Contracts for Difference

This is the first post on Contracts for Difference. The aim of this blog is for me to write down my strategies, trades, reasons for trades and then to revisit those trades to evaulate the results. Hopefully this will ensure I am purchasing based on research and systems and not on emotion.

I have recently read a book called Supercharge Your Trading with CFDs by Jeff Cartridge. Not a bad book for an introduction on trading CFDs and below I’d like to highlight a few of the key points brought out by the book.

Leverage

One of the things about CFDs that is both attractive and at the same time down right scary is the leverage that is available with so much ease. It astounds me that you can obtain leverage of 100:1 when trading indices, so with a mere $10,000 I can trade $1,000,000 of an index. That’s quite amazing.

The other thing I find interesting is you can effectively use someone else’s money during the day without paying any interest, you only pay if you have an open position overnight. What’s more if you sell short then you can actually earn interest on your open positions.

Shorting

You can trade CFDs for profit in either a rising or falling market. CFDs are great for shorting, I thought Jeff’s example of the lawnmower was great to help make sense of selling something you don’t own.

“Imagine borrowing your neighbour’s lawnmower and selling it for $500. You get the $500 now, but at some point in time, the neighbour will want the lawnmower back. If you can buy it back for $300, then you can return the lawnmower and get to keep the profit of $200. If you have to pay $600 to buy back the neighbour’s lawnmower, then you have lost $100.”

Direct Market Access (DMA) vs Market Maker

Now this is something that I am still getting my head around and will probably have to keep revisiting. Essentially 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.” (p.37) “In the market maker model, pricing approximates to the underlying market” (p.38)

In the DMA model, “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.” (p.38)

I’m still not sure which is the best model and there seems to be a healthy debate about the subject. But what I like about the market maker model is that it allows for guaranteed stops.

Trading Indices

There seem to be a few attributes of trading indices that make them particularily attractive to amateurs like myself:

• Lower volatility
• High Liquidity
• Gaps are rare
• Limited slippage
• High leverage (though that can be a negative)
• No brokerage fee

Seems as though trading indices is the ideal learning ground for CFD trading as it minimizes a large number of areas where you could make mistakes. Correct me if I’m wrong.

Seasonl Patterns

Jeff points out a number of seasonal patters that were are all aware of to some degree but perhaps didn’t know the exact timings or statistics. I found this section very interesting.

In brief, history tells us to trade the long side from March to April and October to December and trade short from December to March and April to October.

The election and presidential cycles are also interesting to note, “the election rise in the stock market historically occurs in the year before the election year, showing an approximately 9 percent above average performance. In the election year, the market slightly outperforms, with a 1 percent above average performance.” (p.70) In the next two years the stockmarket underperforms by between 4 and 5 percent.

Profitability on the All Ordinaries index is interesting also with a table on page 72 that shows Monday afternoon or Tuesday mornings are the best times of the week to go short, while Wednesday, Thursday and Friday are good days to go long.

Risk Management

Risk mangement is obviously a huge area of concern with CFDs due to the large amount of leverage available. The most important takeaways from this chapter for me are:

• Always use stops!
• I like guaranteed stops.

Stop placement is still something I will be thinking about with the various methods available. The methods discussed are:

Initial Dollar Stops – where you limit your losses to a fixed dollar amount

Trailing Stops – where you can lock in profits when the position moves in your favour and the stops follow the price up

And there are a number of different types of trailing stops including Previous Trough (peak), Previous x day low (high), Percentage-based trailing stop and ATR-based trailing stop.

Position Sizing

My positions will be small! The main methods or determining the size of a trade are:

• Risk-based position sizing
• Dynamic position sizing
• The 2 percent rule

I like the 2 percent rule, however I think I’ll be starting off with such a small amount of capital that this won’t be feasible. However, I think long term this will be the method I use.

Pyramiding seems to make sense too. If a trade is going in your favour, pyramiding into the trade maximises the returns with the risk being limited.

Analysing Trades

Makes sense. There’s no point persisting with trading strategies that are losing money. Two important numbers are:

• Hit Rate. This shows how often you are right. (= number of wins/number of trades)
• Edge Ratio. It shows how much you make when you are right as opposed to how much you lose when you are wrong. (average win/average loss)

Trading Strategies

I still haven’t worked out what trading strategies I’ll be adopting yet. The most basic of trading strategies is the universal trading strategy. A long trade would be initiated when the share forms a higher low and a higher high is confirmed, and vice versa for short trades.

Psychology

I imagine this is one of the most important areas of trading. You need to be able to control the emotional highs and lows of wins and losses. You need to have a very strong disciplined approach to trading. This website is one of my attempts to ensure I’m structured and disciplined in my approach to trading.

Trading Plan

As I mentioned, I’m still to determine my trading plan. A strong trading plan should encompass the followin areas:

• Stepup. Which trade to enter
• Entry. Make the purchase when your conditions are met
• Determine Risk. Ensure stop losses are in place at appropriate levels
• Exit the trade.
• Execute your plan. You won’t know if you plan works effectively until it is put into practice

Strategies for success:

• Decide what you are going to trade
• Find an edge in the market
• Define your entry points
• Decide on Appropriate stops
• Decide on Risk
• Calculate Position sizing
• To pyramid or not to pyramid
• Test

Once you’ve come up with a plan, back test it. And then back test it again.