Trading Contracts for Difference (CFDs)

Introduction . CFD Providers . Gold Trade . CFD Sector Strategy . Trading the NZD/JPY

Introduction

Description

A CFD is an agreement to exchange the difference between the entry and exit price of the contract. There is no restriction on the entry or exit price, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first. CFDs mirror the movement and pricing of the underlying share. A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Unlike trading a share, to buy $10 000 of a share using a CFD, you do not need $10 000, only the margin requirement, which could be as low as 3 percent or $300. This gives traders access to leverage, enabling them to amplify their returns (and losses) compared with movements in the underlying share.

Mechanics

Buying shares on margin is similar to borrowing money through a margin loan to buy shares, or buying a house using a mortgage. To own a house, you are not required to have the full purchase price, only a deposit. This deposit is required by the bank to ensure that if they have to sell your house they do not lose money. CFDs offer a similar opportunity to a trader. Most people buy shares for cash, but if you use CFDs, you can place down a deposit, known as a margin. This margin requirement is used to protect the CFD issuer if it has to sell a trader out of a position.

The margin requirement varies from share to share and provider to provider between 3 percent and 80 percent of the face value of the share. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.

To trade long, place an order to buy the CFD. Each provider will use a slightly different method to place orders but if you have bought a share before, it will be very easy to adapt to buying CFDs. To trade short, then place an order to sell the CFD. The mechanics of placing the order will depend on the CFD provider that you are using.

Advantages

CFDs are a revolution in trading. During the technology boom back in 1999, as traders we were discussing the opportunity that the Internet created. The ideal scenario was to have a laptop computer, allowing the trader to be anywhere in the world and trade shares anywhere in the world. CFDs finally make this dream a reality. Before the Internet, information on overseas shares was hard to find and trading them was even more difficult. In addition to this, retail clients were not readily able to short sell shares. Shares had to be borrowed in large quantities and specific rules applied to short sell them. That has all changed with the introduction of CFDs. The world’s markets offer an unlimited opportunity and using CFDs traders can now choose exactly what they would like to trade, when they would like to trade and how much they would like to trade. CFDs offer freedom of choice and a lifestyle that many people dream of: the ability to make money 24 hours a day from anywhere in the world, with minimal restrictions on your daily life.

CFDs versus Shares

The key differences between trading a CFD long and trading a share long are due to the leverage that is employed. The initial outlay is much lower when trading CFDs than when trading shares, even though the face value is the same. Brokerage rates vary depending on the amount of trading that is done. GST is not charged on CFD brokerage, yet is charged on share brokerage. The CFD trade attracts finance charges while it is held, while this does not apply to the share trade. The net effect is a return of 20 times the amount using CFDs over shares due to the leverage that is employed.

CFD Providers

Direct Market Access (DMA) or Market Maker

The first model introduced into Australia was a market maker model. A market maker CFD provider will receive an order from its client and then confirm the CFD trade with the trader. It then has a wide range of options open to them to hedge the underlying position. This includes offsetting orders against other traders, buying shares, buying options, warrants or futures to ensure that it remains in a market-neutral position. In the market maker model, pricing approximates the underlying market.

In the second model, DMA, the CFD provider receives an order from its client and then buys or sells the underlying share. Once the share is bought or sold, it confirms the CFD trade to the trader. Every position is protected by buying or selling the underlying instrument. In the DMA model, pricing is identical to that in the underlying market.

There is a huge debate in the CFD world over which model is ‘better’, but this competition is more from a marketing angle than a trading angle. There are some key differences between the way the two operate and a thorough understanding of these will help you to make an informed choice of which style you prefer.

One of the biggest differences is how orders are executed. The market maker model is based on an all or nothing basis, whereas DMA places the order into the market and part fills are possible.

CFD Providers

Gold Trade

The following trades were made utilising the Universal Trading Strategy outlined in Jeff’s book Supercharge Your Trading with CFDs. To order a copy of the book, click here.

The profit for this period of approximately 2 weeks is $4021.

The results are summarised in the table below.

The results are typical of a trend following system with a hit rate of 41% and an edge ratio of 2.38. Ideally the edge ratio could be higher to ensure a robust trading strategy. The margin requirements for 100 contracts of gold are approximately $1800. The return on investment is over 100% in 2 weeks.

CFD Sector Strategy

Enter a long trade on a sector when the 10 day moving average crosses above the 30 day moving average and enter a short trade when the 10 day moving average crosses down through the 30 day moving average. Enter at open the next morning and employ a stop loss at 3% below or above the entry price.

The logic behind the strategy is that at least one of the sectors will be trending strongly overcoming the losses on the sectors that are not performing. The worst case for this strategy is a tightly range bound market.

The profit for this period of approximately 3 months is $2286, noting that many of the positions are still open on the 9th January 2006.

The results are summarised in the table below.

The results are typical of a trend following system with a hit rate of 37% and an edge ratio of 3.15. The margin required for the current positions held, which are approximately $11,000 each, is only $880. More capital is required than just margin money to cover any losses that may occur. The capital required to complete all these trades taking into account a string of losses upfront would be $3000. The return for the 3 month period is 76% and if annualised looks likely to be a return close to 300%.

The strategy has been tested historically and traded profitably in the past.

Trading the NZD/JPY

This three-month period can be broken up into five stages, as shown in the figure below. In stage 1, the market rallied against the underlying theme I identified. In stage 2, the theme played out in my favour. In stage 3, a strong countertrend rally saw it move against me and then stage 4 went my way. In stage 5, the trade was again moving against the underlying theme. The realised profits also occur in five identifiable stages.



In stage 1, I was losing money. Entries were stopped out for a loss and this occurred for almost two weeks. Then the pyramiding came into effect. Now that the trade was going my way, profits were added rapidly, continuing for almost two weeks. It is about this time that dreams of what I could spend all the money on start to take over. It was now tempting to add larger and larger positions but I kept in mind the concept of reversion to the mean. A winning streak occurs because of a trend, and the most likely thing to happen next is a consolidation. This came in right on schedule and my position size was cut back to minimise the impact on my portfolio.

Entries were then stopped out for a loss regularly but the underlying theme remained in place. Ideally, I needed to reduce the impact of the periods when the strategy was not working because the impact on the account was significant. Scaling back position size more quickly after a winning streak would help because I was still trading larger positions as the account grew. Calculating risk purely on the basis of your account size, which I was doing, means that the account has to drop in value a lot before you start to trade less. This can result in unnecessarily giving back profit that has been made. Because of the concept of reversion to the mean, I developed the strategy of removing money from my account once I double the account size. This forces me to trade less. Quit while you are ahead. A profit of almost $14 000 dropped back to $4000 during stage 3, while I continued to trade through this countertrend move.

After a month of losing money, many traders can become frustrated or despondent, but if your underlying strategy remains valid, you are just around the corner from profitability. Minimising the impact of losses by reducing position size is the answer here. Stage 4 came along with a rapid return to profitability, as the pyramiding once again allowed me to increase my position size rapidly as the trade moved in my favour.

The sharp drop in the New Zealand dollar caused the realised profit to increase rapidly up by 400 per cent in a matter of days, before entering stage 5, where once again the trade moved counter trend. The statistics are shown in table 11.3 for the series of trades taken. The hit rate at 19 per cent is very low. This means for every 100 trades taken, only 19 trades are profitable. Psychologically, this is not an easy system to trade because you are wrong so often. However, the strategy is profitable because of a very strong edge ratio of more than 5. This means that when the strategy wins, it makes five times what it loses. Risk is well contained at less than $500 per trade.

Wins and losses trading the yen against the New Zealand dollar can be seen in the table below.

The statistics are shown in the table for the series of trades taken. The hit rate at 19 per cent is very low. This means for every 100 trades taken, only 19 trades are profitable. Psychologically, this is not an easy system to trade because you are wrong so often. However, the strategy is profitable because of a very strong edge ratio of more than 5. This means that when the strategy wins, it makes five times what it loses. Risk is well contained at less than $500 per trade.

If you would like to know more about how you could make money trading CFDs then you can order Jeff’s book Supercharge Your Returns with CFDs, click here.