CFD Preparation Program
CFD Trading Strategies
Hedging with CFDs
Successful traders understand that protecting their capital is just as important, if not more important than making a profit from their trading. Such traders appreciate that it takes money to make money, and they do whatever it takes to protect their investment capital.
Hedging is a strategy that allows you to protect your portfolio against adverse price movements, providing the means to remain in the investments when you may otherwise have been forced to exit at a loss.
CFDs can be used in your hedging strategy to help protect existing positions and your total portfolio. Since a CFD is a margined product its leverage allows you to protect the total value of a share position without requiring the outlay of the full value of the position it will hedge.
In this section we will explain three strategies for hedging:
Hedge - Single Share
This popular strategy uses a CFD hedge to protect a single share position.
Imagine you currently hold 10,000 XYZ Bank shares. It is October 2008 and the bank is experiencing problems due to the current credit crunch stemming from difficulties in the U.S. housing market - creating what you believe is only a short-term weakness, you believe the bank is a sound long-term investment.
Initially you bought 10,000 shares at $5.82 back in November 2005 for a total of $58,200. Currently, XYZ Bank is trading between $7.20 and $7.40. But, with the current credit crunch, you anticipate short-term losses. However, you expect to see the share price will find resistance and increase in the future.
You decide to hedge your position rather than sell out. Therefore you sell an equal number of CFDs at the current market price to offset your share investment and create the hedge. That will be 10,000 XYZ Bank CFDs at $7.40 to cover the 10,000 shares of XYZ Bank shares you own. Assume the margin rate on XYZ Bank is 10%, you are required to pay a margin of 10 percent of the value of XYZ Bank shares - at a cost of $7,400 (10,000 shares × $7.40 per share × 10% = $7,400).
At this point one of the following three things can happen:
- The share price can rise
- The share price can fall
- The share price can stay at current price
Share price rises- if the share price rises, you will gain on your share trade which offsets against the loss on your CFD trade. If the share price climbed from $7.40 to $8.40, for example, you would make $10,000 on your share position but lose $10,000 on your CFD trade.
Share price falls- if the share price falls, you gain on your CFD trade which offsets against the loss on your share trade. If the share price dropped from $7.40 to $6.40, for example, you would make $10,000 on your CFD trade but lose $10,000 on your share position.
Share price stalls- if the share price stalls, both positions will be neutral and you will not incur a gain or a loss on either your share or CFD. For example if the share stalled at $7.40 you would make $0 on your share trade and lose $0 on your CFD trade. At this point, you could either retain the hedge to protect from any potential negative price movement or you could unwind the hedge and buy back the CFDs.
Regardless of the share price, the hedge lets you retain any profit from the point at which you sell the CFD to when you purchase it back.
It should also be noted that when you hold a short CFD position you receive financing on the position.
Hedge - Pairs Trading
Another popular hedging strategy involves buying a company's CFD and simultaneously selling a rival company's CFD. This is called pairs trading because you trade a pair of CFDs. The shares of companies in the same industry tend to move in the same direction so, if the industry performs well, most of the shares of the companies within that industry tend to do well too. Of course, the converse is equally true.
As a pairs trader, you buy a CFD on the share of the strongest company within the industry and sell a CFD on the share of the weakest company within the industry. Once you have entered your pairs trade, you anticipate that one of two things will happen:
- The shares of both companies will rise but the share underlying the CFD you bought will gain more than the share underlying the CFD you sold
- The shares of both companies will lose ground, but the share underlying the CFD you sold will plummet more than the share underlying the CFD you bought.
In both scenarios, you hope to lose money on one of your CFDs and expect to make sufficient on the other CFD to offset your losses and leave a net gain. It is like making a prediction that, if a new Porsche raced a 1961 Volkswagen Beetle, the new Porsche would win. Of course the new Porsche might get a flat tyre or hit a wall before it finished the race, allowing the Beetle to win, but the chances of that happening are slim and the odds are in favour of the Porsche.
Both trades could conceivably move in your favour - allowing you to profit from both the CFD you bought as its underlying security moves higher and from the CFD you sold as its underlying security moves lower.
Conversely, it is also possible that both trades could move against you. You could lose on the CFD you bought as its underlying security moves lower, and likewise lose on the CFD you sold as its underlying security moves higher.
Imagine you wish to pair trade on shares in the Resource Sector industry, and you think BHP Billiton and RIO Tinto make great candidates for a pairs trade. BHP trades at $27.00 whilst RIO trades at $75.00.
It is crucial you balance your trade, otherwise it may not perform the way you expect it to. So ensure you control the same amount of value in the assets on which the CFDs are based. In this case you want to control approximately $100,000 worth - or 3,703 shares at $27.00 per share (3,703 × $27.00 = $99,981) - of RIO Tinto shares and approximately $100,000 worth - or 1,333 shares at $75.00 (1,333 × $75.00 = $99,975) - of RIO Tinto shares.
Once you know how many CFDs you wish to purchase, and the current price, you can enter your trade. Because you are trading CFDs, you are only required to deposit a portion of the total value of the position as margin for the trade. As the margin requirement for BHP is 3% and 10% for RIO you only have to outlay 3% of the value of BHP’s share price, or $2,999 ($99,981 × 3% = $2,999) and 10 %t of RIO Tinto’s share price, or $9,997.50 ($99,975 × 10% = $9,997.50). This means that in total you provide approximately $13,000 in margin to enter this trade with CFDs, not the full $200,000 require if you were to open the share positions.
Remember that you pay, or receive, interest on a CFD position held overnight. In the above example you pay interest of $21.91 per day on the BHP Billiton CFDs you have bought, yet simultaneously receive interest of $10.96 per day on the RIO Tinto CFDs you have sold.
Now imagine that the price of BHP rises slightly to $27.40 and the price of RIO Tinto falls to $74.75 over the next fortnight, and you exit your trade. Your profit on the BHP position is $0.40 per CFD, or $1,481.20 (3,703 × $0.40 = $1,481.20). Your profit on the RIO Tinto position is $0.75 per CFD, or $999.75 (1,333× $0.75 = $999.75). Your total profit on this pair trade is therefore $2,480.95 ($1,481.20+ $999.75 = $2,480.95).
Hedge - Index Diversification
Hedging does not necessarily need you to be in two offset positions simultaneously. You can also hedge your overall account risk by diversifying your investments. Whether you expect shares to rise or fall, you can insure against the price movements by buying or selling a broad range of CFDs.
The easiest way to hedge by diversifying is to buy an index-tracking CFD, a contract that derives its value from a large share index like the ASX200, S&P 500 or the FTSE 100.
You may believe that shares in general will rise but you may not be sure about which specific shares to buy. You could buy Index-tracking CFDs – eg ASX200, FTSE 100, NASDAQ, S&P 500, Dow Jones or DAX index tracking CFDs. If shares in general increase in value you will attain a profit from your trade. Whilst a few stocks in each index might decrease in value, the average performance of the entire index will counterbalance any shares that underperform.
This concept also works when you predict that shares in general will fall. You can then sell index-tracking CFDs to benefit from any adverse movement in the underlying market.
Speculating with CFDs
Typically short-term, speculative trades are generally coupled to major market events such as central bank interest-rate decisions and company results. Traders want to capitalize quickly through a timely entry into trades that will see prices take off on the news, and then a timely exit with their profits intact.
CFDs are an ideal investment tool for speculation because they have the advantage of leverage that allows you to maximise exposure whilst minimizing investment. Using leverage allows you to increase your potential profits and losses so you should always employ stop losses and other risk-management techniques.
In this section we will describe some typically speculative opportunities and explain how to grasp them:
- Speculative Trading Opportunities
- Implementing Speculative Trades
Speculative Trading Opportunities
Speculative trading opportunities tend to have one unifying feature: their link to news announcements. Such announcements may contain the government's latest employment figures or they may be a company's quarterly earnings. Either way, they frequently have the potential to cause dramatic shifts in the market.
Examples of news announcements that could create speculative opportunities are:
- Breaking news
- Company reports
- Economic data
- Index additions/deletions
- Breaking news announcements are unscheduled events that will influence share prices. Breaking news like a merger announcement should be beneficial to share and CFD prices, though occasionally the value of a merger is not apparent and the price adjustment will reflect any uncertainty. Negative news announcements will have an adverse affect on share prices.
- Company reports provide information regarding recent company performance and plans for the future. Scheduled in advance, they give traders every chance to prepare themselves and take full advantage of their contents. Company reports are not only publications of results for the last quarter, half or year. They should also anticipate trading during the next six months and this will have an impact on the share price. Traders need to digest this information and form opinions on it. When a company's report shows it performs well and will continue to do so, its prices tend to move higher. Of course, the converse is equally true. Poor and pessimistic reports have a negative affect on share prices.
- Economic data emerges in news releases commonly scheduled months in advance, offering traders the opportunity to consider the evidence, predict the announcement and capitalise on the market movements that they feel will happen. Economic data includes inflation, gross domestic product (GDP) information, interest rate announcements and unemployment figures, all of which tend to influence broad markets rather than individual companies. It therefore makes sense to utilise index-based CFDs when speculating on these announcements. When economic data indicates that the economy is buoyant, share prices tend to move higher. If that data is poor, however, prices will usually fall.
- Index additions/deletions occur when major market-tracking companies such as Standard & Poor's adjust the composition of their indices. This might happen, for example, if a company can no longer meet market-capitalization requirements and is therefore de-listed from the S&P 500 index.
Index additions and deletions usually occur at prearranged times though the identity of the individual shares involved is not divulged until the announcement is made. Traders may well realise which shares are likely to be affected, but it will not be confirmed until the announcement. Being added to an index typically raises a share's demand and its price. It will of course then be required as a component of index-tracking funds. Conversely when shares are de-listed the index-tracking funds sell the share, and its price typically falls.
The Expected Is Already Priced In
An important point for speculative traders to remember about opportunities precipitated around news announcements is that expected movements are already priced into the share price.
Investment analysts, economists and other market participants analyze anticipated news announcements, trying to second-guess the consequences of the news on pricing. Whilst they are unlikely to entirely agree on anything, they do generate a consensus that is useful. This consensus, containing the average estimate, allows traders to capitalize on price movements once the news announcement is released. This is because the average estimate will already be "priced into" the value of the share. We will explain how this occurs.
After their analysis, traders take advantage of anticipated movements. Rather than wait for the announcement they pre-empt the market. So, by the time an announcement is released, most traders have already taken a position.
When news announcements accord with average estimates, prices barely move. This is because the majority of traders have placed their trades. Yet, when news announcements differ from the average estimate, prices must adjust - either up or down - to accommodate the economic reality. This adjustment creates opportunities for the traders.
Implementing Speculative Trades
Identifying news announcement or other stimuli that should cause prices to move will then provide opportunities to capitalise on price movements in three ways:
- You can enter your trade immediately after the announcement
- You can let the market digest the announcement, then act on it and establish a trend, before you enter your trade
- You can set two entry orders, one above the CFD's current price and one below it, just prior to the announcement
Entering Immediately Following a News Announcement
Entering trades immediately after an announcement can be difficult because prices tend to adjust sharply when investors have incorrectly guessed the news. So to do this you must get the news quickly, evaluate it quickly and then enter your trade order quickly. Moreover, you need to do this before the price has already taken off. And it will do that quickly too. Traders jumping into trades after the announcement will usually pay a higher share price or sell for a lower price.
Entering Once a New Trend is Established
Most CFD traders who trade on news choose to wait until new trends are established. This is typically the easiest way to capitalise on it, because initially the CFD price will fluctuate as investors speculate on how the underlying asset will trend. Once this fluctuation has abated, it is a good time to participate, but traders who work this way need to learn to ignore the superfluous 'noise' before a clear and enduring trend settles. Doing so gives them an advantage over other traders, those who enter too quickly and are caught out by early reversals and prices that trigger their stop-losses.
The direction in which a CFD is going to move is usually clear within 2 to 5 minutes of the news announcement that sparks its movement. Those few minutes will be ample time to shake out any investors trying to buck the trend so it makes sense to use short-term charts - ideally 1 or 2 minute charts to monitor price movements after announcements.
Using Entry Orders Before the News Announcement
Placing entry orders prior to announcements is the most profitable way to trade the news - assuming that you are correct and that the price moves in the preferred direction. By placing orders before the price moves you have the advantage of entering the trade at the price you want. There are risks with entering trades before the news announcement because the market can fluctuate significantly in the aftermath of announcements and will take a little time to settle down. Ultimately the majority of participants perceive the news to be bullish or bearish then act accordingly. In the meantime, you could be knocked into the trade once your entry order is hit, then knocked right back out of it once the price turns around and hits your second entry order.
DISCLAIMER:
This educational material does not constitute financial product advice. While the information is provided in good faith and is derived from sources believe to be accurate and reliable at the time of publication, First Prudential Markets (FPM) makes no warranty as to the accuracy or reliability of the information contained in this material. Before you make any decision to acquire or dispose of an investment you should consider your personal objectives and financial situation and obtain appropriate professional advice. You should not make any decision to acquire or dispose of an investment based on this material and to the extent permitted by law, FPM accepts no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this information. A Product Disclosure Statement is available from First Prudential Markets website www.fpmarkets.com.au and should be considered before deciding to deal in FPM derivative products.