Many Flavours of CFD

November 9, 2018

The US S&P 500 fell 6.9% in October. The last time we saw a decline of this magnitude was in 2011. If we stretch data as far back as 1992, such an occurrence happened in only 15 out of 300-over months.

Should we worry? Not really. This is just a little speck in the grand scheme of things. If we have a long/short, market neutral capable instrument, then there is even less to worry about. That instrument is Contracts for Differences – CFD for short.

What is CFD? For the layman, it’s “Almost like stocks. But can short and can leverage.

In this context, I’ll like to highlight two observations we have from the desk on how our clients (you, the reader) may be missing out on maximising CFDs to the fullest potential.

One: You are not shorting!

Our current data shows:

1. Our clients’ CFD long positions have taken a hit. This is understandable.
2. However, our clients’ CFD short positions remain almost the same! There is a gap identified: You are not shorting!

I reproduce the following table from this Market Journal – “Pure Coincidence?”:

24 years
(Jan 95 – 23 Oct 18)
Post-Dot Com Bubble
(Oct 02 – 23 Oct 18)
Mean Shriller PE 22.19 19.62
Median Shriller PE 21.16 20.49
Average Top 20% 31.98 24.33
Average Bottom 20% 14.87 14.3

As at end-October 2018, Shriller PE ratio is 26.38. This is a slight decrease from my previous article’s high, but not out of the danger zone yet. We are still within the 80th percentile for more than 20 years now. If we take away data from the dot com bubble, valuations are among an all-time high!

With that in mind, are you maximising CFDs to their fullest potential? Are you aware that you can short with CFDs? If the answer is yes, don’t handicap yourself!

Two: You are not cutting your losses

Our data also shows: Margin Calls have been on the rise. This tells us you are hanging on against the market, not cutting your losses.

From an investment point of view, this can be a valid strategy. Markets are upward biased. All market declines are just temporary, sometimes insignificant. Buy the dip and enjoy the ride. I agree.

But this may not be an ideal CFD strategy. Why?

When your balance falls low enough, we have to pull the brakes and issue margin calls. If this is unplanned, it will force you to realise your losses and get out of your positions prematurely.

Another point to note: Losses are different from gains. They sting more. A 5% loss will require a 5.26% gain to break even. A 10% loss needs an 11% gain. A 15% – 17.65%, and so on…

If you lost… You need this much gain to break even…
5% 5.26%
10% 11.11%
15% 17.65%
20% 25%
50% 100%

In and out, in and out

A common trading model I have seen that makes sense is this:

Assume your portfolio is 50,000 (100%)
Risk less than 1% of portfolio size each trade (1% * 50,000)
Identify entry, profit and cut loss levels before each trade.

1% of portfolio / (Entry – Cut loss) = Quantity of shares to long or short
(Profit – Entry) / (Entry – Cut loss) = Reward/Risk Ratio (higher the better)

Use absolute figures (ignore negative signs).

Strictly following this model should confine each individual loss to 1% of a portfolio. Adjust the figures to suit your risk appetite.

There are two main selling points for this model:

1. When Reward/Risk Ratio exceeds one, even if probability of winning is no better than a coin flip (at 50%), a portfolio should be growing given that enough trades are done. This is the law of large numbers.

2. It will take about 100 consecutive losses to wipe out the account. If this happens, let me know. A hundred straight losses is just as valuable: You are a great contrarian indicator.

Of course, this is an overly simplistic view towards trading. When to take profit? What level to cut loss? This is an art as much as a science.

The many flavours of CFD

Applying a combination of long, short and leverage, CFD allows for different strategies to be applied:

1. Opportunistic net long/short positions
2. Market neutral downside protection
3. Relative performance hedge
4. Positive carry (Yield > Financing)

I will focus briefly on two of these:

Market neutral downside protection

If you are a traditional long-only investor (stocks or CFD, it doesn’t matter). Now is a good time to act.

In the face of uncertainty or a market-wide sell down, short an equivalent dollar value of a market proxy (SPY or US S&P 500 Index USD5 CFD) and immunise your portfolio. Wait it out instead of engaging in a panic sell.

Relative performance hedge

This can be useful during periods of uncertainty. (i.e. Earnings releases, pending announcements, market volatility arising from the impact of political and economic risks).

If you are feeling bullish on a particular stock (Microsoft – MSFT for example), long MSFT and short an equal dollar value on a related counter or index.

The long allows you to earn from price movement.

The short hedge protects you against systematic risk (market-wide sell down).

Microsoft (MSFT) Apple (AAPL)
Estimated Earnings 0.962
Actual Earnings 1.14
Earning Surprise 18.5%
Returns 4.38% Returns 1.75%

Return for long MSFT was 4.38%, at a cost of 100% market exposure to news and fluctuation.

Long MSFT and short an equal dollar value of AAPL at the same time to reduce market exposure.

Your returns should be just MSFT’s outperformance against AAPL due to earnings surprises.

If you are bearish, just flip the signs around.

Taper the hedge (full/half etc.) and apply leverage to suit your risk appetite.

Don’t forget order types

Beyond CFD’s long/short/leverage model, we offer different order types. Some of them we call “Advanced Order Types” but they are not as complicated as they sound and are actually quite easy. I will not bore you with the mechanics of each of them.

Contingency Order is one order that I’ve almost never heard anyone talk about. But when we place two of them together, we can create a Straddle-like breakout strategy that strives on volatility and uncertainty.

CFD Contingency Buy Order
Condition: When Asking price exceeds ceiling

CFD Contingency Sell Order
Condition: When Bid price falls below floor

When either order fills, the other can serve as a cut loss to prevent whipsaws/false breakouts. Widen or narrow the ceiling and floor to your heart’s content.

On this note I challenge you to get creative and think deeper on how we can approach things we already know in different ways.

At the end of the day, CFD is just a static model. Long, short and leverage, it doesn’t get more complicated than that. How we use them as tools to approach a dynamic market is what that makes the difference.

When we adopt this mindset, little stands in the way of what we can achieve!

Remember the feeling when you were a child and walked into a candy shop? You pondered all the possible combinations of sweet treats that could fill your bag with delight.

Using this as a metaphor, think about CFDs in the same vein.

And hopefully, your returns will be sweet!

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About the author

Tan Chek Ann
Senior Dealer

I sleep in the day and head the dealing desk at night.

In my nightly work, I attempt to do analysis, revolving around portfolio construction, long/short strategies, responsible leveraging and factors research.

Join me on my journey as I share my thoughts on various topics – though mostly still financial stuff.

Reach me at tanca@phillip.com.sg

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