Contracts for Difference - Sector CFDs

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Sector CFDs

A sector index offers the opportunity of harnessing the rewards of a long-term trend without the same degree of intraday volatility encountered when trading in individual stocks, says Nick Sudbury.

The growth of the FTSE 100 over the last year has not been uniformly reflected across all parts of the market. In fact the gains have largely been driven by the heavyweight oil, and mining stocks, with these areas also leading the recent sell-off. This marked disparity in performance reveals something of the potential for trading the different sectors.

In the UK, the sector indices are based on the FTSE 350, which covers 96.8% of the All-Share index by market capitalisation. The classification system was changed recently so that the industry groupings now comprise 18 highly tradable real-time 'super-sector' indices, together with a number of sub-sectors.

One of the most transparent ways to trade these indices is via a sector CFD. These make it possible to capitalise directly on the key macro economic trends in the market.

The super-sector indices include popular areas such as banks, oil and gas, technology and retail. Traders need to be mindful, however, that some of these give a more diversified exposure than others. For example, while the automobiles & parts sector only contains one or two companies, general retail and support services each have more than 20.

The Hot Money

There is no doubt that in the last 12 months much of the hot money has been backing the mining companies. These businesses have prospered thanks to the insatiable demand of the Chinese economy for raw resources. In the UK this has made mining stocks such as Anglo American (AAL), Antofagasta (ANTO), BHP Billiton (BLT), Rio Tinto (RIO) and Xstrata (XTA) some of the most popular to trade and helped the sector to dominate the broader index.

Tom Hougaard, chief market strategist at City Index, says that sector indices offer certain advantages over the individual stocks. 'The obvious benefit is that they diversify the stock specific exposure and replace it with a pure sector position,' he says. 'Essentially, it is a question of evaluating the risk-reward trade-off. At City Index, for example, we have seen more interest in the mining sector than we have in the individual constituent stocks like Rio Tinto.'

David Jones, chief market analyst at CMC Markets, says that a sector CFD allows traders to take a longer-term view than certain other instruments. 'The sector indices tend to produce smoother trends with less volatility than individual stocks and this can make it easier to manage the position,' he says. 'Taking a longer-term view based on a top-down analysis can make a lot of sense.'

Long-Term View

The beauty of trading a sector is that the trends can be both long-term and substantial. Over the course of the last year, for example, the FTSE 350 mining sector has been in a strong upwards trend that has taken it from around 8300 last May to a peak of over 17000. In practice, most people would operate on a far shorter timescale but to run a trade like this entails using a smaller position so as to allow for a wider stop.

Another strong area has been oil and gas. With supply side pressures forcing up the underlying prices, the companies operating in this field have seen their profits rise substantially. A number of traders have decided to take advantage of this, using the sector index rather than trying to pick out an individual stock. This gives a more diversified exposure to a portfolio of companies including BG (BG.), BP (BP.), Burren Energy (BUR), Cairn Energy (CNE), Premier Oil (PMO) and Venture Production (VPC). Over the last 12 months the oil & gas sector has risen from 6300 to almost 8500, although in recent weeks it has given back some of these gains. At the time of writing City Index were quoting the relevant CFD at 7662 - 7701.

Galvan Research and Trading is an advisory broker that specialises in CFDs. Andrew Gibson, the firm's head analyst, says that a key advantage of the sectors is the low intraday volatility since this means smoother returns. 'Someone running a trend will find that this makes it easier to use a trailing stop, since there is less chance of the position being prematurely stopped out,' he says.

Gibson is, however, concerned about the level of interest in mining and oil companies and says that it reminds him of the tech bubble in 2000. After months of speculation in these areas it looks like the bubble may have finally burst. There is certainly no doubt that the hot money has transformed the sector returns and made them extremely volatile. On 12 May, for example, when the FTSE fell 130 points, the mining sector dropped 4.2%. In early trading on the following Monday morning it was down a further 6%.

The Importance of Research

Mike Estrey, head of research at Blue Index, says that one of the merits of trading sectors like oil and gas is that the constituents tend to behave in a uniform manner.

'The downside is that some of the sectors have quite wide spreads. So for a Fixed Line Telecoms exposure, it would be cheaper to simply trade BT, especially since the company's dominance of the sector means the two are very highly correlated anyway,' he says.

This further underlines why it is important for anyone planning to trade the sectors to do their research beforehand. In particular, being cap-weighted like the main FTSE index means there is the potential for a few large companies to totally dominate the performance, as is the case with GlaxoSmithKline (GSK) and AstraZeneca (AZN) in the pharmaceuticals sector.

One problem, according to Gibson, is that because the sector indices comprise so many different components, it is very difficult to conduct any fundamental research on them.

'The banking sector, for example, contains Asian-dominated companies such as HSBC and international businesses such as Barclays and RBOS, as well as the largely mortgage-based UK banks, all at different weightings,' he says. 'This makes the fundamentals pretty hard to assess, so people can only really trade them technically.'

The flipside is that the sector CFD takes away the headache of having to make a stock selection decision. For example, retail is strong at the moment so if a trader didn't know whether to buy M&S (MKS) or GUS (GUS), they could simply buy the sector instead. The trade-off is that the cost will be higher, since even in the cash market the spread on the sect-or of 2531 - 2536 exceeds that on the shares (GUS in this case) at 1071 - 1072.

'It is all to do with the liquidity, so traders need to weigh up the extra cost of the less liquid sectors against the benefit of achieving the exposure that they want,' says Estrey.

Providers, Contracts and Costs

Sector CFDs are only available from a handful of providers. At City Index, each contract gives an exposure of £1 per index point and the margin requirement is 7.5%. The company arrives at its prices by adjusting the current spot price - which is calculated once per minute through the day by FTSE International - down by 0.2% for the bid and up by 0.2% for the offer.

With City Index quoting the mining sector CFD at 17350 - 17415, margin funds of £4,000 would allow the purchase of three contracts for an exposure of £52,245. If over the next four days the sector strengthened with the quote at 17600 - 17670, the position could be closed for a profit of £555 before financing costs of around £30.

CMC Markets quote 19 UK sectors all at an extremely competitive 1% margin. The company also covers ten of the most volatile US sectors such as biotechnology, semiconductors and systems software. It is unusual to offer overseas sectors but these high beta segments of the US market attract a lot of attention.

'The US sectors tend to be of interest to people who are looking to identify trends and then run them for as long as possible,' says Jones. 'For example, in the last few months the US Banking sector has broken out to multi-year highs and this is a very positive signal that people may look to exploit.'

The spreads on the UK and US sectors are broadly the same. At the time of writing, CMC were quoting the UK Banks CFD at 10512 - 10537 and the US Banks at 382 - 387. Neither City Index nor CMC charge commission - the only costs are the bid-offer spread and the daily financing at LIBOR, plus on long positions held open overnight. By contrast, Barclays Stockbrokers levies a flat rate commission charge of 0.2% on all its sector CFDs.

Combination Trades

One of the advantages of CFDs is that they allow traders to take out both long and short positions. This opens up the possibility of using the sector contracts in more sophisticated combination trades.

Hougaard says that a long-short combination of two sectors, or a sector versus a market, or sector and constituent are best suited to technically-advanced traders.

'If a trader identifies a statistical advantage from some such combination then the CFDs will allow him to take out both the long and short positions,' he says.

A cross trade going long on general retailers and short on banking will generate a profit as long as retail outperforms the banks. Matching the monetary exposures will mean that the combined position will not be affected by general factors that impact on each of these sectors in the same way. In one sense this means it can be thought of as a partial hedge with the cost being the double spread but it is in no way risk-free as the worst scenario would be for both positions to make a loss.

'A long-short combination would probably work best in the event of something like a change in interest rates. If rates were increased, it would be detrimental for the cyclical sectors - someone could potentially short the techs and go long in a defensive area like drugs,' says Estrey.