CFDs are sophisticated products that offer the investor a wealth of opportunities. The key to success, is building a strategy based on your specific needs and attitude to risk.
The science of strategy is one that can take a lifetime to learn, but you don’t have the luxury of a lifetime to strategically plan today’s investment decisions. Many investors employ the strategy of using their CFD account purely as a hedging tool to minimise the potential losses of their share portfolio by benefiting from the fact that CFDs can still earn you money in a declining market. But how else can a CFD account be used? What strategies should an investor be looking to employ?
Here, we talk to the market leaders in CFDs and ask what strategies should be employed when investing with this instrument.
Geoff Langham, head of trading at CMC, says that you need to understand what kind of investor you are before you can build up a strategy. He asks: ‘What do you want out of your investment?’ What level of risk can you live with? What can you afford to loose? What do you know, first of all?’
Trading CFDs will whet the risk taker’s appetite. ‘CFD traders, by and large, have a healthy appetite for risk. They are also sophisticated investors and – coupled with the availability of both fundamental and technical analysis now available through online brokers – they are increasingly confident dealing in an arena previously only enjoyed by the institutions. The biggest single driver of any investor’s trading strategy will be his or her appetite for risk.
‘CFD traders, by and large, have a healthy appetite for risk. They are also sophisticated investors and – coupled with the availability of both fundamental and technical analysis now available through online brokers – they are increasingly confident dealing in an arena previously only enjoyed by the institutions.’
Angus Campbell of FinSpreads agrees: ‘It really depends on what kind of investor you are. If you are a relatively risk-averse investor, you would be looking to invest in substantial amounts on a stock, such as Vodafone, a stock that doesn’t really move that much, or ITV, some of the slightly smaller priced stocks within the index.
‘If you’re a risk-loving investor, you may want to consider changing your strategy slightly. You would look to use a more modest sum on a riskier stock, like Royal Bank of Scotland, AstraZeneca and Standard Chartered and leverage your funds. It depends on whether you are going long or short, because if you are going short, then certainly you may want to consider a larger block of capital because you are going to be earning more interest from that position. Going short, you are being paid for having the larger sum.
With a position like £20,000, you are looking to go long.’ CFDs are of course ideal to employ as part of your overall trading strategy, in that they take advantage of both rising and falling prices. Investors can open a long or short position on thousands of UK, US and European stocks using a CFD. This is difficult and expensive to do in the traditional stock market and makes CFDs ideal for speculative trading.
Going long is the simplest and most straightforward strategy to profit from an upward price movement and has the benefit that no stamp duty is payable. There is no limit for the holding of a long position, but there does come a point in time where going long may become an uneconomic strategy to continue employing.
Most CFD trading revolves around short-term trading, so any comparison between that and long-term strategy is best made by comparing the savings achieved by not incurring stamp duty with the financing cost of a long CFD.
The additional cost of going long on a CFD position over a traditional purchase is only the interest cost. For example, the interest charged on a long CFD is around 6.5% of the contract value. The 10% lodged by way of margin is held to secure the performance of the contract and is not available to be set-off against the contract value.
Conversely, a traditional share purchase incurs stamp duty at 0.5%. The crossover will occur at the time that the interest charged on the long CFD matches the saving made on stamp duty. This point is reached in 28 days – (0.5/1.0 multiplied by 365/6.5). However, this needs adjusting to allow for the fact that the stamp duty on the traditional purchase will be payable three days after the bargain date.
Accordingly, the crossover occurs on day 25. Consequently, for trades outstanding for less than 25 days it is economically more viable to trade the CFD rather than the underlying stock. The crossover point will occur earlier if interest rates rise above the 6.5% used in the example and be later in the event of a reduction in the interest rate.
This is, of course, a basic calculation as there are other costs, but for short-term or intra-day trading – and in the latter case there are no interest costs – the argument is undeniable.
Diversity is the key to success with CFDs
Going short is a simple and straightforward strategy, and one of the principal attractions of CFD trading is seeing a profit if the price of the underlying falls. Such a position can be maintained indefinitely without the need or the associated costs of having to continually roll the position over. Additionally, short positions generate an interest income whereas dividends are paid gross.
Although there are no time limits on CFDs, most investors will use them for either short to medium-term speculation or for hedging of physical stock portfolios.
In practice, most CFDs are closed within three months and the average time is around six weeks.
So it makes more sense to trade a CFD than the stock itself and, says Langham, you don’t necessarily need to be have tens of thousands to enter the market. ‘Nowadays you can put on a £50 investment if you want,’ he explains. ‘Guys with £20,000 to invest would be buying something in reasonable sizes. Someone with £100,000 might come into some liquidity problems.’
Langham advocates diverse trading tactics as the key to a balanced portfolio, and no matter what the amount you have to play with you should look at all the areas that CFDs can be used in. ‘Liquidity is the key, so I would say trading on foreign exchange is probably key to a successful trading strategy. We are seeing a lot of movement in that area, and it’s also where you will find the tightest spreads.’
Langham goes on to explain the sense of using foreign exchange CFDs as part of your trading strategy. ‘The foreign exchange has a 1% margin, which is really powerful. You have an advantage in that we offer it in 20 different indices, and you can get exposure to them quickly. Some of them are 24-hour markets, and the liquidity is always there.’ Of course, the real strength in CFD trading is that you are trading with some serious leverage.
Andrew Edwards, head of trading at ETX Capital has some very sensible advice on the strategies that one should employ across the market, given the benefits that leverage can offer. ‘The investment strategy is the same for CFD and spread betting.
One of the key advantages to both CFDs and spread betting is leverage. You can trade with a lot more than you deposit, so I would suggest using it as much as possible within your own personal trading boundaries. And by that I mean don’t stretch yourself too far. But you can build a large portfolio with a relatively small investment’
Angus Campbell says that, ‘regardless of how much you want to invest the leverage factor means that you are going to be using less of your capital in order to invest. If you’re investing £100,000 you are probably going to be investing in FTSE 100 shares and will only need to use 10% of that to trade £100k of shares – leaving you £90,000 to invest elsewhere.’
Langham points out the benefits and risks of leveraged trading. ‘You want to be very careful of liquidity if you are dealing with any sort of size on margin. You should have a very good understanding of how Level 2 operates. You could also consider playing the sectors because instead of having to buy a considerable amount of Vodafone or a considerable amount of Infineon or Microsoft, you can just buy the UK or UK technology sector, where you have better liquidity and the margins are 3% instead of 5%.’
Pairs trading is another strategy that you can employ with CFD trading. An example of this would be if you believe that one company is undervalued compared with another company – such as Vodafone against Mmo2- you buy the cheaper share while selling the expensive one. This strategy reduces your exposure to market movements but allows you to take advantage of perceived short-term anomalies.
Langham suggests a sensible strategy should be based on the amount of cash you have to bring to the market. ‘When you are dealing in smaller investment amounts, it doesn’t matter too much, your investment choice might move 2%, so your overall position isn’t too big. But when you’re dealing with larger amounts like £100,000, 2% starts adding up.’
The Big Picture on CFDs
With a larger amount such as £100,000, Langham suggests that you need to be aware of a bigger picture before planning your move in the market, and that you need to be aware of the currencies that you are using. ‘You should take into account what the general macroeconomic picture of the world is. You’re looking for more of a balanced portfolio approach. With that you should not only take the indices side of it and take a view if you want to, but you should always look at the forex option. In CFDs, you are effectively buying American stocks in US dollars. If you were to convert those back to pounds there could be an impact, especially with the nature of foreign exchange. With any significant position you take out you should always take into regard the implications of any forex trade.’
With liquidity Langham also suggests that ‘the sectors are a good way to gain large exposure in the areas that you want to without having to trade 10 times every time your use alters. ‘You certainly don’t want to bet the farm. You should be looking for a balanced portfolio, so you want several different instruments and several different types of instruments,’ he adds.
Hedging, going long or short or even both, the ability to lock in a profit on a physical stock position, trading on margin and taking advantage of the leverage that a CFD can offer, having the ability to release cash from your usual stock trading account by transferring your physical stock holdings into CFDs and of course pairs trading, are among many strategies that you can to employ to create a successful CFD portfolio.
But don’t forget the stop losses. ‘The use of stop and limit orders is of paramount importance to risk management. It provides invaluable functionality to close out loss-making positions and take profits at appropriate times.
‘Indeed, one CFD provider was quoted saying that he finds that his most successful clients use the order functionality on the platform frequently to enter and exit positions at self-selected, pre-defined levels.’