Using CFDs to trade Small Caps

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CFDs on the small caps can behave very differently from those based on the blue-chips, and so require different strategies.

Nick 'Sudbury looks on the practicalities of trading small caps.

There was a time when CFD providers focused exclusively on the large cap UK shares, but it is now possible to use these instruments to access far smaller stocks. As far as the investor is concerned, the mechanics of placing the trade will be exactly the same regardless of the size of the underlying company. In practice, though, the behaviour, costs and risks of these exposures are so different that it will affect the nature and viability of the positions.

Using CFDs to trade Smaller Stocks

Most quote-driven CFD providers limit their UK equity coverage to the constituents of the FTSE 350 index. Broadly speaking this encompasses those companies with a market cap in excess of £360 million. These are all order-driven stocks traded on either the SETS or SETSmm platforms.

Salim Sebbata, senior director of retail at E*TRADE Securities, says that brokerages tend to focus their product offering on the top 350 stocks because liquidity and volatility play a key role in being able to hedge any exposure. ‘Quote-driven (SEAQ) stocks are less liquid, have a smaller market size of trades and tend to have higher than average volatility. A combination of these factors and a fast, volatile market influence brokers to focus on offering only the most popular quote-driven CFDs,’ he says.

Investors who may want to use CFDs to trade smaller stocks will need to look for a service that goes beyond the FTSE 350 universe. One such is CMC Markets, which has recently extended its coverage and now provides prices on the top 690 companies listed in this country.

James Hughes, market analyst at CMC Markets, says investors tend to take longerterm positions in the smaller stocks. ‘It could be that people are more familiar with the FTSE 350 constituents and feel they know how the prices move, which makes them more comfortable taking shorter-term positions. Maybe they are more cautious with the small caps and tend to adopt more of a buy-and-hold strategy with them.’

Those with the experience to be classified as intermediate clients have the option of signing up to a direct market access (DMA) CFD service. With these it is possible to trade most order-driven stocks on the SETS and SETSmm platforms. The former covers the constituents of the FTSE 100 and the largest companies in the FTSE 250, while the latter applies to the remainder of the mid caps, together with the FTSE Small Cap universe.

The upshot is that DMA services, such as those from IG Markets and E*TRADE, allow clients to access most UK shares with a market cap of over £10 million. This could amount to anything from 450–690 stocks, depending on the firm in question.

The Practicalities

Mike Estrey, head of research at Blue Index, says its advisory CFD service mainly concentrates on the constituents of the FTSE 350 and only occasionally would it look at a small cap opportunity. ‘The spreads are wider and the margin is higher on the small caps. There could also be liquidity problems if someone is trying to take a big position in a small stock,’ he says.

Equity CFDs are generally priced to match the underlying shares, with the only costs being the market spread, a flat-rate or percentage-based commission, and interest on long positions held open overnight. The key point for traders is: the smaller and less liquid the stock, the wider the spread. For example, the bid/offer spread on Vodafone is a fraction of a penny, whereas on the similarly priced small cap Creston it is 2p.

Tim Hughes, head of sales trading at IG Index, says the wider spread on a small cap means the break-even point for a trade is further away. ‘This forces people to take a view on the stock. It will often be the case with companies such as these that little will happen for long periods of time, then a news item will move the shares sharply higher or lower.’

These long-dormant periods and the thinness of trading can create problems when it comes to using the charts to spot opportunities. Robert Newgrosh, who runs the New Skills technical analysis training courses, says one of the best ways round this is to use point & figure. ‘If a share price is unchanged for a long period, point & figure will automatically cut out all this dead time. The methodology only relies on the closing prices and this can make it more reliable than the bar charts, where intra-day gaps created by the lack of liquidity can easily result in false signals,’ he says.

One of the most bullish signs, according to Newgrosh, is where a small cap makes a new all-time high. He says that with a blue chip this could just be because of strength in the index as a whole, whereas with a small stock it is much more likely to be because of some fundamental change to the business.

The Risks of trading Small Caps

CFD providers have bigger margin requirements for the small stocks to reflect the higher volatility and lower liquidity. Typically with the blue chips the deposit will only be around 3% – 5% of the nominal exposure, while with a small cap this will normally be 10% or more. One consequence of this is that it will automatically serve to reduce the size of the position that a trader could take.

IG’s Hughes says that the small caps are riskier, but the corollary is that those who get the trades right can make higher returns. ‘An investor needs to manage this risk through a policy of diversification and the appropriate use of stops. Stops can however be a double-edged sword because of the problem of knowing where to put them, especially since the small caps can whip around a lot more than the large caps.’

Probably the most common mistake with a stop is to put it too tight and see the trade closed out prematurely by the normal market noise. The easiest way around this is to reduce the position size and move the stop wider so the maximum potential loss remains the same.

James Hughes says that it is important to give the position time to move. ‘One of the best ways to do this is to use the support-andresistance levels, with the stop going just below the area of support or just above the resistance.’

DMA Opportunities on the Small Caps

Tim Hughes says that there are liquidity constraints on the small caps compared with the large caps. ‘Those who use DMA can trade as much as they can find a willing counterparty for. The more cautious approach, however, is to limit the trade size to the normal market size, as otherwise investors could run into difficulties when exiting a position.

DMA allows individuals to place buy and sell orders on the central limit order book of the LSE, which means they can trade directly with other market participants. The beauty of this is that it gives people access to the full liquidity of the market, with orders matched on a price and time priority.

Sebbata says that the benefits of using DMA will differ, depending on whether someone is trading a FTSE 350 stock or a small cap. ‘DMA small cap stocks, specifically SETSmm stocks, have wider spreads, and this can be very attractive to investors. It gives them the ability to make a price and trade inside the spread without the stock necessarily moving – hence booking a profit.’

If a small cap stock is trading at 200–206, someone using a traditional stock broker or a quote-driven CFD provider would have to cross the spread by buying at the offer of 206 and selling at the bid of 200. On a round-trip trade of 5,000 shares this would cost £300. Traders with DMA could instead try to improve on this price. Rather than buying immediately at the offer of 206 they could enter buy orders on the book at the favourable price of 201. This would make them the best bid in the market and put them at the top of the order book, with a good chance of a highly favourable fill saving 5p a share. Someone looking to sell the stock could equally put on a sell order at 205 for a similar potential saving.

‘DMA investors also have the ability to take advantage of auctions scheduled at the open and close of the market. These are often seen as the most volatile and liquid periods of the day, and trading smaller cap stocks makes this feature even more appealing,’ says Sebbata. Stocks traded on the SETS and SETSmm platforms start each trading day with a premarket auction between 7.50am and 8.00am, and end it with a post-market auction from 4.30pm to 4.35pm.

Participation in the auctions is restricted to those with DMA. Orders placed during these periods appear on the Level 2 screen, along with the indicative uncrossing price updating in real-time as calculated by the LSE. This is the price that would enable the maximum volume to be executed where a stock is crossed, namely where a buy order has an equal or higher-priced sell instruction. No order execution actually takes place during the auction, instead all crossed trades go through at the final official uncrossing price as soon as the auction period comes to an end.

Sometimes, a liquidity imbalance arises during the auction that offers the potential to be filled at a significantly better price than is available intra-day. This is especially true for a small cap that issues results that differ significantly from expectations ahead of the start of the opening auction.

Brought to you in association with MoneyAm Shares Magazine