Making the most of CFDs Your guide to speculating, hedging and profiting with CFDs
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A quick guide to CFD strategies for every level of experience Properly explaining the almost endless uses of Contracts for Difference would take a rather large book. However, in this guide you’ll find a quick overview of the most common basic and advanced CFD trading strategies. In these pages, you will learn about: •
Speculate Breaking News Economic Data Company Reports Index Additions/Deletions Mergers & Acquisitions (M&A)
• Hedge Single Stock Index Diversification • Market Neutral Pair Trade Use this guide to spark ideas, or inspire further reading.
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Speculate Trading CFDs as a means of speculation is very common. One of the biggest advantages of using a CFD is the leverage associated with the instruments. It allows you to increase your exposure whilst minimising your investment in a trade. Trading a CFD to speculate is generally over a short to medium timeframe and typically surrounds a market event. Trading this instrument should always be combined with appropriate risk-management techniques such as the use of trailing stops.
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Speculate - breaking news SCENARIO RYANAIR WARNS OF PROFIT “STORM” Budget airline Ryanair announced that profits will be severely impacted by the rising costs of fuel. The high cost of crude oil has clear knock-on effects for airline operators. STRATEGY The effect of this news should send the price of Ryanair down. Our strategy would be to sell Ryanair CFDs with a profit target below the current share price and also cover the position with a trailing stop.
HOW TO EXECUTE THIS STRATEGY Opening trade: Sell 10,000 RYA:xlon @ €3.77. [Alternatively sell at market] Profit target:
Place Limit Buy order for 10,000 RYA:xlon @ €3.10.
Stop Loss:
Place trailing stop to Buy 10,000 RYA:xlon Distance to Market €0.10, trailing step €0.02.
If either order to close is triggered then ensure you cancel the other remaining order!
COSTS We sell 10,000 RYA:xlon CFDs @ €3.77 upon hearing the news. RYA is margined at 10%. We contribute €3,766 as Margin Requirement and receive interest of €1.36 per day as we are short. Nominal value of the trade is €37,662.30. Profit target is set at €3.10 where we buy the CFDs back. A trailing stop is placed to protect our position set at distance to market of €0.10, trailing step €0.02. RISK/REWARD If Ryanair doesn’t go down at all then our trailing stop would buy back the CFDs @ €3.82 realising a loss of €1,000 or €0.10 per CFD. The trailing stop is set close to the market as we are not interested in holding this position if the news has no negative impact on its price. If our profit target is reached then we buy back the CFDs at €3.10 realising a profit of €6,700 or €0.67 per CFD.
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Speculate - Company Reports SCENARIO MARKS & SPENCER CHRISTMAS SALES
(UK)
REPORTS
LOWER
The UK Retailer Marks & Spencer reported on 9 January its sales figures for the December Christmas period. Market consensus predicted a 1.5% drop and some of this was already factored into the share price. If the result is worse than this, you believe there is further for the stock to fall. The result on the 9th is worse than expected and comes in at -2.2% for December and -3.2% for the quarter. STRATEGY The stock had already factored in some of this ahead of the result. Our strategy is to sell if the result is worse than expected. The company will report ahead of the opening on the 9th. If it’s a worse than expected result the stock will open lower than the previous close. Therefore we will sell if the opening price is lower than the previous close.
RISK/REWARD If Marks & Spencer doesn’t continue to go down then our trailing stop would buy back the CFDs @ £4.50 realising a loss of £1,500 or £0.15 per CFD. If our profit target is reached then we buy back the CFDs at £4.00 realising a profit of £4,500 or £0.45 per CFD. HOW TO EXECUTE THIS STRATEGY Opening trade: Sell 10,000 MKS:xlon on a STOP @ £5.02. Profit target: Stop Loss:
Place Limit Buy order for 10,000 MKS:xlon @ £4.00. Place trailing stop to buy 10,000 MKS:xlon Distance to Market £0.15, trailing step £0.05.
The Profit and Stop Loss orders are only placed if our Stop entry order is triggered and filled!
If we trade, we look to take profits below the entry and of course we cover the position with a stop loss. COSTS Our stop is triggered and we sell 10,000 MKS:xlon CFDs at market as the open is lower than the previous close. In this example we trade at £4.45. MKS is margined at 10%. We contribute £4,446 as margin requirement and receive interest of £3.17 per day as we are short. Nominal value of the trade is £44,455.50. Profit target is set at £4.00 where we buy the CFDs back. A trailing stop is placed to protect our position set at distance to market of £0.15, trailing step £0.05.
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Speculate - Economic Data SCENARIO CONSTRUCTION SPENDING SLOWS IN 2007 Ryland Group is a US home building company that is sensitive to housing and construction data released in the US. With the economy slowing, it is predicted that official construction spending for 2007 will show a decrease year on year.
HOW TO EXECUTE THIS STRATEGY Opening trade: Sell 1,000 RYL:xnys @ $33.00. Profit target: Place Limit Buy order for 1,000 RYL:xnys @ $31.50. Stop Loss: Place trailing stop to Buy 1,000 RYL:xnys distance to market $0.50, trailing step $0.10.
The Land Department released the figure that showed a decrease of -2.6% for 2007. STRATEGY If Ryland Group is sensitive to this data then a negative Economic Indicator will send the stock down in the short term. The actual result is negative so then we sell the CFD. We set a profit target below the market and cover our position with a trailing stop. COSTS We sell 1,000 RYL:xnys CFDs @ $33.00 upon seeing the release of data. RYL is margined at 10%. We contribute $3,297 as margin requirement. Nominal value of the trade is $32,967. Profit target is set at $31.50 where we buy the CFDs back. A trailing stop is placed to protect our position set at distance to market of $0.50, trailing step $0.10 RISK/REWARD If Ryland Group doesn’t go down at all then our trailing stop would buy back the CFDs @ $33.50 realising a loss of $500 or $0.50 per CFD. If our profit target is reached then we buy back the CFDs at $31.50 realising a profit of $1,500 or $1.50 per CFD.
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Speculate - Index Additions/Deletions SCENARIO WASHINGTON POST ADDED TO S&P 500 On December 19, 2007 Standard and Poor’s announced that Washington Post will join the S&P 500 on December 28. STRATEGY Typically when a stock joins an index fund, managers that track the various indices will need to rebalance their portfolio. This often means that from the date of announcement to the date of official inclusion there will be buying seen in the stock leading up to the inclusion date. Our strategy is to buy on the date of announcement and sell on the date of inclusion.
HOW TO EXECUTE THIS STRATEGY Opening trade: Buy 100 WPO:xnys @ $769. Profit target: Stop Loss:
Place Limit Sell order for 100 WPO:xnys @ $810. Place trailing stop to Sell 100 WPO:xnys distance to market $20, trailing step $2.
COSTS We buy 100 WPO:xnys CFDs @ $769 upon the release of the news. WPO is margined at 25%. We contribute $19,244 as margin requirement and pay interest of $11.76 per day as we are long. Nominal value of the trade is $79,976. Profit target is set at $810 where we sell the CFDs. A trailing stop is placed to protect our position set at distance to market of $20.00, trailing step $2.00. RISK/REWARD If the Washington Post doesn’t go up at all then our trailing stop would sell the CFDs @ $749 realising a loss of $2,000 or $20 per CFD. If our profit target is reached then we sell the CFDs at $810 realising a profit of$4,100 or $41 per CFD.
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Speculate - Mergers & Acquisitions SCENARIO MICROSOFT BIDS $44.6Bn ($31per share) FOR YAHOO. On February 1, Microsoft proposed a takeover of Yahoo for $44.6bn. This equates to $31 per share. Often with such large takeovers there can be rival bids. The press is talking of potential rival bids from News Corp, Time Warner or even AT&T. STRATEGY Whilst Yahoo CFDs trade at a reasonable discount to the proposed $31 per share bid then we buy. If there are no rival bids then we get the difference between where we buy the CFD and $31. If a rival bid is placed on the table then who knows what the upside will be. However, like all M&A activity the regulator may not approve the takeover. Therefore any position is still a risk and should be covered appropriately.
RISK/REWARD If there are no further bids and the Microsoft takeover is approved then we will close our position at $31 realising a profit of $25,000 or $2.50 per share. Should the bid not be approved or Microsoft withdraw their offer then our trailing stop would sell the CFDs @ $28.20 realising a loss of $3000 or $0.30 per CFD. Finally, if there are any further bids then they will need to be in excess of $31, therefore further increasing your profit. HOW TO EXECUTE THIS STRATEGY Opening trade: Buy 10,000 YHOO:xnas @ $28.50. Stop Loss: Place trailing stop to Sell 10,000 YHOO:xnas distance to market $0.30, trailing step $0.05.
Our strategy is to buy on the date of announcement and hold until further information is released. COSTS We buy 10,000 YHOO:xnas CFD’s @ $28.50 upon the release of the news. YHOO is margined at 10%. We contribute $28,529 as margin requirement and pay interest of $43.59 per day as we are long. Nominal value of the trade is $285,290. We do not set a profit target at this stage. A trailing stop is placed to protect our position set at distance to market of $0.30, trailing step $0.05.
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hedge A CFD can be used as part of a hedging strategy to help protect existing stock positions and portfolios. As a CFD is a margined product, you can use its leverage to protect the total value of a stock position without contributing to the total cost. As the remaining amount is financed, you will then be subject to finance costs that you pay for long positions and receive for short positions.
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Speculate - Single Stock SCENARIO Imagine you are currently long 10,000 ABC Bank shares. Its now November 2007 and you expect the bank to have some short-term issues due to the credit squeeze from problems in the US housing market. However, you believe it´s only a short-term weakness and ABC Bank is a sound long-term investment. Initially you bought 10,000 ABC Bank shares at $5.82 back in November 2005 costing a total of $58,200. Currently ABC is trading between $7.20 and $7.40 but with the credit crisis looming you expect to see a significant short-term loss, perhaps as low as where you entered the trade. But afterwards you expect to see support and the share price to rise again.
If ABC does go down as we originally thought, we then similarly close out the CFD for a profit equal to what we lost on the share position. For example, if ABC went down to $6.00 then our profit on the CFD is $14,000 which is equal to the loss on the share position from its level where we created the hedge. The outcome from the hedge is that we will maintain our profit from the point at which the hedge is established whatever way the market moves. When you are comfortable with the market again, simply unwind the hedge.
So what can we do? So far we have made around $16k or approx 27% on our initial investment... STRATEGY Because we don’t know for sure that the market will go up or down, we then decide to hedge our position rather than selling out. To hedge we will sell an equal number of CFDs at the current market price to create the hedge. When we are comfortable that the market has turned, we then close out the CFD position realising a profit equal to the loss on the share position. COSTS We sell 10,000 ABC CFDs @ $7.40. ABC is margined at 10%. We contribute $7,400 as margin requirement and receive interest of $5.27 per day as we are short. Nominal value of the trade is $73,926. We do not set a profit target at this stage. A trailing stop is placed to protect our position set at distance to market of 0.50, trailing step 0.10. RISK/REWARD If ABC does not go down then our trailing stop buys back the CFD at $7.90 realising a loss of $5,000 or $0.50 per CFD. However, we also realise a gain of $5,000 on our share position. Our only cost is the small commission incorporated into the CFD price.
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Speculate - Single Stock HOW TO EXECUTE THIS STRATEGY Opening trade: Sell 10,000 ABC CFDs @ $7.40. Stop Loss:
Place trailing stop to Buy 10,000 ABC CFDs, distance to market 0.50, trailing step 0.10.
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Hedge – Index Diversification Trading an Index CFD is not strictly only a hedging tool. It is equally used as a tool to speculate on a particular index, market or even region. An index CFD tracks the underlying index on which it is created. Currently there are 16 index tracking CFDs available to trade based on major stock indices from around the world. Diversification is an effective way to spread your risk across many instruments. Using an index tracker CFD is an easy way to achieve this, especially for markets that you do not know well.
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Hedge – Index Diversification THE SCENARIO It’s the end of December 2007. You predominantly trade stocks on the German market. Your portfolio is made of up 12 large-cap German stocks and worth approximately €60,000. Again, with the uncertainty around global equities markets, you would like to potentially profit from any downside movements but at the same time you really don’t want to sell your shares because you believe that long term they are all still good investments.
THE COSTS We will roughly trade approximately €10,000 for each position. For this example the following trades were executed on the December 28th and then revaluated on the February 5th:
THE STRATEGY You believe that over the short term most global stock markets will fall. However, as you don’t regularly trade markets outside of Germany you don’t know which stocks to pick. Plus you cannot short-sell stocks. So the strategy is to sell a number of Index Tracking CFDs. You decide to sell FTSE100, NASDAQ, S&P500, Dow Jones and DAX® Index Tracking CFDs.
Ope ning TTrade rade Opening
Volume ncy Volume Curre Currency
Price Price
Margin ReReq. q. Nom. Margin Nom.Value Value
Margin Re q.
Price 0 5
€
FFeb. e b 22008 0 0 8 Value € ¤ Value
Margin Req. Nom NomVal Val€ ¤ ¤
Price 05
Curre nt
Current
Profit / L oss ¤€ Profit/Loss
% %Change Change
Se ll FT SE100. I
1 G BP
6469
323
6, 469
433
8, 668
5884
7, 885
784
9%
Se ll NAS100. I
6 U SD
2106
632
12, 636
439
8, 775
1775
7, 396
1, 379
16%
Se ll SP500. I
8 U SD
1477
591
11, 816
410
8, 206
1337
7, 428
778
9%
Se ll DJ I. I
1 U SD
13354
668
13, 354
464
9, 274
12270
8, 521
753
8%
Se ll DAX. I
1 EU R
8058
403
8, 058
403
8, 058
6706
6, 706
1, 352
17%
2, 149
42, 981
5, 046
Index Tracking CFDs are margined at 5%. The margin requirement is what you contribute towards the trades.
This is the total market value of the trades in euro.
Your profit on February 5th
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Pair Trading Originally pair trading was developed by a group of quantitative analysts working for Morgan Stanley in the 1980s. Pair trading has the potential to achieve profits through simple and relatively low-risk positions. The pair trade is Market-Neutral, meaning that the direction of the overall market does not affect its performance. The idea is to pick price ratio diverges between two highly correlated stocks. These stocks are usually the same type of business, industry or sub-sector. Plotting the two stocks on a comparative chart shows you everything you need. Lets look at BP and Shell.
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Pair Trading - the entry THE SCENARIO We can see both BP and Shell plotted on a comparative chart. Most of the time the two stocks trade in a relatively similar pattern. However, for varying reasons, time to time they diverge. History will tell us that on most occasions the two stocks will return to trading in a close range.
THE COSTS & HOW TO EXECUTE We buy 17,466 BP:xlon CFDs @ £5.72. We sell 4,908 RDSb:xlon CFDs @ £20.36.
THE STRATEGY Upon seeing such a divergence as in the example given here, we will buy BP CFDs and sell Shell CFDs. We will close the positions when we see the two stocks return to their normal pattern of similar trading.
RDSb is margined at 10%. We contribute £10,003 as margin requirement and receive interest of £7.11 per day as we are short.
BP is margined at 5%. We contribute £5,000 as margin and pay interest of £22.80 per day as we are long.
Nominal value of the BP position is £100,005.08. Nominal value of the Shell position is £100,025.04.
By also trading the CFD we gain the benefits of leverage that give us greater exposure. As the CFD is margined, we are only required to contribute the margin amount to establish and maintain the positions. Our strategy will take a £100,000 nominal stake in each CFD.
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Pair Trading - the EXIT RISK/REWARD The risk in this strategy is in both stocks moving against us. This is generally not the case. However, your analysis of the pair will determine your risk appetite for the trade. THE EXIT As you can see in the chart, 14 trading days later the two stocks converged marking the exit to this strategy. There is no automated way to monitor the convergence therefore you will need to monitor your positions. We sell 17,466 BP:xlon CFDs @ £5.735. We buy 4,908 RDSb:xlon CFDs @ £19.52. The profit on the BP position is 0.015 per CFD or £261. The profit on the Shell position is £0.84 per CFD or £4,122. THE RESULT Therefore the total profit after 14 trading days with relatively low risk is £4,383.
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STOP LOSS orders There are two widely used types of order called a Stop Loss. They are used as a form of protection when trading all kinds of instruments and as the name suggests, they help to stop the loss. It is important to know the difference between the two and how you can use the order types as part of your regular trading activity. Throughout the CFD trading strategies, trailing stops are almost always used to protect the positions entered into.
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STOP LOSS ORDERS STOP LOSS The simple stop loss is straight forward. You place a regular order to buy or sell with an extra parameter known as the stop level. The order is then called a stop order. The stop level is like a trigger. When it triggers, your order is executed for you at market. Below is an example of stop order written out in a logical format:
S im p le
S to p L o s s
8
7 .5
S to c k p ric e
7
6 .5
6
IF THE LAST PRICE IS LESS THAN OR EQUAL TO $5.50 THEN SELL 5,000 AT MARKET
S t o p L o s s L e ve l 5 .5
5
In this example, the stop level is $5.50 which we specify when creating the order. If this was an order to close, ie. to protect an existing position, then we could manually move our stop level up as the price moved along.
m1 m2 m3 m4 m5 m6 m7 m8 m9
m10 m11 m12 m13 m14 m15 m16 m17 m18 m19 m20
The chart shows how a stop loss order looks in relation to the price movement of the underlying instrument. We opened a position at $5.80 and set our stop $0.30 below the entry at $5.50. Unless we manually move the stop level, should the price start to move down, we could then potentially give up all that profit back to the market. Whilst this may protect our initial investment it does not effectively protect any profit that we have made. To manage your stop loss more efficiently you could use a trailing stop loss.
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trailing STOP LOSS The trailing stop loss is a little different. It attempts to move up (or down depending on how you use it) your stop level in an effort to protect your profits. It achieves this by having two new properties on the order called the distance to market and trailing Step.
In our example chart you can see how this works. Eventually the price goes through our stop level and our trade would have been triggered. The result is that not only do we protect our initial investment but we also manage to keep a good proportion of the profits.
Put simply every time the market moves X points (either up or down but not both ways), the trailing stop level will be amended to Y points below the current market price.
Its important to work out appropriate distances to market and trailing steps for these types of order. For example it´s no good placing your stop level too close or too far from market. A good way of determining your levels is to use the AVERAGE TRUE RANGE indicator on a chart.
So, as an example, the initial logic statement for our trailing stop loss would be:
T r a i l i n g S to p L o s s
SET TRAILING STOP TO SELL 5,000 AT MARKET WITH DISTANCE TO MARKET $0.30, TRAILING STEP $0.50 Which is then interpreted as, place a stop loss at $0.30 below the current market price and then each time the price moves up $0.50 move the stop level to $0.30 below the current price.
8
7.5
S to c k p ric e
7
6.5
6
E x it
S to p L o s s L e ve l
5.5
5
m1 m2 m3 m4 m5 m6 m7 m8 m9
m10 m11 m12 m13 m14 m15 m16 m17 m18 m19 m20
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