Accelerate your wealth with CFDs

Published in Your Trading Edge Magazine, 2007

Dale Gillham provides Contracts for Difference (CFD) trading strategies for reaching your financial goals sooner, while managing risk.

Most if not all traders have heard of Contracts for Difference (CFDs). But how many fully understand what they are? 

Trading CFDs generally allows leverage at a ratio of 10: 1, which means for every $1 you can have exposure to $10 worth of CFDs because a small amount of money gains significant leverage.

The ‘difference’ is the profit received or loss paid for the privilege of speculating that a share’s value will rise or fall. 

For example, if you believed the share price of BHP was going to rise from $20.00 to $22.00, you could take a long CFD position on BHP. 

The ‘difference’, as shown in Figure 1 below, is $20,000 - the increase in the underlying share price of $2.00 (share price rose from $20.00 to $22.00) multiplied by the number of CFDs held, which in this case was 10,000.

Figure 1 Click to enlarge

1. Benefits of CFDs

While there are a number of risks associated with trading a leveraged instrument such as CFDs, there are also many benefits. These include:

  • cost effectiveness (because they can be traded on a margin)
  • flexibility (because you are trading on the price movement of a share or index without physically owning it)
  • the ability to profit from falling as well as rising markets
  • receiving dividends and participating in stock splits
  • trading shares, sectors and indices
  • 24 hour trading with global markets
  • hedging market exposure in anticipation of a fall in a share price - a short position can remove or reduce risk without loss of voting rights
  • using a guaranteed stop-loss facility (for a small premium) to minimise losses

2. Avoiding common mistakes

Unfortunately, many traders believe they are leveraged in the physical market when trading CFDs. This is actually an incorrect assumption. 

When trading shares in the physical market, you own the shares and all the rights that go with ownership, including access to franking credits. When trading CFDs, however, you don’t own anything; instead you pay to receive exposure to the movement in the physical share price.

The example in Figure 1, above, demonstrates that you can make money 10 times faster when trading CFDs: but you can also lose it 10 times faster. 

For example, if the share price in the example had fallen by 10 per cent instead of rising, you would have lost 100 per cent of your capital plus costs. Therefore, it is imperative that you consider the risks should the share price go against you.

3. Strategies to create financial freedom using CFDs

What are the strategies you need to consider when trading CFDs?

Firstly, you need to determine the potential length of the trade and then apply your rules accordingly. 

In most cases, CFD trades will last somewhere between a few days and a few weeks. 

Given this, and the fact that CFD trading is highly leveraged, you need to use entry and exit rules that will enable you to respond reasonably quickly. 

One of the most effective rules I have found that works when trading CFDs is Gann’s counter-trend theory.

A counter trend is a movement in the opposite direction to the prevailing trend. 

Gann states that a counter trend is one to four bars or seven to 11 bars. 

Figure 2, below, illustrates a stock that has five bars (daily or weekly) moving in one direction followed by a movement of two bars in the opposite direction. 

From this point, the stock turns and moves up in price in the same direction as the original five bars. 

Once this occurs, we can assume that the two bars that moved opposite or counter to the original five bars was a counter trend. 

The original five bars, however, are part of a trend and not part of the counter trend as five bars falls outside of Gann’s Theory for counter trends.

Figure 2 Click to enlarge

4. Entry rule, stop loss and exit

In a counter-trend move, your entry for a long position (buy) is triggered when price trades $0.01 above the previous bars high as marked on the second last green bar in Figure 2, above. 

I have also marked two stop loss points. The lowest stop loss is $0.01 below the low of the preceding bar and the upper stop loss is $0.01 below 50% of the preceding bars range.

The reason I have marked two stop loss points is that you can use either once you enter a trade, depending on the risk you are willing to take. 

For example, if you choose to place your stop loss $0.01 below the trough of the preceding bar, and this equates to a risk level higher than the allowable 1 to 2 per cent of your total capital, you can either reduce your position size or bring your stop loss up higher. 

That said, be careful that you don’t raise your stop loss too high, as this may result in you exiting the trade too early.

Now that we have addressed the rules for entering and exiting a trade, let’s briefly discuss how you manage the trade. 

A good strategy to adopt once you enter a trade is to bring your stop loss up under each successive trough as shown in Figure 3, below. '

Your exit would then be triggered once the stock closed $0.01 cent below the preceding trough.

Figure 3 Click to enlarge

Notice, in Figure 3, above, we entered the trade on a counter trend and placed the first stop loss underneath the low of the preceding bar. 

After entering, the price of the share rose for two bars before completing a two-bar counter trend, creating a new trough and the necessity to move our stop loss up underneath the second trough. 

Once again, price rose for another four bars, before falling for one bar to confirm a third trough and the opportunity to move our stop loss up again. You would continue to apply this strategy until you exited the trade.

5. Money management

Money management is the most important element in your trading no matter what market or time frame you decide to trade. 

Let’s assume you have a total of $100,000 in capital to invest and your money management rules state that you are willing to place 10% of your money in high risk trades; in other words, you are willing to allocate $10,000 to trade CFD’s.

You need to break this asset allocation down into acceptable position sizes of no more than 20 per cent, which means you would risk $2,000 on each CFD trade you took. 

Given that each CFD trade is leveraged 10:1, each $2,000 would allow you to take a CFD position worth $20,000. By adhering to this rule, you will remain within the allowable risk of one to two per cent of your total capital of $100,000 ($100,000 x 2% = $2,000), which would have only a marginal effect on your portfolio if the trade goes against you.

While I have provided you with a simple trading plan for trading CFD’s, there many other ways in which you could trade this instrument. 

I have kept this example simple to demonstrate what could be achieved if you have the patience and the nerve to stick to a plan. If you decide to trade this instrument, I recommend you develop your own trading plan and back test it using a weekly chart.

6. Stop loss

Regardless of the instrument you trade, it is essential to set a stop loss to protect your capital. 

A stop loss needs to be set for the market you are trading. 

Do not assume that the stop loss you set for a share is the same stop loss you would use when trading CFDs, in fact assuming this will cost you a lot of money. 

Remember, when trading highly leveraged markets, you can lose money at a rate of up to 10:1, therefore a 5% fall in the share price could mean a 50 per cent reduction in your capital.

It is important when setting a stop loss, that it is close enough to protect your capital yet far enough away to allow the trade to unfold. 

While some CFD providers allow you to place automatic stop losses, I strongly advise against this if you are trading with market makers because you are telling them where to take out your position. In other words, you are giving the market maker the upper hand to pull the spread to wipe you out. 

While they will tell you it doesn’t happen, believe me when I say it does – that’s why they call themselves market makers.

7. Capital

Never use all of your available capital when trading CFDs. As a general rule of thumb, you should only trade 10 per cent of your total capital in leveraged products with the remaining amount placed in lower-risk investments like blue chip shares.

8. Position Size

When deciding on an acceptable position size, you need to look at the risk you are taking with your money rather than how much leverage your capital will provide. 

You do this by calculating your stop loss and working out the amount of money you will lose if you get stopped out of the trade. 

If the amount is outside your level of tolerance, you need to reduce your position size until the amount is within an acceptable risk level. 

I always apply a rule of no more than 1 to 2 per cent of my total capital.

9. Entry and Exit Rules

Unlike options, CFDs are not affected by time decay; therefore you can use the same entry rules as you would to trade shares. 

Obviously, when trading a leveraged instrument, your exit is far more important and needs to be managed diligently so you can exit quickly in case the market moves against you. 

Remember any move up or down is amplified at a rate of 10:1.

It is important when trading CFDs that you manage your trades on a regular basis to ensure you exit as soon as the trade confirms there is a high probability of a change in the direction of the market.

I cannot stress enough how important it is to get your exit signal right when trading CFDs, simply because if you exit too early or too late, it can have a dramatic effect on your profits and losses.

To learn how you can accelerate your wealth by learning to trade CFDs or Forex  click here.

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