CFD Trading Strategy

To come out on top in the fast-moving world of contracts for difference you need a trading strategy.

If CFDs are so good, why doesn't everyone trade them?

The biggest obstacle is lack of product knowledge and investor understanding. But that's changing as investors become increasingly market savvy - and that is why CFD brokers are witnessing a huge migration of investors from traditional share buying.

Sophisticated investors are also turning to CFDs for their risk management and tax planning. A short CFD position can remove or reduce portfolio market exposure risk without the loss of voting rights by hedging an existing long share position. Tax planners can trade against existing profitable holdings, selling CFDs to lock in a profit on an equity holding without incurring a tax liability.

As with any form of investment, there is a risk attached and it is possible to lose as well as win. That is where a trading strategy comes into play.

After 17 years trading financial markets I have learned that the one thing all consistently winning traders have in common is a strategy. They all stick to a strict set of rules, taking the emotion out of their decision-making.

Traders should stack the odds in their favour before making a trade. That means spending some time analysing their trading style and mindset, as well as the markets. Some CFD firms offer investors a free suite of tools and seminars designed to assist help. Only once these crucial elements are conquered is an investor ready to trade. Whether using traditional shares, spread bets or CFDs, they will stand a much better chance of staying profitable.


Dow versus FTSE (Dow minus FTSE)

CFD Trading strategy

So how do active CFD traders make money? Unsurprisingly the majority continue to trade as they did while investing in shares through their stockbroker. The majority of trades are indisputably 'buys'.

But an increasing number are using CFDs to their true advantage, selling shares as freely as they previously bought. In this group are a growing band of traders who have discovered one of the most successful methods of CFD dealing: pairs trading.

Pairs trading is a tried-and-trusted method of low-risk and highprobability gains - an arbitrage technique balancing a long trade versus a short trade. Traders buy one stock, future or other financial instrument and simultaneously sell another. By anticipating a divergence or convergence in price between two instruments, pairs trading offers traders the chance to adjust their risk tolerance to the trade.

A risk-averse pairs trade would be a same-sector pair, perhaps buying Vodafone (VOD) while selling mmO2 (OOM). The expectation in this example is that the price of Vodafone will rise relative to the price of mmO2. By pairs trading, a trader reduces exposure to large market moves, in this case a big move in the FTSE 100. In a crash situation, both shares could be expected to fall by a similar percentage, thus exposing a CFD trader to just the convergence or divergence between the two stocks.

A trader with higher risk-tolerance levels would make a more aggressive pairs trade, perhaps trading shares from different sectors, different market caps or even different exchanges.

A recent example of an aggressive pairs trade is the FTSE100 versus Dow Jones index pair. Historically, these markets move in broad unison, swinging around a point of balance. But several times a year the diversity of factors that individually affect each index stretches and skews this perceived equilibrium point.

When this happens, the blue-chip indices start a divergence process that can last for weeks at a time. This is where aggressive pairs traders make huge gains.

Looking at the chart shows the recent example of this divergence. Back in September, we saw the first sign that divergence was occurring and that an arbitrage pairs trade was on the cards.

Note that the Dow Jones index has plummeted by 170 points whereas the UK's market has escaped relatively unscathed.

A collision of events simultaneously sparked a rift between major stock markets. But why? Following the summer's rapid rise, both markets were drastically overbought and were both ready for retracement downwards. But unlike the Dow, the FTSE made very little downward retracement.

Pairs traders took their cue to sell the Dow and buy the FTSE as a CFD pairs trade, expecting the trend to continue. Marked in blue, the chart plots the difference in value between the Dow and the FTSE, or in other words Dow minus FTSE. See how the bear channel knocked off more than 600 points between the two indices: pairs traders made big profits from this aggressive trade.

Having said that, traders had to be quick on their feet. A break of the trend saw the divergence whip back up as the two markets started to converge again. CFD traders had to keep a razor-sharp lookout for this sudden change in direction, with many unwinding their positions and reversing again.

Clearly this is a trade only suitable for those traders who are comfortable with risk and are able to spend a great deal of time watching and trading the markets. For most of us, a good way to start pairs trading is same-sector individual stocks. But once you start with pairs, who knows where it will take you.