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CFDs
Volatility highlights strengths and weaknesses of CFDs
Jeff Cartridge - August 3, 2007
 The recent market volatility highlights both the strengths and weaknesses of CFDs. After a volatile week it is likely that traders in CFDs are disconcerted by the losses that they face in their accounts or are celebrating the opportunity that the volatility has delivered. Of these two scenarios, the one you face will largely depend on how you manage your risk.
One of the key strengths of CFDs is the opportunity to short sell a wide range of securities, allowing a trader to profit from the recent falls in the market. While share traders are left stopped out of the market waiting for the market to recover CFD traders can make the most of the opportunities that are available in a falling market. Large falls in the financial services sector led by Macquarie Bank which fell more than 10% after an announcement about losses in two of their funds were combined with drops across the board following falls in the global markets which had their worst week since September 11 2001. With the market down over 400 points from the peak hit less than two weeks ago there have been many opportunities to profit trading short.
During this time a recent short trade on AWB turned in some excellent profits. This trade was entered by selling short at $4.06 as AWB broke down out of a small descending triangle formed after the recent up trend. AWB continued to fall away over the next two weeks with an opening gap forming after strong falls in the US market. This gap was used as an exit signal and profits were taken by buying back at $3.43 as AWB bounced back strongly. This trade delivered a profit of 63 cents per contract. When the margin requirement of 10% is taken into account the trade delivered a gross profit of 183% on the initial margin required to complete this trade in less than three weeks.
While CFDs can deliver strong profits on the short side in a falling market it is likely that many traders were dreading the opening bell after the first large fall on the US markets on Thursday last week. For traders that ignored risk management that morning could have seen accounts devastated by the effect of leverage and the large opening gaps that occurred. Many CFD traders would have found their account balance sharply lower and in some cases have completely wiped out the equity in their CFD account.
An account can be devastated when traders enter too large a position or too many positions at one time. A sudden fall in the market can place the trader into a margin call situation if the stops that are set do not adequately reduce the risk of a position or an opening gap increases the losses the trader experiences. To ensure risk is kept to a manageable level a CFD trader can calculate their position size based on the amount the trader is prepared to lose if the trade was to hit the stop loss.
In the example below ORG formed a small ascending triangle with an entry to occur if the price broke above the top line and reached $9.66. The stop was set at a level 3% below the entry price at $9.34. A trader in ORG will lose 32 cents per contract if the trade was to go wrong. The CFD trader can now control his or her risk on any trade by controlling the position size. Entering 1000 contracts would result in a loss of $320 plus brokerage, interest and any slippage that may occur. Entering 10,000 contracts would result in a loss of $3200 plus costs. The CFD trader can now decide how much he or she is prepared to lose if the trade goes wrong and calculate the position size accordingly. If the trader wants to risk $500 then the position size is 500/0.32 = 1562 contracts. The trader may want to round this down to 1500 contracts. By calculating the risk on any trade the CFD trader knows the likely outcome after a heavy fall in overseas markets. There is no need to wait anxiously for the market to open to determine the trader’s risk.
While calculating the risk on any trade is important it is still possible to end up with too much exposure to a sudden fall in the markets by entering too many positions in one direction. It is possible to balance an account by including a mixture of both long and short trades on at any time. When the first drop in the US happened I held five long positions and one short. Four of the short positions were stopped out, one for a profit and three for a loss. The net effect was a drop in the account balance of approximately 10%, which would be far less than many other traders experienced. As the long positions decreased in value or were stopped out for a loss the short position gained reducing the impact of the loss.
By recognising the weaknesses of CFDs and effectively managing the risk a CFD trader can be well positioned to profit in market falls like those experienced during the last week. Avoid the temptation to trade too many contracts or to end up heavily biased on one side of the market. With the ability to trade both long and short a CFD trader can profit from the current market volatility.
Jeff Cartridge is the author of Supercharge Your Trading with CFDs. For more information go to www.superchargedreturns.com.au
More articles from this week's CompareShares newsletter:
Commodities: Nuclear power here to stay
Resident trader: Revenge trading
Lottery winners: The perils of sudden wealth
Superannuation: Getting behind the wheel
CFDs: Volatility highlights strengths and weaknesses
Politics: Backing a winner
Smart Investing: Rising debt levels an issue
Shares: Market depth explained
Stock of the week: ASB
Investing: Oil rising to the top… again
Gold: Gold vs the dollar
Whatever your views, you can discuss this article - or any of Jeff's articles - on our message board Your 2 Cents.
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