You could come a cropper if you don’t have information at your fingertips, says David James Norman
Trading with contracts for difference (CFDs) can be a complicated undertaking. That is why arguably the most important part of successful CFD trading is to have a clear plan. Think of your CFD trading like a business: it would be inconceivable to start up a new company without a business plan, and a new trading venture requires the same level of detail.
The first thing is to be clear about your aims. Retail and semi-professional CFD traders are generally looking for short-term trading profit opportunities, using long and short CFD positions as a speculative tool, managing the constituents of a SIPPS portfolio with value added objectives to enhance the value of the portfolio, and short term trading in hot stocks or other instruments to create the basis for short-term out-performance.
Once the CFD trader has a thorough knowledge of the trading strategies to deploy during certain market conditions, the intra- and inter-day market movements become more recognisable and strategy can be viewed as part of a trading plan rather than as a reaction to isolated events.
Three of the main issues that traders ought to be aware of are: market information; market conditions and degree of risk.
Understanding the prevailing market conditions requires access to information and market knowledge. It is worrying that many novice CFD traders are cavalier in the sort of information that they are willing to base their trades on. Many use just one piece of information to confirm when to open new positions.
Believing in a single, isolated instance of confirmation, where several may be needed to verify a particular strategic stance, can lead to higher than reasonable levels of confidence. That can be fatal. A more measured approach to trading using historical and real-time market information is to look for several instances of confirmation, including:
● Current news and views on the traded instrument from professional analytical sources.
● A fair value assessment of the price of the instrument relative to its historical average.
● Technical analysis of the preceding days, weeks and months of price movements in the stock.
● Knowledge of when special reports or corporate events are likely to be announced, including dividends, commodity supply reports, directors’ dealings and earnings.
● The relative performance of the instrument to other instruments in the same sector.
● Any special situations that could, or are, influencing the price of the trading instrument, including forthcoming dividend adjustments to the share price due at the ex-dividend date, the terms of corporate mergers and acquisitions, and broker’s reports.
Good traders learn and adapt. Continual exposure to varied market conditions creates additional learned responses. Over time, traders become more aware that certain market scenarios are playing out with particular market conditions.
The degree to which a trader has the ability to repeat previously successful and profitable behaviour in market scenarios that he has seen before ultimately determines his long-term level of success.
One of the first things to be aware of is that market conditions are in a constant state of change throughout the trading day, but there are some acknowledged and easily identifiable active and quiet spots in most markets. For example, in the European securities markets trading is affected by:
● Market opening and closing times.
● Pre- and post-market auctions.
● The set time for announcing macro economic statistics.
● Corporate statements, AGMs, profit & loss statements, and interim and final results.
● Dividend announcements.
● The opening times of other markets and how they influence the domestic market.
● Derivative market expirations and how they affect the cash markets.
It is also important to be aware of the sorts of markets that you are likely to encounter, and what they mean for CFD traders.
Markets don’t always experience prolonged periods of volatility, and the CFD trader needs to have a plan of action for times when the markets are quiet, so called times of sideways movement. During these periods, the CFD trader’s main objective is capital protection. Be aware that capital can be eroded gradually when it is difficult to see trends developing in markets.
Upward or downward trending markets form the basis for profitable CFD trading. If a trading instrument has adopted a price trend in a particular direction, the best strategy that a trader can deploy is to join it. The leveraged opportunity that CFD traders have, as well as the lack of stock borrowing and favourable financing arrangements, means that they can fully capitalise on trending markets by holding positions for extended periods of time or adding to them as they become more profitable. This is known as pyramiding.
Degree of Risk
There is a general belief in trading that no single trading position should amount to risk exposure of more than 5 per cent of a trader’s available capital.
Most traders acknowledge that they are likely to lose more often than they win, but what is important is to make the winning trades last longer and to cut the losing trades faster. Given that a CFD trader is subject to positive and negative leverage, if he or she deploys more than 5 per cent of allocated trading capital to one trade and the trade goes into loss, the momentum with which the trade loses money may increase dramatically, thus prompting the trader to deliver more capital in the form of additional margin to their clearer. If the trader does not deal with losing trades in a ruthless manner, by cutting them quickly and decisively, then capital can be eroded very quickly.
Although stop-loss limits can be established, it is notoriously difficult to pick the right distance away from the current traded price to place the stop, and losses can accumulate due to the incidental triggering of stop loss limits when markets are volatile. In all, it is very easy to lose money if the CFD trader does not have a pre-determined risk threshold and a firm understanding of the limits for each trade.
The level of capital that a CFD trader can deploy is governed by the risk assessment of the trader by the institution that he or she is using, and the amount of deposited margin.
Institutional traders are likely to have higher levels of capital at their disposal than semi-professional traders, and may enjoy lower costs of trading. Professional cash stock market traders can normally expect to incur less than 1 basis point cost for each individual trade they put on, whereas semi professional traders will be charged upwards of 3-4 basis points depending on their frequency of trading and the total value of the CFD position. Financing costs are levied on the total consideration of the CFD trade, so the higher the overall consideration of a trade the greater the cost of putting it on.
This will influence the CFD trader’s overall trading plan, in that he or she must factor in any costs before deciding if the potential trade has enough profit expectation to cover them. There’s plenty more to learn, but that should be enough for you to be getting along with.
Extract from CFDs: The Definitive Guide to Contracts for Difference, by David James Norman, Harriman 2008