If a stock market investor owns stock but fears a price fall in the short term, he can use a contract for differences to cover the risk.  To do this the investor will open a short position on a contract for differences on the same stock.  The effect of this CFD trade will be to offset any losses that might be incurred on the stock; i.e if the stock position goes down in value the short CFD contract will move into profit territory.  However, this CFD trade will also have the effect to putting the trader into a market-neutral position.  If the stock quotation grows, the contract for differences will record a loss, equivalent to the stock profit.

Contracts for Difference are Zero-Sum

From a practical perspective, the market of contracts for differences is a zero-sum game. This situation is specific for futures transactions. The profits made by some of the participants are always matched by corresponding counter-parties that record a loss.  If the total market doesn’t have a profit or loss, for participants each profit hides the loss of one of the investors.

CFDs: Good Choice for Short-Term Investments

Contracts for difference are a good choice for short-term investment. The possibility to trade very cheaply, via a simple mechanism of trading and permanent marking-to-market make the CFD perfect tools for short-term speculators. For longer investment horizons CFD investments may not always be the best choice since the leverage effect requires a permanent surveillance of the investment and also because of the financing costs that are incurred on a daily basis.  For long-term holdings, risk management can emphasize safer investments such as stocks or for the individuals in contributions to private pension funds.

Not Suitable for All Investors

Finally it should be pointed out the fact that the investments in CFD aren’t suitable all investors as there are a number of trading risks with CFDs .  Depending on the investor’s risk appetite, investment time horizon, time available to trading and his interest in the stock markets, one can make an informed decision on whether CFDs are an appropriate instrument to use.  The increasing popularity of derivatives trading is allowing the market to grow and providers to keep expanding their investment products   If the purpose of trading derivatives is speculation, the investor should not forget that the leverage great when it generates profits but can also be painful when it produces losses.  If a potential investor on financial derivatives market does not take into account the possibility of losses, he is probably better off participating on a traditional market where the price, paid to initiate a transaction, limits the risks and profits.

(copyrighted to Andy Richardson July 29, 2010)

If you make 100s of trades a year, the extra spread you pay with spreadbets will likely come out more than the tax you save.

In the past there used to be bigger tax advantages to spread betting. But these days you get a 10K tax free Capital Gains Tax allowance (+ another 10K if you have joint account with your spouse) and then its only 28% after that. So there really isn’t that much of a tax incentive to go the spread betting route if you bet reasonably often (the extra spreads imposed over a year’s of betting add up and eat into most if not all the 28% tax saved).

Thus, I think that today the tax-free advantaged status of  financial spread betting isn’t as great as it used to be when you compare it to direct access with x number of trades. With a spouse’s Capital Gains Tax allowance added to yours, you can make 20K on direct access before you pay Capital Gains Tax at 28%. Compare that to the spreads you pay over a year and direct may be a better route to go down.

What About Stamp Duty?

Active traders find that stamp duty can take a big chunk out of their profits. Using a spread betting or CFD account is one of several ways they can eliminate this extra cost.   In the UK, spreadbetting is regarded as gambling as opposed to trading and therefore is not subject to tax which means there is no tax on gains, but it also means that you cannot offset your spreadbetting losses, unlike ‘normal’ share/bond trading.  I suspect this arrangement suits the Revenue for good reason.

So should I go with Spread Bets or CFDs?

When starting out, spread betting is a sensible way to go.  With the gambling/trading tax laws (e.g. no tax versus 0.5% stamp duty on shares (which is sickening), it is in everyone’s interest to have a spread betting division which is then at least partially hedged. Even high street banks have spread betting divisions. I have had no problems at all with that.  Later on, it’s probably worth moving onto DMA CFDs (which again are trivial to short), but you probably need £30k+ to make it worthwhile.  Until then it is probably cheaper/easier to just pay the spread.

(copyrighted to Andy Richardson July 29, 2010)

CFDs (Contracts For Difference) add another aspect to your trading strategy, they are leveraged trading products meaning you can ‘buy’ a quantity of shares for substantially less money than buying physicals, or ‘buy’ substantially more than you would normally be able to, or want to! You never physically ‘own’ the shares but receive dividends as if you did, similarly if you are ’short’ you owe any dividends payable.

So are CFDs similar to holding Shares?

A contract for difference is almost exactly like buying and selling the underlying shares but you do not get any voting rights or company reports. Moreover, the interest charges are different to savings accounts because it is normally LIBOR + X%. So it might end up costing you more in the long term to be LONG shares via a CFD than it would if you bought the underlying asset. But if you are a short term-trader this may make little difference.

Investors can benefit from CFD trading from an increase or decline in an instrument. For example:

Scenario 1: Profit from a Correct Anticipation of an Increase in a Share Price

A trader enters a contract to buy 2,000 share CFDs at $10 per share, equivalent to a long position of $20,000 The deposit requirement (aka margin requirement) for this position will be $2,000, based on the stipulated initial margin of 10%. In the circumstance that the share price goes up to $11 per share, the trader could close the position by selling the CFD making a gross gain of profit of $2,000 (excluding charges) in the process.

Scenario 2: Profit from a Correct Anticipation of a Drop in a Share Price

A trader enters a contract to sell 2,000 shares as CFDs at $10 per share, equivalent to a short position of $20,000. Again, the deposit requirement to open this position will be $2,000 (assuming a 10% margin requirement). In the event of a price decrease to $9 per share and a closure of the position through a purchase of the CFDs, the trader will make a gross profit of $2,000 (excluding charges) through his strategy of selling high and subsequently buying low.
Uses and Risks of CFDs

Popular trading strategies of contracts for differences include hedging an existing shares portfolio or hedging share options, taking a directional view of the market (ability to go long or short) and pairs trading. Trading in pairs involves going long in respect of, say, Anglos and shorting, say, Billiton’s, thus creating a portfolio that incorporates your view of different stocks within similar sectors, or an investor could even take a view on different sectors.

Through placing a comparatively small amount of margin with a CFD provider, the investor can obtain massive exposure to the underlying reference instrument. Thus the investor has a ‘turbocharged’ trading tool that he can add to his arsenal of weapons. For this reason when trading CFDs, the profit rewards can be significant when you compare the potential gains to the lower cost of entry. Equally so can the potential losses be significant if the investment price goes in the opposite direction.

CFDs in a Nutshell -:

1) A CFD is a DERIVATIVE, you do not own shares in the companies you take contracts on.

2) A CFD can be a leveraged product and they are called Contract For Difference because they are exactly what they say on the tin. You make (or lose) money on the DIFFERENCE in the price you open your contract and the value of the underlying asset.

example / If you went long on company XYZ shares with a CFD@£1.00 then you will make money for every penny XYZ shares move above £1.00 ie/ The difference. Conversely you will lose the difference for every penny they fall below £1.00

3) You can go LONG or SHORT at any time markets are trading unless there is a Short selling ban in place like earlier this year on financials.

4) CFDs do not expire.

5) If you go long, you pay interest on the CFD but you earn dividend payments.

6) If you go short you earn interest but pay out dividend costs.

(copyrighted to Andy Richardson July 22, 2010)

The following chart shows the price of Gold is currently in a symetrical triangle trading range (however it is probably a bit past the 75% mark.

It’s currently testing the bottom support line, the break out commonly forms in the direction of the prevailing trend which is upwards. This should bounce off the current support line and continue it’s upward trend breaking out soon.

My first real trade I bought too long after my signal – silly move and I got stopped out fortunately.  Then I spotted a short trade, but I’d lost my confidence and I didn’t do anything – silly move.

I’m still formulating my trading strategy so I’m going to sit it out a bit longer until I’m 100% certain of what I’m doing (even though I’m only trading $1000 – I don’t want to lose it).

I’ve been paper trading historical situations plus paper trading live with varying successes and failures, but paper trading is no substitute for the real thing.

Timeframes

All analysts should adopt a multi tiered time frame approach to their analysis.  As a rule you should work from the longest time frame possible down to the target time frame.  eg a trader with a daily time frame should begin with a monthly chart, then a weekly chart and finally a daily.

What do you do when there are conflicting timeframe signals, which signals do you follow?

The key to successful analysis is to ensure analysis of your timeframe is consistent with the target timeframe, avoid blurring timeframes.

Dow Theory

Defining the start and end of a trend.  A turn from uptrend to downtrend is the point the price first produces a lower high followed by a lower low.  A trend is held to be intact until it reverses.

Benefits and problems of Dow Theory:

• Following the theory misses 20-25% of the trend
• Dow theory accounts for 68% of moves in industrial and transport averages and 67% of those in the S&P500

Bar Charts

Covered a lot of past ground.

Key day reversal signal – shows a strong warning or signal of a reversal prior to the trend.  In an uptrend, the day of the key day reversal prices makes a higher high and then closes below the previous days low.  That is, it closes against the prior trend.  The heavier the volume and the wider the range, the more significant the move.  In a downtrend, the day of the key day reversal, price makes a lower low and then closes above the previous days high.

Volume Analysis

Volumes don’t give buy or sell signals, but serves as a way of confirming or contradicting a given underlying price move.  Typically a price which moves in a given price trend is confirmed if accompanied by higher volumes.  A slight exception is price downtrends don’t necesarily need to be accompanied by strong volumes.

Price Gaps

• Breakaway gaps – point to a new trend and are rarely filled
• Continuation gaps – occur after a trend has begun, confirms the trend
• Exhaustion gaps – suggest the end of trends, these gaps are always filled

If the price gaps in your favour, move your stop loss up to the edge of the gap, if a price gaps against you the look to exit your position.

Elliot Wave

States that markets follw a systematic and repetitive rhythm consisting of 5 waves up followed by a 3 waves structure of decline.

Rules:

1. Wave 3 of the upwaves (1,3, & 5) must NOT be the shortest in terms of price advance
2. The low of the wave 4 must be higher than the high of the wave 1
3. The low of wave 2 must be above the low of wave 1

It’s a controversial theory.

Technical Divergence

Divergence is the opposite of confirmation and refers to a situation where different technical indicators such as RSI, MACD and stochastic fail to confirm one another.

There was then some discussion of Intermarket technical analysis with the basic premise being all markets are interrelated etc and discussed some concepts of correlation.

Trendlines

Rules:

1. Declines that approach an uptrend line or price rises that approach a downtrend line are often good opportunities to initiate positions in the direction of the major trend.
2. The penetration of an uptrend line is a sell signal and the penetration of a downtrend line is a buy signal.

Head and Shoulder Patterns (HSP)

The typical HSP starts with and then consists of the following aspects.

1. A strong rally climaxing on heavy trading volumes, followed by a minor dip / retracement in relatively light volumes – this is the left shoulder
2. Then a high volume advance that penetrates higher levels above point 1, then retraces to about where the previous slips was – this higher high is the head
3. Then there is a 3rd attempt at a new high but doesn’t quite get to point 2 then it retraces – this is the right shoulder
4. Then there is a decline in price that cuts through the lows on either side of the head peak – this is called the neckline

A HSP is only confirmed once the neckline is cut.

The theory is that following a cut in the neckline, the price is projected to fall to a certain level, the magnitude of which is equal to the price distance from the peak of the head back to the neckline.

Fibonacci

Fibonacci series – 1,1,2,3,5,8,13,21,34 . . . . etc

The ratio or two consecutive numbers is 1.618 inversely is 0.618 this is usually rounded to 62% and 38%. This percentages plus 50% are used by technicians in retracement analysis.

Exponential Moving Averages (EMAs)

This is a variation of the simple moving average, the practical difference is that for an equal length average, the EMA is more responsive to the latest price observations and hugs the price closer.

The EMA weighs the more recent days as more important than those days in the distant past.

Percentage Bands

Bands mathematically define for analysts whether the price has moved too far from its moving average line. Typically short term traders use 3% bands and long term traders use 10-20% bands.

Bollinger Bands

A very similar technique to percentage bands, except instead of the fixed percentage bands either side of the price you place the bollinger bands which are 2 standard deviations above and below.

A standard deviation is a mathematical measure of volatility so the bands will expand and contract with the price volatility.

The Momentum Indicator

Measures trend acceleration of price. The indicator theoretically and usually reaches a peak just before the trend in price reaches its high and reach a bottom just before prices hit their low. As long as the oscillator keeps reading new highs it is safe to hold long positions. When the indicator does not confirm what the price is doing it indicates the trend has stopped. The momentum indicator is one that compares todays closing proice to a price selected a period of time ago.

Momentum Indicator: M = Pt – P(t-n)

Where M = Momentum
Pt = Todays closing price
P(T-n) = Closing price n days

MACD: The Moving Average Convergence Divergence

Developed by Gerald Appel it combines some of the oscilltion principles with the features of a dual moving average cross over approach.  The best buy signals are given when prices are well below the zero line (oversold) and the bar column crosses from below to above the signal line.

Directional Movement Indicator (DMI)

Welles asserts that markets trend only about 30% of the time.  This model aims to permit trades only when the market is trending.

1. Directional aspect
2. Behaviour of the ADX (ADX = degree of trendiness)

Stop Loss Styles

• Visual stops
• Trailing stops
• Times tops
• Dollar value stops

The first section, the Mechanics of technical analysis starts off by discussing the basic types of charts including the bar chart, Japanese candlestick, line and point and figure charts.  Time frames are also very important to be aware of, and a good trade will use a combination of timeframes.

Some practical rules for finding support and resistance:

• Times tested
• Volume spent
• Recent trading
• Round numbers

1. Take a profit – as price approaches a support a short seller would take profits and conversely as price approaches a resistance long traders should have a tendancy to take profits
2. Place by orders near and above a defined support, and place sell orders near and under resistance levels
3. Establish a new position on a break of a level
4. Stop loss setting – use a breach of a level to limit your losses
5. Once broken, they reverse roles

Once you have worked out the basic trends of price and the important support and resistance levels you are able to start sketching out a plan.

Key patterns to look for:

• Rectangle
• Double top
• Triple top
• Triple bottom

Some of the basic technical analysis theories include the following:

The Moving Average

This is the basis of trend following systems.  Buy and sell signals are simple, ie when price closes above the simple moving average you have a buy signal and if the price closes below the single moving average you have a sell signal.

The Double Moving Average

Rather than use the price in the case of the simple moving average as the trigger to buy or sell, DMA uses a faster moving average as the trigger.  This technique lags the market and theoretically misses more of a profitable move but it has fewer false signals.

The Triple Moving Average

It is three double moving averages used in combination.  eg 5-15-30 or 5-13-34 are popular combinations.  The only time you are allow to buy under this system is when your fastest average is above you 2nd which is above your 3rd average.

RSI: The Relative Strength Indicator

This theory was developed by J.Welles Wilder Jr in the 1970s.  The RSI measures the strength of a market price by monitoring changes in its closing price.

RSI = 100/(100-21 + RS)

Where RS = Avg of x days up closes / Avg of x days down closes
Normally x = 14 days

RSI is a number that fluctuates between 0 and 100, horizontal lines at 30 and 70 define oversold and overbought readings.  Buy signals occur when RSI reading drops below the 30 RSI level and then crosses back above it.  Conversely sell signals occur when the RSI reading moves over the 70 RSI level and then crosses back under.

Note: you don’t sell when the RSI gets overbought, but when the RSI reading exits the overbought zone.

RSI is best for stable or ranging markets, it’s not as good for trending markets.

Stochastic Oscillators

These were popularised by George Lan in the early 1970s, and are based on the concept that the latest closing prices tend to cluster at the high end of recent price ranges in an uptrend and at the low end of ranges in a downtrend.

%K = 100 x (Cn – Ln) / (Hn – Ln)

Where:

%K = George Lane’s Stochastic Indicator
Cn = The latest close
Hn = The highest high of the past n days
Ln = The lowest low of the past n days
n = normally 14 days

This method uses the same 30 / 70 oversold and overbought zones as above.

The first CD is “Detox: Psychology of Trading” and is presented by Mark Sear and the aim of this cd is to “teach you how to prepare phsyically and mentally for trading, how to control your emotions and effectively manage your trading capital”

Each CD is broken down into 3 parts, Mechanics Strategy, and Advanced Strategy. I’m just going to pick up a few things that caught my interest while studying this section.

Mechanics

What is a CFD? “A contract for difference is a contract between you and your CFD provider to settle the difference between the price at which you buy the CFD and the price at which you sell.” (p.9)

The Benefits of trading CFDs:

• Liquidity
• Traded on margin
• Traded long or short
• Traded online
• Low transaction cost
• Access to international markets
• Dividend and stock split

Interesting to note that a “dividend is credited to your account on the day the stock goes ex dividend not weeks later.” (p.12)

There is discussion on the advantages and disadvantages of trading different markets such as the US, UK and EU. Also the need to be careful of gappy trades such as commodities like gold or ooil as they can gap up or down by large amounts. This can be particularily hazardous for amateur traders.

Page 37 discusses the major trading styles:

• Scalping, extremely short term trades with very small price movements
• Intra-day position, short term within the day where trades could last for a few hours
• Intra-day zonal, trading intra day at a preset price zone
• Intra-day news trading, react to a news item or event
• End-of-day positional, based on the end of day closing price
• End-of-day news trading, based on big news events of the day
• Swing trading, trading up and down movements of the market
• Weekly (and longer) trades, using big trends that may last several weeks
• Trend trading, similar to swing
• Pairs trading, trade two stocks or indices simultaneously
• Shorting

I’m thinking at this stage I’ll probably be weekly trading.

Strategy

The first part that caught my attention in this section were the lists of characteristics describing winners and loser.

First the winners:

• Properly capitalized
• Low risk tolerance
• Trade only when there is an opportunity
• Actually trades when there is an opportunity
• Treats trading like a business
• Emotional control
• Has a trading plan
• Focused
• Has a trading system

Loser characteristics

• Under capitalised
• Lacks discipline
• Doesn’t study the markets
• Chases the market
• Stubborn
• Always looking for one big trade
• Afraid of missing a move
• Misinterprets news
• Lets losers get too big
• Takes profits too quickly
• Sees trading as simple
• Takes larger risks
• Lacks emotional control

Discipline is obviously a very big part of trading, and this is emphasised in the course. Some tips to becoming discipline (p.11):

• Review trades
• Set sensible goals
• Sort out easy problems before big ones
• Have a strategy to follow
• Always ask “is this a good trade?”
• Work at trading
• Just do it

Tied in strongly with discipline is control of your emotions. Some warning sign that you are losing control includes:

• Phone a friend syndrome
• Head in sand syndrome
• “I’m hoping syndrome”
• Doubling up
• It can’t go any higher/lower

Rudyard Kipling wrote a poem called IF which is well worth a read.

Money Management Styles:

• Fixed contracts
• Fixed sum
• Fixed percentage of capital
• Optimal F
• Secure F
• Kelly

And most importantly of all – NEVER trade without a stop loss.

Advanced Strategy

Make sure you develop a trading plan.

Ensure you review all trades, and with your open trades ask the following questions:

• Has it reached your target?
• Is it close to target?
• Should you be adding to it?
• Is it prudent to cut some?
• Is the trade working out as planned?
• Could you make better use of your capital elsewhere?
• Should you close the trade or hold onto it?
• Is the trade close to your stop?

Review closed trades weekly when the market is closed.

Keep a trading diary including trades you take and trades you don’t.

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.