BHP. One advantage of this is you’re not exposed to what’s happening in the broader market: if the whole ASX 200 crashed, the two shares would presumably crash together, and your exposure is simply the convergence or divergence of the two share prices, not the drop in the market. A more aggressive approach might be to pair trade on stocks in different sectors – even different exchanges – or to pair trade the markets themselves. For example, quite often traders will take a view on the relative merits of the Australian versus the American stock markets, and they can express that by, say, buying the ASX200 and selling the Dow Jones Industrial Average, or vice versa. Getting the best out of trades like this really does require you to watch the markets like a hawk, though, and is better suited for professionals.
• Tax management. This is a way of making some money out of a stock without selling it, since selling would trigger a tax event. A typical approach is called a capital cash release, where the stock you don’t want to sell is used as security to enable you to access more funds for other investments.
• CFDs lend themselves well to technical analysis or charting – a whole other investment discipline, and beyond the scope of this article.