Introduction to CFD’s (Part 2)
This the second in a 3 part explanation on the basics of CFD’s and how they can be used from beginner to advanced. To ensure your understanding of terms used in this page, please refer to the Glossary.
This the second in a 3 part explanation on the basics of CFD’s and how they can be used from beginner to advanced. To ensure your understanding of terms used in this page, please refer to the Glossary.
Developing a good trading plan will provide you with a solid framework to improve your trading. The first step to developing a trading plan is to define your specific goals and a time frame to achieve them. Successful trading is a by product of adhering to a sound plan that addresses your entry and exit strategies, risk and money management.
Fundamental or technical analysis can be used to analyse signals to determine when you should enter into a trade. There are a number of methods that can be used to determine your entry including ‘buy low, sell high’, ‘buy high, sell higher’ or ‘buy high, sell low’ for short selling.
A good trade entry price will generally account for around 10 – 20% of your overall trading success. Successful traders are able to pick entry points accurately, however overall they can often have more unsuccessful trades than successful but are still very profitable, through utilising good risk and money management strategies.
The exit price of the trade should be determined prior to entering a trade. A stop-loss can be used to minimise any losses on a losing trade or to lock in profits on winning trades. A stop-loss should take into account the market you are trading, your trading goals, your trading time frame and your risk level. There are four main ways that stop-losses can be set. These methods can be used in isolation or together. It is important that you examine each exit price methodology to work out which method is best suited to your trading plan. Some methods are outlined below:
Many traders overlook the importance of money management but it is a key component in determining your trading success. Money management refers to the process of analysing trades for risk and potential profits and managing trades to ensure trading longevity and maximise profitability. The important role money management plays is best illustrated through drawdown analysis.
Drawdown refers to the amount of money that is lost trading, expressed as a percentage of your total trading capital. If every trade you took was profitable, your account would never experience a drawdown. Drawdown measures the money that is lost while trading but does not measure the overall performance. Drawdown is calculated when a trader experiences a losing trade and continues as the trading account hits new equity lows.
Assuming you start trading with $10,000 capital and your first trade incurs a $1,000 loss your drawdown is 10%. You place another trade with your remaining $9,000 capital and achieve a $1,000 gain then
a further $2,000 loss, your capital is now $8,000 so your drawdown would be 20%.
($10,000 – $1,000 +$1,000 – $2,000) = $8,000 a 20% loss on the $10,000 capital.
Maximum drawdown is the amount of money that is lost prior to getting back to break even. If you began with $10,000 and lose $3,000 before getting back to break even, your maximum
drawdown would be 30%. The process of recouping drawdowns is referred to as drawdown recovery which becomes increasingly difficult as drawdowns increase.
Drawdown recovery highlights the importance of intelligent money management and refers to the percentage gain necessary to recover from any drawdown. If you experience a 20% drawdown you need to make 25% (not 20%) profit to break even.
As the drawdown increases the percentage gain needed to recover the loss increases rapidly as illustrated in the following table.
In the previous section, we have covered why it is important to manage your money correctly, that it becomes increasingly difficult, deeper you dig into your capitol. In this section, we would like to discuss how we can manage this risk.
Trading in CFDs requires astute money management to be successful in the long term. As a trader your ability to collate, retain and use your knowledge and trading information will increase your likelihood of trading successfully. The traders who tend to enjoy the greatest sustained success are those who stick to predetermined, clearly defined rules.
We will look at three money management rules you should incorporate into your trading:
The number one and most important rule of trading is – preserve your capital. Without capital you are unable to trade. As Jesse Livermore said “A trader without money is like a shop owner without inventory”.
Preservation of your trading capital is perhaps the most important goal. Regardless of whether you make bad decisions during any trading period, if you employ capital preservation, you will have a chance to recoup losses and ultimately achieve success. The common-sense rules we suggest that you impose on your trading will enable you to survive all market conditions. If you understand and observe these rules, you will already have an advantage over most traders. That advantage means you should, of course, not only survive but outperform the market.
The single factor that causes most traders to overextend themselves and suffer losses is greed. Greedy traders take unnecessary risks. Typically they will fool themselves that a single indicator is the absolute key to success.
Unfortunately, there is no secret to sure-fire gains in the markets. Most traders have confidence in specific indicators. Many focus on particular markets and hope that this focus, and the quantitative or qualitative data they collect, will prove to be the key to investment success. But markets are dynamic and essentially volatile. In such an environment there are no cast-iron certainties. To help you avoid a roller-coaster ride, we are going to show you how to live to trade another day so that, no matter what changes take place in the market, you can enjoy at least modest and worthwhile success.
Know what you are willing to risk before you enter a trade is the basic tenet of living to trade another day. If you do not risk too high a proportion of your capital in any one trade, or in a handful of trades, then you will be able to continue trading whatever the outcome of your trades. In other words, it is not sound investment practice to put too many eggs in one basket.
You will have to decide what you are willing to risk in any one trade. The amount that you wish per trade could be based on a percentage of capital, fixed amount or other method. A few of the frequent money management styles are below:
1. Fixed % of Capital
With this style, all trades will risk the same percentage of capital. Once you decide the percentage of capital you are willing to risk, the rest is simple math. Most traders feel comfortable risking approximately 2 percent of their total account balance in any one trade. This is a general rule of thumb, but it is up to you to decide how aggressive or conservative you want to be. If you want to be more aggressive, you could risk a larger percentage of your account in any one trade. If you want to be more conservative, you could risk a smaller percentage of your account in any one trade. It is up to you to determine how much you are willing to risk.
Once you have decided what percentage of your account, all you have to do is enter that value into the following equation:
Account balance × risk percentage = amount at risk
Assume you have an account balance of $50,000 and would like to risk 2 percent of your account in any one trade.
$50,000 × 0.02 = $1,000
2. Fixed Contracts
When using a fixed contract style you trade every position in the same way. This style is reasonably safe, but limits the growth of your account. This method does not cater well with varying share prices. This is because of its very nature – it says “I will do ‘x’ CFDs on every position”.
Eg – Your trading capital is $50,000
If you decide to enter 5 trades you will allocate the same number of CFD contracts per trade regardless of the share price.
3. Fixed Sum
Under this style the same amount is risked on each trade. The major issue is that this style is that it doesn’t take into account the state of your account. Refer to the example below;
– Your trading capital is $50,000
– You decide to enter five trades allocating $10,000 to each trade.
Remember that whatever money management style you use the amount is the maximum amount you will risk in any single trade. If you have multiple positions open you should be aware that you will have more at risk. If you are employing the fixed capital % style explained above on a $50,000 capital with a 2% fixed risk each position and decide to open 5 x $10,000 positions, for example, you would risk only $1,000 per trade but have a total amount at risk of $5,000. After deciding how much you are willing to risk, you are ready to determine your trade size.
What we should emphasize at this point is that while you wish to limit your potential loss to a pre-determined amount you should be aware that the total amount of your investment is potentially at risk unless you have a ‘stop-loss’ (we will explain stop losses below but in short a stop loss is a limit at which you would definitely sell an investment that was losing money and minimise your losses).
You need to know how to determine trade size to prevent unnecessary exposure to risk. Trade size is the volume of CFDs you buy or sell in any individual transaction. Once you know how much you are willing to risk, you need to know how to set up your trades so that you do not risk more than you are comfortable with. It is pointless deciding what risks you will tolerate but then, entering a transaction that exposes you to more than your comfortable level of risk.
To determine your trade size, you must first decide what level you will set your stop loss. Once you have decided where to place the stop-loss, you will calculate the difference between the stop loss price and the point where you enter the trade. Then you enter that difference into the following simple equation.
Amount at risk ÷ distance between entry price and stop-loss price = size of your trade
e.g. $1,000 ÷ ($1,000 – $700) = $300
The size of your trade is now, in effect, not the whole amount invested but the part of it which is at risk between your entry point and the stop-loss.
Knowing exactly how to size your trade will help you eliminate a situation where you could lose more than you are comfortable losing. Using a stop loss you will make investing much less stressful, and the presence of such boundaries will increase the likelihood of you making an overall profit on your trading.
Hedging is the action of taking an equal but opposite position usually through a derivative, such as a CFD in order to mitigate or reduce the risk of an existing open position. A hedge will create neutral market exposure so any price changes will be offset by opposing positions.
A short hedge using a CFD is one of the simplest ways to lock in a price by short selling a share to offset the risk of any adverse price movements. A hedge allows a trader to offset any losses in a long position with profits from an opposite short position.
CFDs are a useful tool for hedging existing shareholdings because a short position can be made to hedge the exact position size required. Some hedging tools have standardised specifications and may not move in the same correlation of the underlying share. The risk that the hedge does not cover all the risk of the position is commonly referred to as basis risk. As CFDs are priced mirroring the market a neutral position hedge can be created with zero basis risk quickly and cost effectively.
Traders will short sell for two distinct reasons; to speculate and profit from selling high or overvalued shares with the intention of buying back to close the positions at a lower price in the future and to hedge risk.
Hedging via a CFD allows you to protect physical share positions without the complications of traditional short selling such as borrowing shares to sell.
We will discuss three hedging strategies
This popular strategy uses a CFD hedge to protect a single share position.
Imagine you currently hold 10,000 XYZ Bank shares. It is October 2008 and the bank is experiencing problems due to the current credit crunch stemming from difficulties in the U.S. housing market – creating what you believe is only a short-term weakness, you believe the bank is a sound long-term investment.
Initially you bought 10,000 shares at $5.82 back in November 2005 for a total of $58,200. Currently, XYZ Bank is trading between $7.20 and $7.40. But, with the current credit crunch, you anticipate short-term losses. However, you expect to see the share price will find resistance and increase in the future.
You decide to hedge your position rather than sell out. Therefore you sell an equal number of CFDs at the current market price to offset your share investment and create the hedge. That will be 10,000 XYZ Bank CFDs at $7.40 to cover the 10,000 shares of XYZ Bank shares you own. Assume the margin rate on XYZ Bank is 10%, you are required to pay a margin of 10 percent of the value of XYZ Bank shares – at a cost of $7,400 (10,000 shares × $7.40 per share × 10% = $7,400).
At this point one of the following three things can happen:
Share price rises– if the share price rises, you will gain on your share trade which offsets against the loss on your CFD trade. If the share price climbed from $7.40 to $8.40, for example, you would make $10,000 on your share position but lose $10,000 on your CFD trade.
Share price falls– if the share price falls, you gain on your CFD trade which offsets against the loss on your share trade. If the share price dropped from $7.40 to $6.40, for example, you would make $10,000 on your CFD trade but lose $10,000 on your share position.
Share price stalls– if the share price stalls, both positions will be neutral and you will not incur a gain or a loss on either your share or CFD. For example if the share stalled at $7.40 you would make $0 on your share trade and lose $0 on your CFD trade. At this point, you could either retain the hedge to protect from any potential negative price movement or you could unwind the hedge and buy back the CFDs.
Regardless of the share price, the hedge lets you retain any profit from the point at which you sell the CFD to when you purchase it back.
It should also be noted that when you hold a short CFD position you receive financing on the position.
Another popular hedging strategy involves buying a company’s CFD and simultaneously selling a rival company’s CFD. This is called pairs trading because you trade a pair of CFDs. The shares of companies in the same industry tend to move in the same direction so, if the industry performs well, most of the shares of the companies within that industry tend to do well too. Of course, the converse is equally true.
As a pairs trader, you buy a CFD on the share of the strongest company within the industry and sell a CFD on the share of the weakest company within the industry. Once you have entered your pairs trade, you anticipate that one of two things will happen:
In both scenarios, you hope to lose money on one of your CFDs and expect to make sufficient on the other CFD to offset your losses and leave a net gain. It is like making a prediction that, if a new Porsche raced a 1961 Volkswagen Beetle, the new Porsche would win. Of course the new Porsche might get a flat tyre or hit a wall before it finished the race, allowing the Beetle to win, but the chances of that happening are slim and the odds are in favour of the Porsche.
Both trades could conceivably move in your favour – allowing you to profit from both the CFD you bought as its underlying security moves higher and from the CFD you sold as its underlying security moves lower.
Conversely, it is also possible that both trades could move against you. You could lose on the CFD you bought as its underlying security moves lower, and likewise lose on the CFD you sold as its underlying security moves higher.
Imagine you wish to pair trade on shares in the Resource Sector industry, and you think BHP Billiton and RIO Tinto make great candidates for a pairs trade. BHP trades at $27.00 whilst RIO trades at $75.00.
It is crucial you balance your trade, otherwise it may not perform the way you expect it to. So ensure you control the same amount of value in the assets on which the CFDs are based. In this case you want to control approximately $100,000 worth – or 3,703 shares at $27.00 per share (3,703 × $27.00 = $99,981) – of RIO Tinto shares and approximately $100,000 worth – or 1,333 shares at $75.00 (1,333 × $75.00 = $99,975) – of RIO Tinto shares.
Once you know how many CFDs you wish to purchase, and the current price, you can enter your trade. Because you are trading CFDs, you are only required to deposit a portion of the total value of the position as margin for the trade. As the margin requirement for BHP is 3% and 10% for RIO you only have to outlay 3% of the value of BHP’s share price, or $2,999 ($99,981 × 3% = $2,999) and 10 %t of RIO Tinto’s share price, or $9,997.50 ($99,975 × 10% = $9,997.50). This means that in total you provide approximately $13,000 in margin to enter this trade with CFDs, not the full $200,000 require if you were to open the share positions.
Remember that you pay, or receive, interest on a CFD position held overnight. In the above example you pay interest of $21.91 per day on the BHP Billiton CFDs you have bought, yet simultaneously receive interest of $10.96 per day on the RIO Tinto CFDs you have sold.
Now imagine that the price of BHP rises slightly to $27.40 and the price of RIO Tinto falls to $74.75 over the next fortnight, and you exit your trade. Your profit on the BHP position is $0.40 per CFD, or $1,481.20 (3,703 × $0.40 = $1,481.20). Your profit on the RIO Tinto position is $0.75 per CFD, or $999.75 (1,333× $0.75 = $999.75). Your total profit on this pair trade is therefore $2,480.95 ($1,481.20+ $999.75 = $2,480.95).
Hedging does not necessarily need you to be in two offset positions simultaneously. You can also hedge your overall account risk by diversifying your investments. Whether you expect shares to rise or fall, you can insure against the price movements by buying or selling a broad range of CFDs.
The easiest way to hedge by diversifying is to buy an index-tracking CFD, a contract that derives its value from a large share index like the ASX200, S&P 500 or the FTSE 100.
You may believe that shares in general will rise but you may not be sure about which specific shares to buy. You could buy Index-tracking CFDs – eg ASX200, FTSE 100, NASDAQ, S&P 500, Dow Jones or DAX index tracking CFDs. If shares in general increase in value you will attain a profit from your trade. Whilst a few stocks in each index might decrease in value, the average performance of the entire index will counterbalance any shares that underperform.
This concept also works when you predict that shares in general will fall. You can then sell index-tracking CFDs to benefit from any adverse movement in the underlying market.
When trading you complete not only against other traders, but against yourself. Traders can be emotional and irrational and while such emotions and instincts can provide trading successes, they are more likely to hinder your trading unless you learn to control them. This is why understanding trading psychology is important.
It is not possible for a trader to remove themselves from their emotions therefore it’s useful to learn to understand yourself as a trader, identifying your own strengths and weakness, so that you can opt for a trading style that best suits you.
In this section, you will learn about four psychological biases that may adversely influence your trading results, and you will learn what you can do to overcome them:
Overconfidence bias is an inflated belief in your skills as a trader. Any traders who finds themselves thinking that they know the business inside-out and that they have nothing more to learn, may well suffer from an overconfidence bias.
Overconfident traders tend to get themselves into trouble by trading too frequently or by placing extremely large trades with the intention of making a killing. It’s not inevitable, but an overconfident trader invites disaster.
If you want to know if you have a tendency to be overconfident, ask yourself, “Have I ever delayed or reversed a decision because I couldn’t believe I was wrong?” Likewise, you could ask yourself, “Have I ever put more on a trade than I know is really prudent?”
One way to overcome an overconfidence bias is to stick to a strict set of risk-management rules. These rules should limit the number of markets you invest in, the number of shares or CFDs you trade at one time, how much you are willing to risk on any one trade and how much of your account are you willing to lose before you take a break from trading and re-evaluate your trading strategy.
Anchoring bias is a belief that the future is going to look extremely similar to the present. When you anchor yourself too closely to the present, you may fail to notice dramatic changes in the offering.
Anchored traders tend to get themselves into trouble because they wrongly believe that current trends will continue or that companies they’ve always favoured will never let them down. Due to the fact they are emotionally attached to a share or CFD, they continue to invest in a way which is not optimal in changed circumstances. With each trade, they lose more money because they are bucking the trend.
If you want to know if you have any anchoring tendencies then ask yourself, “Have I ever lost money because I couldn’t accept that a trend had ended?” If you have done this, you need to be aware of that tendency.
One way to overcome anchoring is to seek a new perspective. Look at different time-frames on your charts. If you usually rely on hourly charts for data, look instead at the daily and weekly charts to examine long-term trends as well as levels of support and resistance. You could also examine shorter-term charts to see if trends are reversing.
Broadening your perspective in this way will help you to avoid anchoring yourself to any one point.
Confirmation bias is the habit of only looking for information that supports your beliefs. If you anticipate the price of BHP Billiton (BHP) is going to rise, for example, you will only really take in news and data that reinforce your belief.
Traders who pursue confirmation of their beliefs tend to miss warning signs that would otherwise protect them from unnecessary losses. Ultimately, this can only lead to losing money because decisions to buy or sell, or even to do nothing, are being made on false premises.
To know if you have any confirmation bias tendencies, ask yourself, “How often do I look for signs that I may be wrong in my analysis?” If your answer is rarely or never, you may be a confirmation seeker and you need to actively work to ensure that such a bias never interferes with your better judgment.
One way to overcome confirmation bias is to find an individual or group with whom you can discuss your trading. You don’t need somebody who will perpetually agree with you. Traders with different perspectives and ideas will help you to be more circumspect. Sometimes your convictions will only be reinforced by talking with other traders, but at other times, they may force a total and timely rethink.
Loss aversion bias is based on the theory that losing $1,000 will have a bigger impact on you emotionally than gaining $1,000 will. In other words, fear is a more powerful motivator than greed.
Ironically traders who fear losses are much more likely to hold onto losing positions than traders who are able to accept short-term losses and exit their trades. A reluctance to give up a losing position will not only cause you to incur bigger losses but also preclude you from finding better alternative positions.
If you want to know if you have any loss aversion tendencies, ask yourself, “Have I ever held onto a losing position, beyond the point where I knew I should have quit, because I hoped the trend would reverse and wipe out my losses?” If you have, then you need to be aware of that tendency.
One way to overcome a loss aversion bias is to trade with physically-set (i.e. automatic) stop-loss orders. Many traders trade with just a mental stop-loss that, when it comes to the crunch, they fail to honour. They let their emotions interfere with their better judgment as they try to justify irrational decisions that prevent them from quitting and cutting their losses.
In conclusion, as soon as you invest in anything you should set your stop-loss order. It should be physically set, operate automatically, and you should respect it.
The rapid growth of CFDs has in part resulted from their similarity to share trading but has been fuelled by the advantages that CFDs offer retail clients. Two key advantages are the ability to profit in falling markets through short selling and the ability to gain additional market exposure through leveraged trading.
We have introduced the concept of leverage and aimed to highlight the benefits it can present and also illustrate the potential dangers. It is essential that all traders employ a level of leverage which is appropriate to their experience and capital. We have highlighted the fact that establishing a trading plan that covers entry and exit criteria, sound risk and money management is essential for your trading success. Spend time trialling the various systems available to ensure you are using the most appropriate systems for your trading style. As this manual has illustrated, CFDs are a powerful product that enable you to make more effective use of your capital. They present a flexible and low cost alternative to traditional share trading.