Algorithmic and Mechanical Forex Strategies | OneStepRemoved

Making Sense of CFD Trading

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Contracts for Difference a.k.a. CFDs are derivatives trading instruments between two parties. There are thousands of global markets which can be traded in a CFD format. With CFD trading, you’re essentially speculating on the price movements of financial instruments. These could be bonds, FX pairs, commodities, indices, or stocks. It doesn’t matter whether the asset prices are rising or falling – all that matters is that you call it correctly. With CFDs, you’re not taking ownership of the underlying asset – you’re simply speculating on price movements. Even so, understanding your risk vs. reward in any transaction is essential. In the United Kingdom, there is no stamp duty on profits generated through CFD trading, making this an attractive option for traders and investors.

CFD chart

Other benefits to CFD trading include the fact that it is a terrific hedging tool against losses that you suffer in physical investments. With CFDs, you don’t need to have all the money available upfront to purchase the contract – leverage and margin are used. This is a double-edged sword however since you must assume the pros and cons of leverage. If trades go your way, you will profit from leverage, and if they go against you, you stand to lose more than your initial investment. Nonetheless, many UK traders and European traders enjoy CFD trading since it is a flexible alternative to conventional investments.

CFDs in Action

The concept of a CFD is best understood by way of an example. At inception, you decide the number of CFDs you wish to trade. Every point movement is associated with a specific profit or loss. If markets move in your favour, you will profit off every point. If they don’t, you will incur a loss. CFDs allow traders to go long if they are bullish on the market, or short if they are bearish on the market. It is entirely possible to profit in either direction. One of the most popular uses of CFD trading is hedging. Simply put, this means that you can use CFDs to prop up your other investments that aren’t doing so well. For example, if you purchased Google stock through your broker and the price started decreasing, you could open a CFD trade on Google and go short on it to generate profits accordingly. That way, you’re minimizing any potential losses through your Google stock. This is true of any asset category – indices, commodities, forex, stocks, or bonds.

Any product that you trade on margin opens you up to potentially larger profits or losses. Since you are only paying a fraction of the overall cost of the trade (the contract), you don’t need all of the money upfront. Therefore it is inherently attractive to many traders. Popular CFD trading markets include the Dow Jones, the NASDAQ 100, the S&P 500, the FTSE 250, the FTSE 100, the Nikkei 225, thousands of stocks, currency pairs, commodities like oil, copper, gold, sugar, platinum, natural gas, and bond markets. According to leading CFD provider, Wilkins Finance the best CFD definition is one which explains what a CFD is, how it works, what advantages are involved, and what the current risks are. It must be borne in mind that CFD trading is a high-risk activity and is not suited to all types of traders. If you have a keen grasp of the risks of this type of trading activity, it is certainly an option worth considering.

Trade Oil CFDs with an Eye on Futures

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For most traders, the simplest way to trade Oil is through CFDs. Oil CFD trading is deemed a less costly option as CFD contracts are minimal compared to Oil futures contracts. That means Oil CFDs are easy on the margins. Furthermore, in a CFD trade, there’s no need to “roll” (or extend) a contract.

If you trade Oil CFDs rather than Oil futures, you can still use Oil futures data to make an informed decision. Then, you get the best of both worlds, i.e. the low costs of CFDs and the insight of Oil futures (usually WTI contracts).

Watch Oil Futures Volume

The first insight that Oil futures data can give you when trading Oil CFDs is volume. Since oil CFDs are OTC (Over-the-Counter) there is no volume available. By using the CME website you can view the volume of the front month contract in WTI. With that data, you can conclude how strong the momentum of a recent Oil trend. If you get high volume, then momentum is strong and, of course, vice versa.

Oil CFDs

Source: CME

Winter is Coming

Oil demand tends to jump during winter months; that, of course, is because demand for heating amplifies the need for energy. But what does it means in practice, as a trader? Say you opened an Oil trade, either long or short, ahead of winter. Demand expectations could change the trend once winter began. How could Oil futures help you?

Once again, the CME site can come to your rescue. Let’s say you’re in August and the Oil futures contracts for November are much higher. You realize that there’s a greater likelihood that Oil will head higher over the coming weeks. Now, what if the price is more or less the same as the Oil CFD contract?  That means there is a low expectation of rising Oil for the upcoming winter.

As seen in the sample below (from the CME WTI oil contracts) December and January are roughly at the same price of $46.41 for Oil WTI contracts. And that means low winter expectations.

There is one caveat; only watch the winter months’ futures when winter is really approaching. Otherwise, the price may not be that indicative.

Oil CFDs

Source: CME

Watch Open Interest Ahead of Inventories

If you trade forex then you know all about the monthly Nonfarm Payrolls report and how it affects the major FX pairs. Well, Oil has its own “Nonfarms,” albeit in miniature. Every Wednesday, the Energy Information Administration (EIA) releases its weekly petroleum status and inventories report.

Data on future and options (where the big money is) can come in very handy. Any open buy side interest ahead of the EIA release is quite revealing. That suggests that any fall in inventories could ignite a bullish bounce. So every Wednesday, you get an indication of a potentially big move and adjust your trade accordingly.

Oil CFDs

Source: CME

Spot Reliable Pivots

Sure, open interest can help you sense sentiment but there’s more. It can also allow you to spot pivots. How? Think of it; all of the big Oil producers have a certain price below which they will lose money. When you examine the Oil open interest chart, this time from options, you can easily identify that price by a high concentration of puts. Those puts option are in place to protect producers against an Oil collapse. Then you can rely on those pivots during your day trade or when swing trading.

Oil CFDs

Source : CME

Oil CFDs vs Futures

Of course, there are many more nuances to trading Oil CFDs which can be addressed another time. For now, though, understand that Oil CFDs are the smart way to trade Oil. Having said that, however, it doesn’t mean you can’t gain valuable insight from the derivatives market.

SPY Crisis Strategy Questions

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Ed wrote me an email asking how he can trade the SPY Crisis Strategy. He likes the idea, but the problem is that his account balance is too small. He was under the impression that he can only participate with a futures account.

That was true several years ago. Luckily, the brokers have wised up and offer traders many more options. SPY is the ETF based on the S&P 500. ETFs are technically “Exchange Traded Funds”, but you can think of the SPY as a stock. You would place SPY trades in the same way that you buy or sell any stock in your brokerage account. Wikipedia offers a great ETF explanation if you’re new to the concept.

The returns that I posted for the strategy assumed that you were trading SPY without leveraged. If you’re a forex or futures trader, there are a few options available:

Forex traders can inquire if their broker offers index CFDs, especially if you want to trade the idea from MetaTrader. A CFD stands for “Contract For Delivery”, but don’t worry. Your broker has no desire or interest to make deliveries on oil or the S&P 500 CFDs. CFD is a legalistic creation where the broker promises to deliver the object traded on a certain date. In reality, the contract is perpetually rolled 2 days into the future. The position allows you to hold the spot price of the S&P 500 without needing to purchasing any stocks or resorting to the futures market.

The best option for futures traders are the e-minis (Symbol: ES). You should trade the front month contract for all signals. This is certainly the most efficient way to trade the idea. The only reason I stuck with the ETF is that I don’t have to dive into messy backtesting assumptions with continuous contracts and rolling open positions.

NinjaTrader is a great option regardless of the instrument that you trade. It’ll handle any market that you select: CFD, futures or the ETF.