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CFD Trading Strategies
David James Norman
2 CFD Trading Strategies CFD Trading Strategies 3
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Contents Preface
This book has been written to provide insight into how to build a
successful strategy to trade CFDs. As many traders know, a trading
strategy is not just a case of recognising market conditions and
placing appropriate CFD orders to capitalise on them; strategy
encompasses the entire approach to trading.
This book, then, describes a trading strategy in its larger sense and
builds an understanding of a traders overall strategic goals, his or her
trading plan, the trading strategies used to achieve the goal and the
all-important psychology that the trader needs to deal with in
order to be successful.
The book includes the following topics:
An overview of the CFD product
The range of marketindex CFDs available to trade
The logistics of trading CFDs
A range of CFD trading strategies for different market conditions
Managing a CFD account, risk control methods
The book is made up of four main sections:
1 Introduction to CFDs (pages 48)
2 CFD Trading Logistics (pages 917)
3 CFD Trading Strategies (pages 1837)
4 Dealing with risk and psychology (pages 3755)
The views below represent the opinion of independent analysts
The Trader Training Company Limited. These views are based
on technical analysis including but not limited to price action,
volume and market breadth studies.
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Introduction to CFDs
Before a trader can build an effective trading strategy, he or she
must understand the behaviour of the instruments that he or she
wishes to trade, and the medium through which to trade, implicitly.
If the trader chooses CFDs, then time must be taken to study their
unique characteristics. CFDs behave differently to other traded
instruments, like futures and options for example, even if they are
based on the same underlying cash instruments and move in line
with their price changes.
As an introduction then, lets go through the main characteristics of CFDs.
What is a CFD?
A CFD is a contract between a trader and a CFD
Provider. Once it has been bought or sold, it is
not tradable on an open market but must be
closed out with the same provider. The CFD
provider, in this case marketindex, acts as the
counterparty to the traders buy or sell order
and the difference between the purchase price
of the CFD and the price at which it is sold
is credited or debited to the traders margin
account by the provider.
The price behaviour of buying or selling a
CFD is the same as buying or selling the
underlying instrument in that the CFD responds
to movements in the price of the underlying
instrument in the same way, point for point.
The range of trading instruments that
underlie the CFDs that marketindex offers,
is as follows:
Government bonds including Bund, Bobl,
US T Bond and 10 Yr Notes
Stock indices including FTSE 100, Dow
Jones, Euro Stoxx and Hang Seng
Foreign Exchange including all major crosses
Commodities including oil, wheat, coffee
and sugar
Precious metals including Gold, and Silver
CFD trading is popular with traders because of
the broad range of products that marketindex
offers and the exibility that this provides in
being able to shape a trading strategy.
As the table shows, the CFD trader enjoys a proftable trade that costs 5% of the underlying value of the FTSE 100 Index
with 10 times the protability.
Trading CFDs differs from trading the
underlying instrument in that:
The CFD is traded on margin while the
underlying instrument is not
The CFD trade is a contract with
marketindex rather than a trade through
a broker that will eventually result in
ownership of the underlying instrument
marketindex will give, or receive, from the
trader the cash difference between the
opening price of the CFD trade and the
closing price depending on the prot or
loss of the position
A trader can sell a CFD contract short while he
may not be able to with a cash underlying
Theres no UK Government stamp duty tax
on trading CFDs in the UK
Leverage
CFD traders benet from trading on
margin. This means they deposit a certain
amount of capital into a margin account
and marketindex offers them a percentage
increase in that capital to trade with
depending on the type of instrument. This
is called leverage or gearing. An example of
the gearing effect on protability through
leverage can be seen in the table below,
comparing a theoretical long FTSE 100 Index
purchase and a CFD. The FTSE 100 index
notional value is 45,000 (10 x Index level).
marketindex offers the trader gearing at 20x
his margin deposit. Each tick incremental
movement is worth 1. Using the same
amount of money, the trader buys 10 CFDs,
to the theoretical single FTSE 100 index
purchase. Both positions have the same
notional value of 45,000, but the CFD
trader is only required to deposit 2,250
(45,000 x 5%).
How does a CFD compare to its underlying Instrument?
Initial FTSE 100 Price @ 4500 Long 1 FTSE 100 Index Prot () Long 10 FTSE CFD Prot ()
+10 pips 10 100
+20 pips 20 200
+30 pips 30 300
+50 pips 50 500
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This trade is summarised in the
following table:
Short CFD
Conversely, traders often take short CFD
positions when they expect the underlying
traded instrument to fall in price. When
a trader believes that a stock index, such
as the FTSE 100 Index (FTSE), is going to
fall in price, he sells a FTSE 100 CFD on
marketindex, referred to as going short.
Example
A trader believes that the UK stock index of
leading shares is showing some short term
weakness and might fall. He sells 10 FTSE 100
CFDs at the current FTSE price level of 4451.6
expecting the FTSE 100 index level to fall at
least 50 points over the coming week. He
holds the open position for ve days, during
which time the index rises to 4514, and then
buys back the 10 CFDs for a 62.4 point loss.
Interest payments over the ve day period
are credited at LIBOR at 0.475% plus the
dividend adjustment bringing the overall
nancing rate to 1.09%.
Strategy Summary
The short CFD position attracts a fnancing
credit as opposed to the nancing cost of the
Long CFD position. Although not a great deal
of money, it is nonetheless a positive in a
losing trade
The Proft and the Loss on the long and short
transactions represent a high proportion of the
margin capital because of the 20 x gearing
Risks of leverage
Trading on margin can be very protable,
but it also has its risks. Leverage can work
both ways, by increasing prots but also
increasing losses. Although traders are able
to benet from very small incremental price
changes, large price movements can cause
high levels of losses if the position is highly
geared. Traders need to be aware of the risks
as well as the benets of geared positions
before they place orders.
Pip values
Each CFD has a pip value which represents
the change in the value of the instrument
price movement, up or down for a one point
incremental movement. Pip values can vary
between providers and instruments. As an
example, if a trader buys or sells a FTSE 100
Index CFD that has a pip value of 1 per unit
bought/sold, then if the index moves from
4500 to 4501, the CFD prot will be 1.
The best way to explain how a CFD trade
works is to provide an example:
The following includes two simple
examples of Index CFD trades: a long CFD
trade and a short CFD trade.
Long CFD
Traders often take long CFD positions
when they expect the underlying traded
instrument to rise in price. When a trader
believes that a stock index, such as the FTSE
100 Index (FTSE), is going to rise in price, he
buys a FTSE 100 CFD on marketindex.
Example
A trader notices that the UK stock index
of leading shares is gaining upward
momentum and is establishing a trend.
He buys 10 FTSE 100 CFDs at the current
FTSE price level of 4451.6 expecting the
FTSE 100 index level to increase at least
60 points over the coming week. He holds
the open position for 5 days, during which
time the index rises to 4514, and then
sells the 10 CFDs for a 62.4 point proft.
Interest payments over the 5 day period are
charged at 2% above LIBOR at 0.475% plus
a dividend adjustment bringing the overall
nancing rate to 3.09%.
Product Pip Value
Mini FTSE 100 Index 1
Gold CFD 0.01
Corn CFD 0.01
Sugar CFD 0.06
Mini S+P 500 0.62
Mini EuroSTOXX 50 0.88
Day 1 FTSE 100 CFD
CFD Price 4451.6
Trade Buy 10 FTSE 100 CFD
Margin used 2,225.80
Notional
Transaction Value
44,516
Day 5
CFD Price 4514
Trade Sell 10 FTSE 100 CFD
= 62.4 pips proft
Interest paid at 3.09% x 4 overnights
x 45,140/360 = 15.50
Notional
Transaction Value
45,140
Prot /Loss 62.4 pips x 1.00 x10
- 15.50 = 608.50
Below is a table of the current
marketindex pip values:
Day 1 FTSE 100 CFD Day 5 FTSE 100 CFD
CFD Price 4451.6 CFD Price 4514
Trade Sell 10 FTSE 100 CFD Trade
Buy 10 FTSE 100 CFD
= 62.4 pip loss
Margin used 2,225.80 Interest paid at
1.09% x 4 x 45,
140/360 = 5.47
Notional
Transaction Value
44,516
Notional
Transaction Value
45,140
Prot /Loss
- 62.4 pips x 1.00 x 10
+5.47 = -618.53
This trade is summarised in the following table:
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Permitted CFD order types
There are a range of CFD order types including
market orders and limit orders as well as
more complex orders that involve two or more
instruments. Marketindex has four main order
types: Market, Limit, Market if touched
and Stop.
A brief description of the main order
types follows:
Market order
If a trader sends a CFD market order, he
expects it to be lled at the prevailing market
price immediately. Traders use market orders
if they want to get into a position quickly, or
if the market is moving and there is a danger
that they may miss the opportunity to trade
if they do not send a market order.
Example
The Gold CFD price is moving upwards quickly
and the trader wants to go long as he is
expecting the price to continue to rise. He sends
a market order into marketindex to buy 1000
mini Gold CFDs at market. The order is flled
immediately at the prevailing offer price.
Limit order
A limit order differs from a market order in that
the order has a condition whereby a particular
price has been selected and the order will not
be transacted unless the CFD price reaches that
level. Limit orders can take time to trade as they
are often placed at price levels that are away
from the current best bid and offer.
Market if Touched (MIT) order
A Market if Touched order will only transact
if the price level that the trader has selected
is touched. This kind of order is used with
charting levels for example. If a trader expects
the price of oil to touch $65 per barrel but then
to continue upward they might look to buy
1000 units of oil at $65 MIT so that they can
take advantage of a prolonged upward move
or a breakout on the upside.
Stop loss orders
Stop orders enable traders to control the risk of
an open CFD position. For example, if a trader
has an open long position in Sugar CFDs and he
expects the price may fall temporarily he may
place a stop order to sell out of the position if a
certain price is reached on the down side while
still holding the position in the belief that it still
might go up.
CFD Trading Logistics
The characteristics of CFDs make them exible and adaptable to a
number of different trading strategies. They enable traders to use a
wide variety of trading positions including long and short leveraged
trades and trades that enable the trader to offset the risk of holding
the underlying instrument through hedging. The important thing
is to be able to adopt a trading approach that suits the traders risk
prole and objectives. The CFD strategies should be seen as trading
tools that are available to help the trader to full their objectives.
The rst part of this section, then, deals with setting objectives.
Establishing a Successful
Trading Plan
Too many CFD traders start trading without
a well thought out plan. It is interesting to
compare the amount of forethought that
goes into buying a new car, with the limited
preparation that some CFD traders put into
their trading plans. Most people would
spend time researching the type of car they
wanted to buy, its specications, its colour
as well as the cost.
They would probably try and reduce
the cost of buying it and make plans
for insuring it, taxing it and the costs
associated with running it. If asked which
of the endeavours, buying a car or trading
CFDs, was the more risky, they are likely to
suggest the trading, so why so little effort
put into planning when starting
CFD trading?
It is possibly due to the fact that there are
not that many sources for trading plan
information readily available.
Well, here is some information
that might help
The creation of a trading plan
Trading plans form the blueprint for a
CFD traders trading activity. Each plan
needs to have a clear trading objective, an
understanding of how much work will be
needed to produce the plan, a structure for
the trading plan and which trading strategies
should be used, and a format for money
management and controlling risk.
One of the overriding objectives in
structuring a trading plan is to eliminate
controllable risks. Some risks you just cant
anticipate, like unexpected stock market
crashes, but there has to be a contingency
plan for all market conditions.
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The amount of time that a CFD trader takes
to research his or her chosen market, be it
commodities, currencies, bonds or equity
indices will never be wasted if there is method
and good research records kept.
Here is an example trading plan summary
to give an example of the requirements. In
the plan, the following aspects are covered:
The main trading goal
Degree and scope of preparation required
Typical trading behaviour of the
instruments selected
The way in which the market is
currently moving
How much risk the trader is willing
to accept
The trading approach
The amount of available trading capital and
the overnight nancing costs
The main trading goal
To trade for a six-week period in energy and
metals commodity CFDs to take advantage
of a general upward price trend in raw
industrial products stimulated by growing
global demand. The prot projection is for an
increase of 10% 15% in the overall value of
the fund over this period, with risk exposure
of no more than 20% to be taken in any one
commodity CFD at any time. Losses will be
capped at 5% of overall fund value.
Preliminary Research
Research will be conducted into factors
affecting each commodity. As can be seen,
there is interplay between many factors
affecting the oil and metals prices. Each one
of these factors needs to be assessed along
with the likelihood that it will inuence price
movements.
Energy products:
Seasonal demands on inventory, important
weekly gures, national and international
stockpiling levels, new oil elds and natural
gas elds and effects on production,
historical oil price movements over ten
years, critical near term support and
resistance levels, the current level of the
Baltic shipping index, the current position
of 20, 50 and 200 day moving averages,
relative strength projections with regard to
overbought/oversold status, current week/
day trading behaviour of oil futures, the
futures and options expiry calendar, major
broker activity in oil market, outlook for
the US Dollar.
Metals:
National and international demand for
industrial metals including gold and silver.
Industrial Production and other national
statistics linked to consumption levels
affecting industrial output, particularly in
the US, Europe, China and India. Weekly
Inventory levels in main industrial end-
user countries, the current position of 20,
50 and 200 day moving averages, relative
strength projections with regard to recent
overbought/oversold status, current week/
day trading behaviour of metals futures,
the futures and options expiry calendar,
major broker activity in metals market,
outlook for the US Dollar.
This is not an exhaustive list of research
topics but thorough knowledge of all of
these factors will assist the trader in being
able to establish an accurate measure
of where the current prices for these
commodities are in relation to the business
cycle. The next step is to understand the
way the price is behaving and that means
understanding the context in which the
instrument is trading.
Typical trading behaviour of the
instruments selected
Commodity products prices generally
react to swings in global or national
industrial demand. That price reaction
may be quick or slow depending on the
sentiment of the market, but there are
some important inuences on the price
movements of these instruments that
need to be understood. The rst of these
is that commodities now make up a large
part of hedge fund and money manager
fund composition and so their prices react
more aggressively to large turning points in
the commodity price cycles that exist. An
understanding of the position of the current
price in the commodity price cycle, and
the instruments vulnerability to sudden
demand pressures needs to be understood.
On a micro level, traders need to observe
the market action, watching how prices
move intra-day and inter-day and then
to make notes on the types of transactions
that take place including recurring trades
with similar sizes, trades that have large
impact, and any unusual trades that occur.
In addition, the CFD trader needs to know
who else is trading, how many market
participants are major institutions,
at which time intervals do they trade
and what types of trades they put on.
Depending on the granularity of real time
price data that the CFD trader has, he or
she can perform analysis of the trades
that move the market and the trail left
behind them.
Notice needs to be taken of trading
algorithms and their composition, when
they are trading and how often they are
used. Time of day observations need to be
made with regards to trading activity with
special note taken of high volume periods
and lesser volume periods.
It is also crucial to understand the effect on
the price behaviour of the commodity with
regard to macro economic statistics as well
as the levels of volatility reached intra-day
and over longer periods.
The Trading Approach:
Choosing strategies
Choosing the right trading strategy
requires knowledge of the following:
1 The CFD traders overall trading objective
2 The market conditions, now and in the past
3 How much risk the trader is willing to take
given the current market conditions
4 How much capital he or she is willing
to apply
The objective will be for the CFD trader to
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select from his armoury of trading strategies
the right ones to deploy given the current
market conditions.
These strategies can be grouped into the
following categories:
Aggressive short-term strategies that are
used to capitalise on price volatility and
sudden changes in price momentum
Market neutral strategies that look to
take advantage of anomalies in the price
movements of related products, like
Longer term strategies that adopt
a buy and hold or sell and hold
position.
Those strategies that control risk
And short term hedging due to adverse
price movements
Trade Execution Plan
This is where the trader needs to think about
the mechanics of trade execution. How easy
will it be to execute the orders that make up
the trading strategy? What happens when
only part of the order gets transacted and
one leg of a multi-legged strategy is left
unlled? The point of execution is where the
trading strategy meets reality, where the
success or failure of the plan lies.
Questions to ask
The rst question to ask is how easy will
it be to trade in the prevailing market
conditions? Market conditions are
constantly changing depending on the
time of day, the size of the orders that are
hitting the market, the impact of economic
statistics that are being announced and
whether the derivatives markets based on
the cash underlying instruments are close
to expiry or are experiencing volatile trading
conditions as well as many other inuences.
There are numerous reasons for price
movement and it can be useful for a trader
to break the trading day into periods during
which certain things occur.
Second question: How do you classify
market conditions?
Classifying Market Conditions
By being able to classify different market
conditions accurately, a trader is more likely
to recognise protable trading opportunities.
In particular, because of the exaggerated
effects of leverage, The CFD trader needs to
examine closely the varying levels of market
momentum during a trading phase and to
take advantage of the velocity of market
price movements. Traders protability is
often linked to the degree to which he or she
takes advantage of short-term or prolonged
directional price momentum.
Every market has its busy season when prices
move strongly in one direction or another.
Traders success is often determined by how
well they recognise less protable periods
of price noise and how efciently they
make use of the more prolonged price trends
during the busy periods. There are three
distinct market conditions which are easily
recognisable when they have happened:
the Breakout, Ranging markets and the
Trending market. The skill is being able to
pre-empt these market conditions from the
information available, something that not
many traders can successfully achieve.
Here is a description of these market
conditions:
The Breakout
The Breakout is characterised by a sudden
sharp price movement away from a trend or
range, whereby the price of the instrument
increases or decreases strongly in one
direction. For example, if the Gold price is
trading at $950 and has been doing so for
3 or 4 days, it may suddenly jump to $980
in a very short period of time, breaking out
from its narrow range. Sudden breakouts
are good trading opportunities, but they
are often very hard to spot. CFD traders
can line themselves up to take advantage
of breakouts by being ready to use market
orders to buy into sharply rising markets or
sell into sharply falling markets.
The following screen shot is an example of a breakout:
In the above example, the USD/CAD currency cross has experienced a strong breakout from the
ranging level of the previous price moves.
Example
The CFD trader buys Wheat CFDs and sells Gold CFDs in the expectation that the spread
between the two instruments will narrow.
1-Day Chart of the Wheat price
Day 1 Gold Wheat
CFD Price (USD) 949.40 5.031
Trade Sell 100 CFDs Buy 10,000 CFDs
Notional Transcactional
Value
57,989 30,729
Day 30
CFD Price 911.30 4.759
Trade Buy 100 CFDs Sell 10,000 CFDs
Prot/Loss 2,328 -1,663.20
Gold versus Wheat
It may seem strange to put two very
different commodities together in
a correlation or relative value trade.
Although at first there does not appear
to be much of a correlation, one being
a precious metal and the other an
agricultural commodity, they have a near
90% correlation at certain times in the
business cycle. Normally during times
of economic uncertainty, both Gold and
wheat are viewed as stores of value. That
is, Gold is the investment of last resort as
it is a rare tangible metal and holds an
immediate cash value, and wheat is the
most important global foodstuff and thus
has value as human sustenance.
The objective with a relative value trade like
this is to capture the price ratio retracement of
a large price move of either commodity in
relation to the other. For example, if a CFD
trader believes that the correlation is due to
break down soon, he might sell Gold while
buying wheat if the signs are that economic
uncertainty may be reducing. In this example,
whereas both commodities trended downwards
at the end of 2008, the Gold price moved
strongly upwards in the early part of 2009
while the wheat price has struggled to break
over a certain threshold. This now presents an
opportunity to sell Gold while buying wheat in
the expectation that the relative value/correlation
between the two commodities starts to narrow.