When the going gets tough, the tough stick to their trading strategies, says Katie Hope
Everybody harbours a secret desire to be an investment legend. The so-called “Sage of Omaha” Warren Buffett, George Soros, whom it is obligatory to refer to as “the man who broke the Bank of England” and even fictional red-braced trader Bud Fox from the film Wall Street, which coined the 1980s mantra that “greed is good”, are the pinups of the trading world.
What these financial heroes all have in common is an easily identifiable trading strategy. In Buffett’s case, his well-known “buy ‘em and hold ‘em” ploy is mimicked by millions of investors who rush to buy the same stocks as his investment vehicle Berkshire Hathaway selects.
But copying others is rarely the route to success. The best traders have an armoury of trading strategies for different market scenarios, which they must be versatile and quick to deploy. The type of strategy that CFD traders use should be determined by what they want to achieve, the current market conditions, the degree of risk they are prepared to take and – crucially – the amount of cash they have to splash.
Among the most popular trading strategies for CFDs is the short-term, aggressive speculative ploy that uses both long and short positions to take advantage of spikes in market volatility and abrupt price movements.
Using CFD positions as a hedge for positions in your physical share portfolio is also common, as is using CFDs to capitalise on the changing price differentials between products.
Dave Norman, an ex-trader who now risk-manages professional equity traders, says the three most popular tactics are long, short and pairs strategies.
“The leverage available for directional trades means that they are the most popular by far, providing low cost, high reward opportunities if the directional decision is correct and the movement experiences a degree of momentum,” he says.
He says pair trades are also popular, but points out that because two legs of a strategy are opened, they charge twice the fees.
But what exactly are these strategies? A long strategy is based on a trader’s belief that an instrument, a stock index such as the FTSE 100 for example, is going to rise in price.
The trader may not want to commit a large amount of capital to the trade, but still want to take part in the expected rise in price. Since he only wants to opt for a small amount, he chooses index tracking CFDs on the FTSE.
The minimum entry price is typically one unit, so in this case a pound. He can then use margin to leverage his position without committing a large amount of capital and make far more profit than his initial outlay
A short strategy is basically the same but based on the belief that something will fall in price. In the cash UK market, delivery of a short stock has to be undertaken by the third day after the trade was taken.
The stock will have to be borrowed, which incurs stock lending costs. In the case of heavily shorted stocks – recently for example the bank Bradford & Bingley or housing developer Barratt Developments – the limited amount of stock available to loan plus an inbuilt risk premium means that it has become prohibitively expensive to short these shares.
The beauty of a CFD is that you can go short without having to borrow the stock to deliver.
The other most popular option is pairs trading whereby two apparently correlated instruments can be bought long and sold short against each other in order to take advantage of discrepancies in their price relationship while they remain out of kilter.
But in the current market volatility, with commodities, shares and indices constantly switching from positive to negative in fast, whippy moves, what kind of strategy works best?
Dave Norman says the long and short strategies outlined above still make sense, as long as you make careful use of stop losses. “Volatility doesn’t always spell directional momentum. It can mean erratic low volume markets with little directional certainty.
Therefore the loss limiting stops are essential but set wide enough not to be triggered by the price ‘noise’ that volatile stocks, for example, may experience,” he says.
Tim Hughes, head of sales at CFD provider IG Markets, however, believes that in current conditions it makes sense to follow a trend over a longer period. He warns that traders should resist the natural temptation to counter trend when new flow creates a dramatic share price movement, as fundamentals are being largely ignored at the moment.
“A strategy that best captures this would see trades placed reacting to news, and going with the trend, but trading with tight stops to be swiftly out should the trend reverse,” he says.
This strategy would have worked very well recently with any of the housing stocks such as Barratt Developments – which towards the end of last week rose dramatically, having previously fallen sharply – US mortgage giant Fannie Mae, or Marks & Spencer.
Most of these dramatic moves have been to the downside, but this isn’t necessarily always the case. The key is discipline. “Use stop loss orders to contain your risk and set targets to take profits at levels which keep the risk-reward ratio in your favour.
“These rules are always important, but never more so than in these periods of high volatility when indiscipline can be quickly punished,” says Mark Outten, senior dealer at CFD and spread bet provider GFT.
Follow the rules, and you could become a trading hero too. In your own lunchtime, anyway.