Contracts for Difference (CFDs) Questions and Answers

Q.A: Can you suggest me a CFD provider that provides GSLO's?

A: Well, for one there is IG Markets as you can clearly see where your GSLO is set. The only drawback is that sometimes IG Markets won't allow you to move the GSLO up when you want to.

CMC Markets also provide a Guaranteed Stop but I've found it difficult to use as there is no obvious record of it other than the transaction number they give you. That might have been changed since I last used it.

Q.B: I have been reading your site, but remain unclear on your recommendations for determining position size using CFDs. How do you calculate a position size when using these products?

A: The problems with leverage surround traders' improper use of it. The seemingly typical approach of traders who are new to CFDs is to put $10,000 into an account and promptly buy $100,000 worth of stock in the belief that the position merely has to increase by 10% and they have doubled their original equity.

What generally happens is that the market drops by 15% and they end up owing the CFD provider $5,000 in addition to losing their entire $10,000. This occurs because most traders cannot listen to the market and let the market tell them what to do.

Leverage is most sensibly applied as a means of pyramiding and only then when you use a GSLO.

Let me answer this by asking - what is the total size of your portfolio? and how do you aggregate your positions for performance review? If you have 100k to trade then how you apportion it is largely irrelevant to the overall position sizing since position sizing works off the value of the portfolio.

Q.C: I am somewhat confused regarding profit-taking on CFDs.

A: It is precisely the wrong thing to do. I would suggest that if you have an extremely limited trading bank that trading leverage is not for you since with leverage it is possible to lose more than you put in.

From a trading perspective taking small profits may make you feel good but will most likely end up with you going broke. This will occur for one of two reasons.

1. The psychology that drives us to take small profits also prevents us from taking small losses. The sort of trading system that takes small profits generally also takes large losses.

2. The profitability of trend following systems is dependant upon large outsized gains to make up for the large number of small losses that are generated by a disciplined system. Within these large outsized gains the systems eventually decays because of the larger number of losing trades and the transaction costs within the system.

You need one or two very large wins during the course of a year to make the system profitable.

Q.D: I have $5000 in capital. My 2% risk is $100. I want to buy stocks at $25 & my GSLO is $24.50 so my risk is 0.50c per share?

A: In normal circumstances using a GSLO the margin will be your risk amount in this instance $100 so you can buy 200 shares. $100 risk/$0.50 stop = 200 shares.

However IG markets insist that the GSLO being 5% away from your entry price so your stop would need to be $1.25 away from your entry. This would mean that your position size would be $100/$1.25 = 80 shares.

Q.E: I was always under the impression that CFD providers hedge their risk for a given share position by buying/selling the underlying instrument in the real market.

A: Hedging can be achieved in a variety of ways. Firstly either as a direct counterparty transaction - you go long one they go short one. Or it can be done on a book basis whereby a global view is taken as to whether the firm is long or short and this can be hedged more easily via a derivatives market such as a futures market.

Q.F: I have been looking into a CFD account, but after reviewing some packages from various vendors, have decided against them. My main concern is that the interest is charged on the full amount.

A: You also need to take into account -:

1. Dividends received over the time - the average long term yield on the ASX 200 for instance is about 4% to 5%.
2. You are credited interest when you go short.
3. FX trades can be established so that they are free carry trades - you are paid to hold the position. For example if I were long AUD/YEN I would be paid around 3.5% interest simply to hold this position. In the past three years holding the $A would have generated large cash inflows because of our relatively higher domestic rates.
4. When you are long on an index you receive a pro rata dividend for each stock within the index that goes ex dividend.
5. A capital protected margin loan will cost you between 15% to 30% pa.

Another benefit is the Guaranteed Stop Loss. You have to pay to use it, but once your stop is set, you don't have to worry about slippage or watching your trade during trading hours to see if you need close out your position. These benefits are harder to quantify but are definitely a plus in my books.

Q.G: If you don't have enough capital to trade, then boosting it through CFD leverage seems to be ignoring good money management in my view.

A: From personal (limited) experience, I can say that this is not necessarily true. I trade with money management parameters of maximum value at risk of 5% and initial position size of 0.5% risk (a very conservative number but one which allows me to sleep at night), and about a month ago came across a situation where many of my long positions were closing in on my stop losses so my total value at risk was well under 5%, so by my trading plan, I was able to open new positions. However, all my funds were tied up in physical shares. Using CFDs, I was able to open additional positions whilst still staying within my risk profile (including one which is rapidly turning into the second big winner in my portfolio).

Yes, these long positions are more costly than owning real shares, but having no position at all would have been worse.

Q.H: If you are paid a pro-rata dividend for each stock in the index that goes ex-dividend when you are holding a long position in the index, does it follow that you have to pay a pro-rata dividend for each stock in the index that goes ex-dividend if you are holding a short position in the index?

A: Yes - dividends are debited from your account if you are short the index.

Q.I: Leverage and Risk - I have been trading CFDs for six months and have found it hard to minimise risk whilst leveraging.

A: I think a more productive approach is to allow the funds within the trade to grow by pyramiding - the approach you are currently using will place you in danger of losing a substantial portion of your funds should you have a series of cascade losses.

For example 5 losses in a row will drop your account 20% which will require a 25 % return on your remaining capital to return you to your point of origin.

Pyramiding with GSLO's allows you to add capital to a position in "relative safety" - by doing this it is also possible to explore some very creative pyramiding strategies.

Q.J: I have been told to not touch stocks trading under 500,000 daily due to liquidity issues.

A: I can't comment on the CFD aspects but, in general, I'd recommend you stick to using average daily volume as your liquidity filter. Short-lived volume spikes could exceed your filter value at some stage, tempting you to take the trade. However, you also have to think about the other side of the trade, as well. What's to say that, after all the excitement, volume levels decrease back to their normal levels leaving you trapped in an illiquid stock/CFD?

Another way you could look at the problem is to use average daily $ turnover (volume*price), rather than straight volume. You could then set a liquidity filter using some set multiple of your average trade size (e.g. if my average position size is $10,000 I may not want to trade stocks with an average daily turnover of less than $100,000, i.e. 10X my average position size). This should ensure that, on any given day, there should be enough liquidity for you to exit your position.

Q.K: If one has never shorted a stock is it worth setting up an account with a full service broker to achieve this end - or nowadays - can one skip straight to using CFDs for this purpose?

A: If you are confident in your system and confident in your ability to handle leverage (you don't bite of more than you can chew) I don't see a reason why you wouldn't move to cfd's.