So far in our CFD trading series of articles, we’ve explained how CFDs work and why traders use them. This week, we’ll be diving into the types of trading strategies employed by traders when using CFDs to open and close positions.
Most traders will specialise in a single trading strategy to gain the best competitive edge. As we discussed in our article about fees, a trader’s edge needs to be high enough to cover fees and provide them with a profit that justifies the level of risk.
It follows that a trader would be more likely to see positive financial returns if they master one strategy rather than attempting a combination of strategies with below-average levels of execution.
We’ll look at four common types of trading strategies in this article.
Day trading is an umbrella term that encompasses many different short-term trading strategies such as:
- High-frequency trading
- Quantitative trading
- Momentum trading
What they have in common is that a day trader will, as the name suggests, be a position held for a very short period. However, this even includes trades that are held open for a single minute.
The CFD format lends itself well to day trading because:
- CFD platforms offer very fast execution
- Settlement is equally brief, allowing traders to move in and out of trades quickly
- Overnight or holding fees don’t apply if positions are closed same-day.
For many amateur investors learning about the world of investing, day trading can be seen as a lifestyle that guarantees success to those who perform good research. This view is promoted by online marketers and those looking to gain social media followers but is not accurate as most traders loose money when engaging in this activity.
The issue with this simplistic view is that it downplays the risks of trading and the level of competition between traders in the market. If profits came to everyone who devoted their hours to trading, there would be many more day traders than there currently are today.
We won’t make generalisations in this article about the difficulty or success rates of day trading because there is so much variety in how day traders operate; how much capital they employ and what signals they use to generate trading ideas.
However, it is fair to say that day trading can be a long-hour commitment. It can also be quite stressful due to the personal financial risk you take with each trade.
It’s important to be realistic about your likelihood of success and look for information from real day traders before opening an account, rather than being taken in by the promises of a marketer that trading is ‘easy’ and only takes ‘2 hours per day’.
Reactionary trading is the strategy of aiming to be one of the first traders to capitalise on new information when it is released to the public.
It’s no secret that information moves markets. Financial instruments such as shares and indices are valued as a function of future expectations about profitability and returns to investors. When new information is released that changes these forecasts, valuations will move in step.
A reactionary trader will open long or short positions in the recent subjects of positive or negative stories alike and look to close out the trades after prices have adjusted to the news.
Speed matters when you’re competing against other CFD traders and even professional investors. Reactionary traders will subscribe to newswire services such as Bloomberg or Reuters to ensure that they are among the first to hear about a news flash as it occurs.
CFD traders who look to trade equity or commodity indices will be concerned with macroeconomic, political and weather events that could have a pervasive effect on economies.
Traders who prefer to trade individual stocks will be focused on product developments, people moves and industry insights that will affect trading forecasts for an individual business.
Risk-offsetting, also known as hedging is the strategy of using CFDs to fully or partially offset a pricing risk inherent in another asset held by the trader.
By holding a long position in an asset and taking out a hedge with a CFD, a trader can create a ‘net position’ that is not possible to achieve via other means.
These positions can include trades that seek to capture a widening or narrowing in the relative pricing between two individual securities.
Or they could take a directional bet on stock movement relative to the overall stock market, i.e. they think a stock will increase by more than the stock market.
Here are some examples to bring this concept to life:
If a trader believed that Apple Inc was relatively under-priced compared to the market, they could take a long position in Apple’s stock and a short position in the NASDAQ equity index. (See the US NDAQ 100 derivative price chart).
With this overall position, a trader will not experience significant profits or losses from any movement in Apple’s price that is purely explained by the overall stock market rising or falling. That’s because a gain in Apple’s price would be offset by a loss in the short position on the market. The trader’s net return will instead be driven by Apple’s performance relative to the index – outperformance will create profits and underperformance will create losses.
The exact size of hedge trades and the decision of what instrument to use will impact the overall effectiveness of a hedge. Hedging does not eliminate all risk from trading but allows a trader to make a more complex bet on more specific scenarios.
It’s important to protect yourself from large losses when trading CFDs. Ensure to research the market thoroughly as well as utilising demo accounts to get used to the trading environment.
Long term trades
The final CFD trading strategy we’ll cover today is long-term trading.
Although holding CFD trading positions over longer periods will incur fees such as overnight holding costs, there are several advantages to using CFDs to take a position:
- CFD trading enables traders to make long-term short positions – where they believe an asset is overpriced but cannot pinpoint precisely when a market price correction will take place
- CFD trading also allows for trading on margin, allowing a trader to take a leveraged position which might allow them to capture higher returns from trades they have a high level of confidence in.
- CFD trading allows for the trading of specialist indices such as commodities like oil and precious metals, which cannot be bought through a traditional brokerage.
Overall, some of the unique characteristics of CFDs lend themselves to these trading strategies compared to traditional stockbrokers that do not allow short selling or trading on margin.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when spread betting and/or trading CFDs. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.