Contracts for Difference and Volatile Markets

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Trading CFDs in Volatile Market Conditions

Volatile market conditions are the order of the day and CFD traders need to adjust. Nick Sudbury goes to defcon three.

Anyone who follows the markets will be all too aware of the recent upsurge in volatility. One way that this has manifested itself is in a big increase in the typical daily trading ranges. Throughout August for example it was perfectly normal for the FTSE and the Dow to move by well over 100 points during the day.

To put this into perspective, the VIX - an index that uses options to measure the implied volatility of the S&P 500 - recently leapt up to 30. This can be interpreted as meaning that the market is expecting the S&P to end up in a year's time somewhere within the range of +/- 30% of its current level. Broadly speaking this is equivalent to a daily range of +/- 2%. During the first part of the summer the VIX had been trading at around 10, which amounted to an expected daily range of just +/- 0.6%.

Salim Sebbata, senior director, UK retail at E*TRADE, says that when traders see wild swings in the market, the first thing they should do is review their leverage. 'If they determine that they can sleep at night, then they are comfortable with the amount of risk they are exposed to. Volatility calls into question how much risk someone is willing to carry, and the rather unscientific sleep factor is a good barometer of risk tolerance.'

Adjusting for the extra volatility

Higher volatility creates both risk and opportunity. It is important, however, for CFD traders to adjust their approach. Those that do this may be able to exploit the larger price movements, while those that don't will run the risk of their positions being repeatedly stopped out by the heightened market noise.

Mike Estrey, head of research at Blue Index, says it has taken into account the extra market volatility and adjusted the recommendations of its advisory CFD service accordingly. 'We have widened the stops and reduced the position sizes. The overall effect is to reduce the chance of getting whip-sawed out of a position, while keeping the same level of risk, namely the same possible loss.'

The second precaution that Blue Index has taken is to make sure its recommendations are carefully balanced on longs and shorts within each of the major markets. This strategy has the benefit of making the overall portfolio market-neutral so that the return is not dictated by the direction of the intraday index movement.

Being market-neutral eliminates an important source of risk but it is not the same as a hedge. The reason for doing it is that the performance of the resulting long short portfolio will be driven by the stock-specific element of the returns. This means that, if the short positions fall in value relative to the long positions, then the investor will make money. However, if the shorts gain relative to the longs then the portfolio will return a loss.

Tim Hughes, head of sales trading at IG Index, says that sizeable market-neutral positions would need to be actively managed to avoid any inadvertent exposures. 'If the market goes against a long position, the size of the resulting exposure falls, whereas if the price rises against a short, the exposure and the resulting risk would both increase. Given the extent of the recent price movements, it is important to manage the trades to ensure the longs have the same monetary exposure as the shorts, otherwise the portfolio would no longer be market-neutral.'

Hedging investment portfolios

A long-term investor who has built up a substantial share portfolio can protect it during times of market weakness by using index CFDs. These offer a flexible way to hedge the exposure and so avoid the risk of heavy losses without incurring the costs and potential tax consequences of selling the underlying holdings. The idea is that any loss on the portfolio would be broadly compensated for by the gain on the CFDs.

Take the example of an investor with £100,000 in a wide range of blue-chip UK equities. By shorting the FTSE 100 index CFD it is possible to engage a broad hedge against the value of the portfolio falling, says Martin Slaney, head of Spread Betting at GFT Global Markets. 'If the December FTSE is quoted at 6,100 to 6,104, selling £16 a point [16 CFDs] at 6,100 equates to a consideration of £97,600. If the index then fell 100 points, the investor would be able to buy back the FTSE contract at 6,000. The CFD trade would have made £1,600 profit, which is approximately what the portfolio would have lost over the same market move,' he explains.

Index CFDs are priced from the associated futures contract with the provider adding an extra spread to the underlying quote. At GFT for example the cost of the FTSE 100 CFDs is four points. The typical margin requirement is around 4%, which in this case would amount to £4,000, although many investors prefer to hedge only a proportion of the portfolio.

Slaney says it's often difficult deciding on the exact timing of when one should engage such a hedge-type trade. 'One strategy adopted by some of GFT's customers, which helps remove the emotions often attached to such a decision is to use a trailing stop entry order. A sell order left to trail the FTSE no more than, say, 100 points below the current price will follow the market to the upside but will only be filled as a trade when the market suffers a major drop down. This misses the initial move but protects against any further falls.'

Exploiting the volatility

Estrey says the extreme volatility has created a number of opportunities. 'One or two of the defensives, such as BT (BT.A), fell too far, as did some of the mining stocks. A long-term investor could pick up some real bargains. The question for leveraged CFD traders is: are they are prepared to risk being stopped out a few times as the shares fall further before they can capitalise on the expected recovery?'

One interesting example that Sebbata noticed was how large-cap technology stocks in the US were more resilient than financial services stocks. 'Some people have been playing this divergence [using a pairs trade]. Direct market access gives traders quicker executions that might cost a little more than quote-driven CFDs, but in many instances the potential upside makes up for the additional cost,' he says.

An important pattern that has emerged in recent weeks is the trend for the Dow to experience large reversals late in the session. 'Quite often we have seen the Dow trading significantly higher or lower two-thirds of the way through the day, only for it to experience a reversal near the close. At IG Markets we call this the eighto'clock bounce,' says Hughes.

An hourly chart of the Dow reveals significant late reversals took place on 17, 18, 20 and 25 July and on 13, 15 and 16 August. The magnitude of these moves is such that CFD investors with leveraged positions need to decide how they are going to handle them.

Someone with a profitable position opened earlier in the day, who wanted to try and keep the exposure overnight, would need to actively manage the position of the stop loss. By successively moving this up behind the price increases on a long position, or down following the falls on a short, the investor would be able to lock in the majority of the gain. This would allow an attempt to maintain the position while guarding against a late reversal turning the profit into a loss.

It is also possible to trade the reversal itself. An investor in the UK could look at the Dow at around 7pm and decide at that point whether the trade was on. If so, an automatic order could be left to open a position so as to capture the anticipated move. For example, if the Dow was down on the day, an investor who anticipated a late reversal could enter an order to buy should the price recover to hit a specified higher level. A good-untilclose order would automatically expire if the index failed to reverse sufficiently to trigger the trade.

James Hughes, market analyst at CMC Markets, says traders have to adjust their approaches for the volatile conditions. 'When markets are chopping around a lot it makes sense to use support and resistance levels. What makes these so good is that they work in both the short term and the long term.'

When looking for key support and resistance levels, traders will tend to start with the longer term chart. They will then shorten the time interval and focus on the more immediate data to try and refine their entry and exit points.

According to CMC's Hughes, the two big support levels on the Dow are 13,200 and 13,000. Both were temporarily breached, with the index closing below them on the 15 and 16 August, before the buyers kicked in and helped push it up over 400 points. 'The most important level of support is just below 6,000 on the FTSE. This goes back to October, and a break below 5,960-5,980 could potentially herald a large fall,' he says.

The FTSE index broke above the psychologically important 6,000 level in October 2006. This area of resistance was subsequently established as the key level of support and, when it was tested in early December and early March, it held firm on both occasions. The FTSE finally breached and closed below the 6,000 mark on 16 August, although this quickly encouraged the buyers back into the market and helped the index to add over 300 points.