-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
Make it happen
marketindex
rbs.co.uk/marketindex
CFD Trading StrategiesDavid James Norman
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
2CFD Trading Strategies CFD Trading Strategies 3
rbs.co.uk/marketindex
Contents Preface
This book has been written to provide insight into how to build a
successful strategy to trade CFDs. As many traders know, a trading
strategy is not just a case of recognising market conditions and
placing appropriate CFD orders to capitalise on them; strategy
encompasses the entire approach to trading.
This book, then, describes a trading strategy in its larger sense andbuilds an understanding of a traders overall strategic goals, his or her
trading plan, the trading strategies used to achieve the goal and the
all-important psychology that the trader needs to deal with in
order to be successful.
The book includes the following topics:
An overview of the CFD product
The range of marketindex CFDs available to trade
The logistics of trading CFDs
A range of CFD trading strategies for different market conditions
Managing a CFD account, risk control methods
The book is made up of four main sections:
1 Introduction to CFDs (pages 48)
2 CFD Trading Logistics (pages 917)
3 CFD Trading Strategies (pages 1837)
4 Dealing with risk and psychology (pages 3755)
The views below represent the opinion of independent analysts
The Trader Training Company Limited. These views are based
on technical analysis including but not limited to price action,
volume and market breadth studies.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
4CFD Trading Strategies CFD Trading Strategies 5
rbs.co.uk/marketindex
Introduction to CFDsBefore a trader can build an effective trading strategy, he or she
must understand the behaviour of the instruments that he or she
wishes to trade, and the medium through which to trade, implicitly.
If the trader chooses CFDs, then time must be taken to study their
unique characteristics. CFDs behave differently to other traded
instruments, like futures and options for example, even if they are
based on the same underlying cash instruments and move in linewith their price changes.
As an introduction then, lets go through the main characteristics of CFDs.
What is a CFD?
A CFD is a contract between a trader and a CFD
Provider. Once it has been bought or sold, it is
not tradable on an open market but must be
closed out with the same provider. The CFD
provider, in this case marketindex, acts as the
counterparty to the traders buy or sell order
and the difference between the purchase priceof the CFD and the price at which it is sold
is credited or debited to the traders margin
account by the provider.
The price behaviour of buying or selling a
CFD is the same as buying or selling the
underlying instrument in that the CFD responds
to movements in the price of the underlying
instrument in the same way, point for point.
The range of trading instruments that
underlie the CFDs that marketindex offers,
is as follows:
Government bonds including Bund, Bobl,
US T Bond and 10 Yr Notes
Stock indices including FTSE 100, Dow
Jones, Euro Stoxx and Hang Seng Foreign Exchange including all major crosses
Commodities including oil, wheat, coffee
and sugar
Precious metals including Gold, and Silver
CFD trading is popular with traders because of
the broad range of products that marketindex
offers and the flexibility that this provides in
being able to shape a trading strategy. As the table shows, the CFD trader enjoys a protable trade that costs 5% of the underlying value of the FTSE 100 Indexwith 10 times the profitability.
Trading CFDs differs from trading the
underlying instrument in that:
The CFD is traded on margin while the
underlying instrument is not
The CFD trade is a contract with
marketindex rather than a trade through
a broker that will eventually result in
ownership of the underlying instrument
marketindex will give, or receive, from the
trader the cash difference between the
opening price of the CFD trade and the
closing price depending on the profit or
loss of the position
A trader can sell a CFD contract short while he
may not be able to with a cash underlying
Theres no UK Government stamp duty tax
on trading CFDs in the UK
Leverage
CFD traders benefit from trading on
margin. This means they deposit a certain
amount of capital into a margin account
and marketindex offers them a percentage
increase in that capital to trade with
depending on the type of instrument. This
is called leverage or gearing. An example of
the gearing effect on profitability through
leverage can be seen in the table below,
comparing a theoretical long FTSE 100 Index
purchase and a CFD. The FTSE 100 index
notional value is 45,000 (10 x Index level).
marketindex offers the trader gearing at 20x
his margin deposit. Each tick incremental
movement is worth 1. Using the same
amount of money, the trader buys 10 CFDs,
to the theoretical single FTSE 100 index
purchase. Both positions have the same
notional value of 45,000, but the CFD
trader is only required to deposit 2,250
(45,000 x 5%).
How does a CFD compare to its underlying Instrument?
Initial FTSE 100 Price @ 4500 Long 1 FTSE 100 Index Profit () Long 10 FTSE CFD Profit ()
+10 pips 10 100
+20 pips 20 200
+30 pips 30 300
+50 pips 50 500
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
6CFD Trading Strategies CFD Trading Strategies 7
rbs.co.uk/marketindex
This trade is summarised in the
following table:
Short CFD
Conversely, traders often take short CFD
positions when they expect the underlying
traded instrument to fall in price. When
a trader believes that a stock index, such
as the FTSE 100 Index (FTSE), is going to
fall in price, he sells a FTSE 100 CFD on
marketindex, referred to as going short.
Example
A trader believes that the UK stock index of
leading shares is showing some short term
weakness and might fall. He sells 10 FTSE 100
CFDs at the current FTSE price level of 4451.6
expecting the FTSE 100 index level to fall at
least 50 points over the coming week. He
holds the open position for five days, during
which time the index rises to 4514, and thenbuys back the 10 CFDs for a 62.4 point loss.
Interest payments over the five day period
are credited at LIBOR at 0.475% plus the
dividend adjustment bringing the overall
financing rate to 1.09%.
Strategy Summary
The short CFD position attracts a nancing
credit as opposed to the financing cost of the
Long CFD position. Although not a great deal
of money, it is nonetheless a positive in a
losing trade
The Prot and the Loss on the long and short
transactions represent a high proportion of the
margin capital because of the 20 x gearing
Risks of leverage
Trading on margin can be very profitable,
but it also has its risks. Leverage can work
both ways, by increasing profits but also
increasing losses. Although traders are able
to benefit from very small incremental price
changes, large price movements can cause
high levels of losses if the position is highly
geared. Traders need to be aware of the risks
as well as the benefits of geared positions
before they place orders.
Pip values
Each CFD has a pip value which represents
the change in the value of the instrument
price movement, up or down for a one point
incremental movement. Pip values can vary
between providers and instruments. As an
example, if a trader buys or sells a FTSE 100
Index CFD that has a pip value of 1 per unit
bought/sold, then if the index moves from
4500 to 4501, the CFD profit will be 1.
The best way to explain how a CFD trade
works is to provide an example:
The following includes two simple
examples of Index CFD trades: a long CFD
trade and a short CFD trade.
Long CFD
Traders often take long CFD positions
when they expect the underlying tradedinstrument to rise in price. When a trader
believes that a stock index, such as the FTSE
100 Index (FTSE), is going to rise in price, he
buys a FTSE 100 CFD on marketindex.
Example
A trader notices that the UK stock index
of leading shares is gaining upward
momentum and is establishing a trend.
He buys 10 FTSE 100 CFDs at the current
FTSE price level of 4451.6 expecting the
FTSE 100 index level to increase at least
60 points over the coming week. He holds
the open position for 5 days, during which
time the index rises to 4514, and then
sells the 10 CFDs for a 62.4 point prot.
Interest payments over the 5 day period arecharged at 2% above LIBOR at 0.475% plus
a dividend adjustment bringing the overall
financing rate to 3.09%.
Product Pip Value
Mini FTSE 100 Index 1
Gold CFD 0.01
Corn CFD 0.01
Sugar CFD 0.06
Mini S+P 500 0.62
Mini EuroSTOXX 50 0.88
Day 1 FTSE 100 CFD
CFD Price 4451.6
Trade Buy 10 FTSE 100 CFD
Margin used 2,225.80
Notional
Transaction Value
44,516
Day 5
CFD Price 4514
Trade Sell 10 FTSE 100 CFD
= 62.4 pips prot
Interest paid at 3.09% x 4 overnights
x 45,140/360 = 15.50
Notional
Transaction Value
45,140
Profit /Loss 62.4 pips x 1.00 x10
- 15.50 = 608.50
Below is a table of the currentmarketindex pip values:
Day 1 FTSE 100 CFD Day 5 FTSE 100 CFD
CFD Price 4451.6 CFD Price 4514
Trade Sell 10 FTSE 100 CFD Trade Buy 10 FTSE 100 CFD
= 62.4 pip loss
Margin used 2,225.80 Interest paid at1.09% x 4 x 45,
140/360 = 5.47
Notional
Transaction Value 44,516
Notional
Transaction Value45,140
Profit /Loss - 62.4 pips x 1.00 x 10
+5.47 = -618.53
This trade is summarised in the following table:
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
8CFD Trading Strategies CFD Trading Strategies 9
rbs.co.uk/marketindex
Permitted CFD order types
There are a range of CFD order types including
market orders and limit orders as well as
more complex orders that involve two or more
instruments. Marketindex has four main order
types: Market, Limit, Market if touched
and Stop.
A brief description of the main order
types follows:
Market order
If a trader sends a CFD market order, he
expects it to be filled at the prevailing market
price immediately. Traders use market orders
if they want to get into a position quickly, or
if the market is moving and there is a danger
that they may miss the opportunity to trade
if they do not send a market order.
Example
The Gold CFD price is moving upwards quickly
and the trader wants to go long as he is
expecting the price to continue to rise. He sends
a market order into marketindex to buy 1000
mini Gold CFDs at market. The order is lled
immediately at the prevailing offer price.
Limit order
A limit order differs from a market order in that
the order has a condition whereby a particular
price has been selected and the order will not
be transacted unless the CFD price reaches that
level. Limit orders can take time to trade as they
are often placed at price levels that are away
from the current best bid and offer.
Market if Touched (MIT) order
A Market if Touched order will only transactif the price level that the trader has selected
is touched. This kind of order is used with
charting levels for example. If a trader expects
the price of oil to touch $65 per barrel but then
to continue upward they might look to buy
1000 units of oil at $65 MIT so that they can
take advantage of a prolonged upward move
or a breakout on the upside.
Stop loss orders
Stop orders enable traders to control the risk of
an open CFD position. For example, if a trader
has an open long position in Sugar CFDs and he
expects the price may fall temporarily he may
place a stop order to sell out of the position if a
certain price is reached on the down side while
still holding the position in the belief that it stillmight go up.
CFD Trading LogisticsThe characteristics of CFDs make them flexible and adaptable to a
number of different trading strategies. They enable traders to use a
wide variety of trading positions including long and short leveraged
trades and trades that enable the trader to offset the risk of holding
the underlying instrument through hedging. The important thing
is to be able to adopt a trading approach that suits the traders risk
profile and objectives. The CFD strategies should be seen as tradingtools that are available to help the trader to fulfil their objectives.
The first part of this section, then, deals with setting objectives.
Establishing a Successful
Trading Plan
Too many CFD traders start trading without
a well thought out plan. It is interesting to
compare the amount of forethought that
goes into buying a new car, with the limited
preparation that some CFD traders put into
their trading plans. Most people would
spend time researching the type of car they
wanted to buy, its specifications, its colour
as well as the cost.
They would probably try and reduce
the cost of buying it and make plans
for insuring it, taxing it and the costs
associated with running it. If asked which
of the endeavours, buying a car or trading
CFDs, was the more risky, they are likely to
suggest the trading, so why so little effort
put into planning when starting
CFD trading?
It is possibly due to the fact that there are
not that many sources for trading plan
information readily available.
Well, here is some information
that might help
The creation of a trading plan
Trading plans form the blueprint for a
CFD traders trading activity. Each plan
needs to have a clear trading objective, an
understanding of how much work will beneeded to produce the plan, a structure for
the trading plan and which trading strategies
should be used, and a format for money
management and controlling risk.
One of the overriding objectives in
structuring a trading plan is to eliminate
controllable risks. Some risks you just cant
anticipate, like unexpected stock market
crashes, but there has to be a contingency
plan for all market conditions.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
10CFD Trading Strategies CFD Trading Strategies 11
rbs.co.uk/marketindex
The amount of time that a CFD trader takes
to research his or her chosen market, be it
commodities, currencies, bonds or equity
indices will never be wasted if there is method
and good research records kept.
Here is an example trading plan summary
to give an example of the requirements. In
the plan, the following aspects are covered:
The main trading goal
Degree and scope of preparation required Typical trading behaviour of the
instruments selected
The way in which the market is
currently moving
How much risk the trader is willing
to accept
The trading approach
The amount of available trading capital and
the overnight financing costs
The main trading goal
To trade for a six-week period in energy and
metals commodity CFDs to take advantage
of a general upward price trend in raw
industrial products stimulated by growing
global demand. The profit projection is for an
increase of 10% 15% in the overall value ofthe fund over this period, with risk exposure
of no more than 20% to be taken in any one
commodity CFD at any time. Losses will be
capped at 5% of overall fund value.
Preliminary Research
Research will be conducted into factors
affecting each commodity. As can be seen,
there is interplay between many factors
affecting the oil and metals prices. Each one
of these factors needs to be assessed along
with the likelihood that it will influence price
movements.
Energy products:
Seasonal demands on inventory, important
weekly figures, national and international
stockpiling levels, new oil fields and natural
gas fields and effects on production,
historical oil price movements over ten
years, critical near term support andresistance levels, the current level of the
Baltic shipping index, the current position
of 20, 50 and 200 day moving averages,
relative strength projections with regard to
overbought/oversold status, current week/
day trading behaviour of oil futures, the
futures and options expiry calendar, major
broker activity in oil market, outlook for
the US Dollar.
Metals:
National and international demand for
industrial metals including gold and silver.
Industrial Production and other national
statistics linked to consumption levels
affecting industrial output, particularly in
the US, Europe, China and India. WeeklyInventory levels in main industrial end-
user countries, the current position of 20,
50 and 200 day moving averages, relative
strength projections with regard to recent
overbought/oversold status, current week/
day trading behaviour of metals futures,
the futures and options expiry calendar,
major broker activity in metals market,
outlook for the US Dollar.
This is not an exhaustive list of research
topics but thorough knowledge of all of
these factors will assist the trader in being
able to establish an accurate measure
of where the current prices for these
commodities are in relation to the business
cycle. The next step is to understand the
way the price is behaving and that means
understanding the context in which the
instrument is trading.
Typical trading behaviour of theinstruments selected
Commodity products prices generally
react to swings in global or national
industrial demand. That price reaction
may be quick or slow depending on the
sentiment of the market, but there are
some important influences on the price
movements of these instruments that
need to be understood. The first of these
is that commodities now make up a large
part of hedge fund and money manager
fund composition and so their prices react
more aggressively to large turning points in
the commodity price cycles that exist. An
understanding of the position of the current
price in the commodity price cycle, and
the instruments vulnerability to suddendemand pressures needs to be understood.
On a micro level, traders need to observe
the market action, watching how prices
move intra-day and inter-day and then
to make notes on the types of transactions
that take place including recurring trades
with similar sizes, trades that have large
impact, and any unusual trades that occur.
In addition, the CFD trader needs to know
who else is trading, how many market
participants are major institutions,
at which time intervals do they trade
and what types of trades they put on.
Depending on the granularity of real time
price data that the CFD trader has, he or
she can perform analysis of the trades
that move the market and the trail left
behind them.
Notice needs to be taken of trading
algorithms and their composition, when
they are trading and how often they are
used. Time of day observations need to be
made with regards to trading activity with
special note taken of high volume periods
and lesser volume periods.
It is also crucial to understand the effect on
the price behaviour of the commodity with
regard to macro economic statistics as well
as the levels of volatility reached intra-day
and over longer periods.
The Trading Approach:
Choosing strategies
Choosing the right trading strategy
requires knowledge of the following:
1 The CFD traders overall trading objective
2 The market conditions, now and in the past
3 How much risk the trader is willing to take
given the current market conditions
4 How much capital he or she is willing
to apply
The objective will be for the CFD trader to
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
12CFD Trading Strategies CFD Trading Strategies 13
rbs.co.uk/marketindex
select from his armoury of trading strategies
the right ones to deploy given the current
market conditions.
These strategies can be grouped into the
following categories:
Aggressive short-term strategies that are
used to capitalise on price volatility and
sudden changes in price momentum
Market neutral strategies that look to
take advantage of anomalies in the pricemovements of related products, like
Longer term strategies that adopt
a buy and hold or sell and hold
position.
Those strategies that control risk
And short term hedging due to adverse
price movements
Trade Execution Plan
This is where the trader needs to think about
the mechanics of trade execution. How easy
will it be to execute the orders that make up
the trading strategy? What happens when
only part of the order gets transacted and
one leg of a multi-legged strategy is left
unfilled? The point of execution is where the
trading strategy meets reality, where thesuccess or failure of the plan lies.
Questions to ask
The first question to ask is how easy will
it be to trade in the prevailing market
conditions? Market conditions are
constantly changing depending on the
time of day, the size of the orders that are
hitting the market, the impact of economic
statistics that are being announced and
whether the derivatives markets based on
the cash underlying instruments are close
to expiry or are experiencing volatile trading
conditions as well as many other influences.
There are numerous reasons for price
movement and it can be useful for a trader
to break the trading day into periods during
which certain things occur.
Second question: How do you classify
market conditions?
Classifying Market Conditions
By being able to classify different market
conditions accurately, a trader is more likely
to recognise profitable trading opportunities.
In particular, because of the exaggerated
effects of leverage, The CFD trader needs to
examine closely the varying levels of market
momentum during a trading phase and to
take advantage of the velocity of market
price movements. Traders profitability is
often linked to the degree to which he or she
takes advantage of short-term or prolonged
directional price momentum.
Every market has its busy season when prices
move strongly in one direction or another.Traders success is often determined by how
well they recognise less profitable periods
of price noise and how efficiently they
make use of the more prolonged price trends
during the busy periods. There are three
distinct market conditions which are easily
recognisable when they have happened:
the Breakout, Ranging markets and the
Trending market. The skill is being able to
pre-empt these market conditions from the
information available, something that not
many traders can successfully achieve.
Here is a description of these market
conditions:
The Breakout
The Breakout is characterised by a sudden
sharp price movement away from a trend or
range, whereby the price of the instrument
increases or decreases strongly in one
direction. For example, if the Gold price is
trading at $950 and has been doing so for
3 or 4 days, it may suddenly jump to $980
in a very short period of time, breaking out
from its narrow range. Sudden breakouts
are good trading opportunities, but they
are often very hard to spot. CFD traders
can line themselves up to take advantage
of breakouts by being ready to use market
orders to buy into sharply rising markets or
sell into sharply falling markets.
The following screen shot is an example of a breakout:
In the above example, the USD/CAD currency cross has experienced a strong breakout from the
ranging level of the previous price moves.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
14CFD Trading Strategies CFD Trading Strategies 15
rbs.co.uk/marketindex
Ranging markets
Markets have times when they range within
very narrow price intervals. There can be
long periods of time when nothing seems to
happen, which can be tricky periods to trade.
The benefit of leverage is most obviously
seen in markets that are moving strongly
upwards or downwards, but when there is
little directional momentum the CFD trader
needs to change tack. Such ranging markets
suggest that traders could look to buy at thelower levels of the range and sell at the upper
levels of the range.
For example, it could be said that the
BOBL has established a level and is
ranging between 113.60 and 114.00.
The CFD trader could place limit orders
to buy at 113.60 and to sell at 114.00.
There is risk associated with this however,
as a potential breakout in ei ther direction
would automatically trigger the limit order
leaving the trader with a short position
in an upward moving market or a longposition in a downward moving market.
Trending markets
CFD traders are likely to make most of their
money from correctly anticipating trends in
price movements. If the trader spots a trend
and joins it, like the Oil price trend in the
screen shot below, it can be very profitable.
Because of the leveraged position the long
CFD trade presents, the profits from joining
a trend can be substantial. The art is to
add to the winning positions as the trend
develops. This is known as pyramiding andis described in more depth in the Trading
Strategies section.
Summary
CFD traders need to be able to adapt to all
different kinds of market conditions.
A traders success will be dened by his or
her ability to spot the prevailing market
condition and to adopt the correct trading
strategy to maximise profitability.
As can be seen in the example above, Crude Oil is very obviously in a strong uptrend.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
16CFD Trading Strategies CFD Trading Strategies 17
rbs.co.uk/marketindex
Choosing the best trading approach and trading instrument
Being able to recognise types of market condition is very useful,
but it is also necessary to pick the right tradable instrument. Each
instrument has different characteristics and some traders prefer
certain products to others. For example, traders may prefer to
trade commodities rather than stock indices as they tend to be
more volatile.
There are some basic rules when it comes to picking the right product
to trade and they can be summarised as follows:
1. Reasonable levels of liquidity
More liquid trading instruments offer better
trading opportunities in that they tend to have
narrower trading spreads and better volume on
the bid and offer. They also provide more trade
data to analyse and have better opportunity
for traders to easily exit long or short positions
without moving the market price. This low
market impact is essential when it comes to
taking profits as the last thing a trader wants
to do is to find his profit eroded because the
exit trade moved the market adversely.
2. Reasonably predictable price behaviour
A number of trading instruments have
reasonably predictable behaviour given
certain occurrences in the market. For
example, given sustained US Dollar
weakness, the Oil and Gold prices should
rise. They have an in-built inverse
relationship to movements in the US
Dollar which is widely known. Trading
opportunities in these commodities
can present themselves when currency
movements move in their favour.
3. Knowledge of Fundamentals
Fundamental analysis is very important
when it comes to trading commodities in
particular. Given that commodities, like Oil
for example, respond to changes in global
industrial demand, consumer activity and
sentiment and the level of supply and
demand, it is important that the CFD trader
knows what these fundamentals are.
4. Good Information sources
In addition to the above, it is also crucial to
have sources of information available that
support or refute trading decisions. If the CFD
trader can rely on detailed information to
assist in making trading decisions, he or she
will be more likely to make the right decisions.
5. Picking your default instrument
Many traders have their favourite trading
instrument. It is one that they feel very
comfortable with and one that they can
trade when times in the market become
difficult. The trader will take time to
understand the price movements of this
particular instrument implicitly and will be
able to rely on steady trading profits once
the trading conditions are right.
Risk Control
Controlling position risk is a very important
aspect of trading. There is a general belief
that traders should not risk more than 5%
of their available trading capital in any one
trading position. Given that a CFD trader
will experience the benefit or problem of
positive and negative leverage, keeping
trade sizes within manageable levels is
crucial to long term survival. No matter how
attractive a certain trade looks, the tradermust remember that there are no certainties
that the prevailing market conditions will
continue. By limiting the degree of leverage
in a single trading position, the trader has
reduced the likelihood of blowing up if the
trade starts to go against him.
Any losses that do occur will be magnified
by the leverage associated with the trade, so
strict risk control methods should be used
including stop losses, correct understanding of
important technical levels and price activity,
and a good understanding of volatility.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
18CFD Trading Strategies CFD Trading Strategies 19
rbs.co.uk/marketindex
CFD Trading StrategiesOnce the CFD trader has a clear view of his or her objectives, they can
select trading strategies that help him to achieve their trading plan
aims. The main component of success is the trading strategy.
This section looks at the following trading strategies:
Speculative and Hedging Strategies
Trading Momentum: Coffee
When Coffee moves, it really moves, as can
be seen in the following screen grab. The
commodity can be very volatile and when
it establishes a trend, it will continue it for
some time. This type of price trend gives rise
to the use of a momentum trading strategy.It is tempting, when the CFD trader believes
a big market move is about to occur, to
place a large opening trade at the top of
an expected down move. This approach
is, however, risky and difficult to time.
Momentum strategies enable the trader to
take advantage of continuing building of
directional price momentum so that the
trader is rewarded for adding to a profitableposition rather than deploying all his or her
trading capital in one hit.
A 1-Day chart showing Coffee in a steep downtrend
Speculative and hedging trading strategies
Trading momentum: Coffee
Trading Volatility: Sugar
Correlation or Pairs trading: X Dax versus M Tec Dax
Hedging: Corn
Oil: Breakout in US T-Bond versus US Dollar
Cross Asset Trading Strategies
US T-Bond versus US 10 Yr Notes
Gold versus Wheat
Euro Stoxx versus Dax
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
20CFD Trading Strategies CFD Trading Strategies 21
rbs.co.uk/marketindex
Example
In early July 2008 a CFD trader recognised that
Coffee was trading in a long term downward
trend. From the beginning of July 2008 to the
end of October 2008 the Coffee price dropped
from 2500 to 1550, a very large move on the
downside. The downward price momentum
was extreme and a trader who was disciplined
enough to ride this downward momentum
would have been handsomely rewarded. How
should the CFD trader have traded during thistwo month period?
Firstly, if the trader had done his fundamental
research he would have known that Coffee
tends to trend strongly in one direction
sometimes for very long periods of time.
This can be due to overproduction of Coffee
and reduced consumer demand for example,
or conversely, lower production levels
meeting higher consumer demand.
It so happens, that the period from July to
September 2008 coincided with a growing
fear of a reduction in demand from
consumers for designer coffees through
outlets like Starbucks and Costa Coffee. The
anticipation was that demand for coffee
beans would slow as a global recession took
hold. Coupled with an abundant harvest,
the price momentum was downward.
How then could the CFD trader take
advantage of this developing downward
momentum? Mainly by adding to short
positions in Coffee CFDs whilst maintaining
adequate risk controls in the form of stop
loss limits set some distance above the
prevailing market price.
Strategy Summary
The CFD trader pyramided his positions by
selling short CFDs at intervals
He wasnt tempted to take undue risk
of opening up a large short position
in early July but instead waited to see
confirmation of the downtrend in late
July and August
This continuing downtrend began to gain
momentum in September and the CFD
trader was able to enjoy a large profit on
his short CFD positions.
The trades summary table does not
include the financing debit charge over the
period the trader has open positions but
these charges at 1.09% (LIBOR + dividend
adjustment) would also be credited to the
traders account.
Coffee trade summary table
Day 1 Coffee CFD
CFD Price (US Dollar) 2502.0
Trade Sell 10 CFDs (1 Pip = 6.10)
Notional Transcactional Value 15,268
July 14th 2008 Coffee CFD
CFD Price 2319.0
Trade Sell 10 CFDs
Notional
Transactional Value14,151
August 17th 2008 Coffee CFD
CFD Price 2161.0
Trade Sell 10 CFDs
Notional
Transactional Value13,187
October 11th 2008 Coffee CFD
CFD Price 1693.04
Trade Close 30 Short CFDs
Profit /Loss 4,941 + 3,821 + 2,857 = 11,619
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
22CFD Trading Strategies CFD Trading Strategies 23
rbs.co.uk/marketindex
Trading Short Term Volatility: Sugar
Favourable trading opportunities can
suddenly present themselves when events,
like unexpectedly poor economic numbers
or interruptions to commodity supply,
trigger an increase in market volatility.
The questions that follow are:
What does this explosion in Volatility look
like and how does the trader recognise this
sudden shift?
Sudden increases in volatility usually
manifest themselves in erratic fast moving
price changes in the underlying instrument,
say Sugar, and subsequently are reflected in
the erratic range of price changes of Sugar
CFDs from February 25th to April 18th
2009. Traders will see wider fluctuations
in prices in the order ticket window of
marketindex for example, which can
provide short-term trading opportunities.
With increased opportunity comes
increased risk which tends to widen
CFD bid and offer price spreads and
CFD traders can take advantage of this
widening price difference by attempting
to buy on the bid price and sell on the
offer price by placing limit orders on both
sides of the market.
A chart showing increased volatility in the Sugar price
Scenario 1: Normal Market Conditions Scenario 2: Volatile Market Conditions
Lower Sugar
CFD Price
Upper Sugar
CFD Price
Lower Sugar
CFD Price
Upper Sugar
CFD Price
438.13 439.13 445.50 451.50
Scenario 1:
Normal Market Conditions
In this Scenario, the Sugar CFD bid and
offer price fluctuations are only as wide
as the normal spread size of 1.00. There is
little opportunity to profit from these small
price movements.
Scenario 2:
Volatile Market Conditions
In Scenario 2, the volatile price fluctuation
sees a 6.0 point move over a short time
period as volatility has entered the market.
The CFD trader could place a limit order to
buy at 446.00 and a limit order to sell at
450 which means that fluctuations in the
market price of Sugar could potentially see
him filled on both sides and therefore able
to profit by 4.00 points on the trade. It must
be added that there is increased risk of lossin volatile market conditions, but as long as
traders adopt risk management measures
available on marketindex, like placing stops
once the trader has taken a long or short
position, then the risk of potential loss can
be reduced
There are also other easily recognisable
signs of increasing volatility. For example,
changing volatility levels can be observed
by watching the increase or decrease in
options premiums linked to the underlying
cash instrument. If an option premiumincreases suddenly it tends to suggest
an increase in volatility as the options
premium over the intrinsic value, often
known as time value, denotes the likelihood
that that particular option will expire in-
the-money. So if a cash commodity like
Sugar is trading at 440 in June and the
premium on the 450 August call options
suddenly increases, it can signify that
there are greater expectations that the
calls may potentially be in-the-money by
expiry. CFD traders should keep a close eye
on options premiums.
Secondly, the VIX index (Volatility Index)
is often a good sign of shifts in market
volatility as it is a standard measure ofoverall market volatility which is created
by calculating the 30-day at-the-money
implied volatility of CBOE listed OEX options.
So, this method of trading becomes more
profitable the wider the price fluctuations
of the underlying instrument and the CFD
trader could look to take advantage of
short-term fluctuations by positioning limit
bids and limit offers at strategic places.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
24CFD Trading Strategies CFD Trading Strategies 25
rbs.co.uk/marketindex
Relative Value or Pairs Strategy Trading:
mi X-DAX versus mi X-Tec-Dax
Indices, like the mi X-DAX and mi X-Tec-DAX
whose prices are historically correlated, can
experience unexpected divergences in the
ratio of their prices, so that traders can take
advantage of the divergence of relative values
of those indices while they remain out of kilter.
The mi X-DAX follows the DAX index of the
30 largest companies on the Frankfurt Stock
Exchange owned by XETRA. The mi X-Tec-DAX
follows the 30 largest companies from the DAX
technology sectors. The X indices are based on
cost of carry adjusted DAX futures and correlate
very closely even though they dont have the
same constituent stocks.
Pairs trading involves selling a temporarily
overpriced instrument and buying an
underpriced instrument both of which have
a historically close price correlation. The
objective with a pairs trade is to capture the
price ratio retracement of a large price move in
a stock relative to another. For example, a trader
can open a short position in the mi X-DAX and
a long position in the mi X-Tec-DAX and look
to profit from the movements in the relative
values of the two indices.
If a CFD trader believes that one index is under-
priced compared to another, then he can buy
the cheaper index CFD while selling the more
expensive one. While this strategy reduces
overall exposure to market movements as the
trade is established on a cash neutral basis, it
enables the trader to capitalize on short-term
misalignments in the two index prices.
1-Day chart of the mi X-Tec-DAX
1-Day Chart of the mi X-DAX
The table shows a relative value
trade involving the mi X-DAX
and the mi X-Tec-DAX
What are the risks involved?
Open positions in two previously correlated
CFDs can quite suddenly become seriously
offside for no apparent reason. No matter
how closely correlated the prices of two
CFDs may have been historically, those
correlations break down from time to time.
Strategy notes
The fall in the mi X-Tec-DAX price was less
than the fall in the mi X-DAX price so the
relative value strategy profited overall
A strategy of this kind can also be risky as
correlations can break down temporarily
between instrument prices
mi X-DAX mi X-Tec-DAX
CFD Price (EUR) 5249.13 659.4
Trade Sell 10 CFDs Buy 10 CFDs
Notional Transaction
Value45,401.97 5703.43
CFD Price 5219.73 642.4
Trade Buy 10 CFDs Sell 10 CFDs
Profit/Loss 254.29 - 47.04
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
26CFD Trading Strategies CFD Trading Strategies 27
rbs.co.uk/marketindex
Hedging: Corn
Traders who have long positions or portfolios
in cash underlyings or futures may wish to
hedge temporarily with short CFDs rather
than to close the futures position. This can
be due to the cost of closing out longer term
positions and the difficulty of reopening
them once markets stabilise.
A trader can effectively hedge by taking a
short position with another instrument to
offset the long position. CFDs are effective
instruments for hedging as described below.
Example
A commodities trader has an open short
position in Corn futures and expects
some short term price volatility. He has a
substantial profit locked up in the futures
position but is loathed to close it by buying
the futures because he may have significant
market impact when trying to close the
position, and will attract a large capital
gains tax charge in the current tax year. He
wants to maintain his short futures position
rather than buy them back to take a capital
profit, but is worried that the profit may be
reduced in the short term. He expects further
downward falls in the long term but needs
to maintain the capital value of his overall
position. He decides to buy Corn CFDs to
hedge the short futures position for a three
week period. By doing this, he has locked
in the current Corn price during a period
of volatility and has hedged any potential
losses. The Corn future is quoted in 5,000
bushels per futures contract and the Corn
CFD on marketindex is based on the price
movement of the future. At the end of the
three week period, the value of the futures
position has fallen by USD 24,500 while the
Corn CFD has risen in value by GBP 18,160.
Strategy notes
Although the hedge was not perfect, the long CFD position offset the loss making short
futures position to reduce the loss substantially.
As a general rule, unless there are very good reasons for it, it is usually better to cut a loss
making position than to hedge.
1-Day chart showing the Corn price falling steeply
Trade summary table
Day 1 Corn Future (expiry 9th
September 2009)
Corn CFD
Price450 cents per bushell (5000 per
contract) 4.323 GBP
Trade Short Position of 100 Futures Buy 150,000 CFDs
Per Pip value per 1 contract/
CFD$12.50 0.01GBP
Position Per pip value $1250 908
Day 10
Price movement (Loss 50 pips) (Profit 50 pips)
Trade Maintain Short position of 100 Maintain Long CFDs
Day 20
Price movement (Loss 20 pips) (Profit 20 pips)
Trade Maintain Short position of 100 Sell 150,000 CFDs
Profit/Loss -$24,500 18,160
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
28CFD Trading Strategies CFD Trading Strategies 29
rbs.co.uk/marketindex
Oil versus US Dollar
Traditionally, the Oil price and the level of
the US Dollar move inversely. As a US Dollar
denominated cash instrument, movements
in the currency affect the price of the
commodity. The objective for the CFD trader
is to watch market sentiment for potential
US Dollar movements as indications of
impending Oil price movements. The screen
shot below shows the Oil price beginning to
turn upwards after a very long and sustained
downward price trend. This upward movement
in the Oil price is in contrast to weakness in
the US Dollar. I have used the US Dollar versus
Canadian Dollar to demonstrate US Dollar
weakness in this instance. What strategy
should the CFD trader use? Quite simply,
the trader could transact a long or short CFD
position in Oil CFDs according to the
prevailing price relationship between Oil and
the US Dollar. If the US Dollar is weak, then
the Oil price may show some strength, and
vice versa.
What risks are there?
Firstly, there is a risk that the price
relationship between the two instruments
breaks down and the open Oil CFD position
goes into loss
Secondly, other factors affecting each
instrument other than their price
relationship may take precedent.
For example, short term interest rate
fluctuations may affect the US dollar
more readily whereas shortages in US
Oil inventories may give rise to a sudden
upward spike in the oil price
1- Hour chart of Crude Oil showing oil price strength
Example
It is June 2009 and the CFD trader observes US Dollar weakness and expects this to continue
for some weeks. He takes a view that the oil price will have a sustained rally from its current
$68 level, particularly as far month future prices for September are indicating Oil price
strength at around $75 per barrel. He decides to take a long Oil position in CFDs.
1-Hour chart of US Dollar versus the Canadian Dollar showing US Dollar weakness
June 2009 End June 2009
CFD Price (USD) 68.35 CFD Price 70.90
TradeBuy 1000 Crude Oil
CFDs
TradeSell 1000 Crude Oil
CFDs
Notional Transaction
Value41,720 Profit 1,557.53
Strategy Summary
As can be seen from the marketindex charts, the oil price did move up towards $75 and the
US Dollar continued to be weak.
It must be remembered that a strategy of this kind can also be risky as the correlation between
the USD and the Crude Oil price can break down temporarily.
Financing costs have not been included in the trade summary but would also be deducted.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
30CFD Trading Strategies CFD Trading Strategies 31
rbs.co.uk/marketindex
Breakout in US T-Bond
Market If Touched (MIT) CFD order
Traders can use MIT orders to take advantage
of sudden sharp breakouts in traded
instruments. An MIT buy order can be placed
above the current market price and an MIT sell
order can be placed below the current market
price. If the price of the CFD drops to the level
where a CFD MIT sell order is placed, the tradewill occur leaving the trader short of CFDs
at that level. This can be an effective way to
trade breakouts. For example, the US T-Bond
experienced a sudden price breakout on the
downside as can be seen in the chart above,
The CFD trader placed an MIT order to sell at
118.20 before the price fall with the current
US T-Bond price at 118.40. When the CFD
started to fall in price, the MIT order to sell at
118.20 was triggered and the trade went into
profit as the market price continued to fall.
Strategy Summary
The short trade generated by the MIT
order continued to profit as the US
T-Bond price fell showing that the MIT
order was a successful way to go short
in a falling market
Financing costs have not been included in the
trade summary but would also be credited.
Cross Asset Trading Strategies
US T-Bond versus US T-Notes
Firstly, a couple of points about bonds:
Bond prices move in the opposite direction
to bond yields
Bond yields move in the same direction to
movements in interest rates
Bond prices move in the opposite directionto movements in interest rates
Therefore, if the belief is that interest ratesare due to rise, then the expectation is that
bond prices will fall and yields will rise
The effect of interest rate moves are feltmore keenly at the long end of the yield
curve, so the US Treasury 30 Year Bond. The
US T-Bond, is likely to be more volatile than
the US T-Note. This is mainly due to the
longer time to maturity remaining for the
US T-Bond compared to the US T-Note.
Bond yields are plotted along a time series
known as a Yield curve
The Yield curve slopes up or down
according to the expectations in
movements in interest rates, so if short
term rates are expected to fall the short
end of the curve will be downward sloping
(remember, bond yields and interest rates
move in the same direction)
However, if the medium and longer term
expectations for interest rates are up, then
the middle and long section of the curve
will be sloping upwards.
Trade summary table: US T-Bond MIT Trade
1-Day chart of the US T-Note
Chart showing sudden break out in the US T-Bond price
US T-Bond
CFD Price 118.40
Trade Sell 1000 CFDs at 118.204 MIT
Closing Trade
CFD price 117.414
Trade Buy 1000 CFDs at 117.414
Profit 482.32
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
32CFD Trading Strategies CFD Trading Strategies 33
rbs.co.uk/marketindex
Example
A CFD trader believes that the yield
differential between the US T-Bonds and the
US T-Notes will widen as interest rates begin
to stiffen. He expects the US T-Bond to move
more swiftly than the US T-Note.
A US T-Bond /US T-Note CFD spread is
effectively a trade on the longer end of the
yield curve. If the trader expects the 20-30
year yield to gain on the 10 year yield, he
would go long the US T-Note CFD and short
the US T-Bond CFD. (That is, if the 20-30
year yield gains, then the price falls in the
long end, and if the 10 year yield does not
then the price will remain the same or go up,
then long the 10 year).
US T-Bonds are often more volatile than
the US T-Note because of the longer time
to maturity, so this type of strategy might
be ratiod with a 12 US T-Note CFD position
versus 10 US T-Bond CFDs. However, for
expected changes in interest rates, then long
US T-Bond, short US T-Note if interest rates
are likely to decline and short US T-Bond and
long US T-Note if interest rates are likely to
go up.
Trade Summary
The US T-Bond did move in a more
pronounced manner than the US T-Note
making the strategy profitable.
A strategy of this kind can also be risky as
correlations can break down temporarily
between instruments like this
Financing costs have not been included in the
trade summary but would also be deducted /
credited.
Day 1 US T-Note US T-Bond
CFD Price (USD) 116.084 115.404
Trade Buy 1200 CFDs Sell 1000 CFDs
Per pip movement 7.32 6.11
Notional Transcactional
Value85,084 70,488.31
Day 5 US T-Note US T-Bond
CFD Price 115.944 115.214
Trade Sell 1200 CFDs Buy 1000 CFDs
Profit/Loss -102.48 116.05
Trade Summary
Based on this understanding of the
relationships between bond yields,
prices and interest rates, the expectation
currently in June 2009 is that US interest
rates will soon revert to normal levels,
having been artificially low for some time,
so we could see the yield curve steepen.
That is, the Bond yields all along the yield
curve will reflect the expectation of higher
interest rates.
However, the Long end is likely to respond
more vigorously, thus steepening the curve.
The objective of this trade is to capture the
different movements in the CFD prices as the
instruments react in different ways to the
expected movements in interest rates. As can
be seen from both of the screen shots, the
Bond CFDs are closely correlated but as CFD
traders, we might expect one to move more
quickly than the other.
What could go wrong?
The expected differential movement betweenthe two instrument prices does not occur.
1-Day chart of the US T-Bond
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
34CFD Trading Strategies CFD Trading Strategies 35
rbs.co.uk/marketindex
Example
The CFD trader buys Wheat CFDs and sells Gold CFDs in the expectation that the spread
between the two instruments will narrow.
1-Day Chart of the Wheat price
Day 1 Gold Wheat
CFD Price (USD) 949.40 5.031
Trade Sell 100 CFDs Buy 10,000 CFDs
Notional Transcactional
Value57,989 30,729
Day 30
CFD Price 911.30 4.759
Trade Buy 100 CFDs Sell 10,000 CFDs
Profit/Loss 2,328 -1,663.20
Gold versus Wheat
It may seem strange to put two very
different commodities together in
a correlation or relative value trade.
Although at first there does not appear
to be much of a correlation, one being
a precious metal and the other an
agricultural commodity, they have a near
90% correlation at certain times in the
business cycle. Normally during times
of economic uncertainty, both Gold and
wheat are viewed as stores of value. That
is, Gold is the investment of last resort as
it is a rare tangible metal and holds an
immediate cash value, and wheat is the
most important global foodstuff and thus
has value as human sustenance.
The objective with a relative value trade like
this is to capture the price ratio retracement of
a large price move of either commodity in
relation to the other. For example, if a CFD
trader believes that the correlation is due to
break down soon, he might sell Gold while
buying wheat if the signs are that economic
uncertainty may be reducing. In this example,
whereas both commodities trended downwards
at the end of 2008, the Gold price moved
strongly upwards in the early part of 2009
while the wheat price has struggled to break
over a certain threshold. This now presents an
opportunity to sell Gold while buying wheat in
the expectation that the relative value/correlation
between the two commodities starts to narrow.
1-Day Chart of the Gold price
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
36CFD Trading Strategies CFD Trading Strategies 37
rbs.co.uk/marketindex
1-Day chart of the mi EuroSTOXX CFDs
1-Day chart of the mi X-DAX CFDs
Example trade
10.45am mi EuroSTOXX mi X-DAX
CFD Price 2522.10 5087.53
1 Pip 12.80 GBP 1.28 GBP
Trade Sell 15 CFDs Buy 15 CFDs
12.45pm mi EuroSTOXX mi X-DAX
CFD Price 2549.10 5119.03
Trade Buy 15 CFDs Sell 15 CFDs
Profit/Loss -349.93 408.17
Strategy notes
The relative value trade worked well with
the increase in the short Gold trade prot
exceeding the loss from the long wheat trade.
A strategy of this kind can also be risky as
correlations can break down temporarily
between the commodity prices
Financing costs have not been included in the
trade summary but would also be deducted
/credited.
mi EuroSTOXX Versus mi X-DAX
A frequently traded spread is the Euro Stoxx
Index of 50 major European stocks versus
the mi X-DAX CFD based on the Index of
30 leading German Stocks. Some of the
German stocks are in both indices so there
are interesting correlations between the two
indices. They move very closely in line with
one another so any changes to their relative
value are often quite small and short lived.
Strategy Example
The CFD trader expects there to be some
short term volatility in European markets as
the European Central bank is due to make an
announcement on interest rates very shortly.Volatility could push the mi EuroSTOXX/ mi
X-DAX spread out of line for a very short time
so the trader decides to Sell mi EuroSTOXX
CFDs and buy mi X-DAX CFDs over the
announcement.
Strategy Notes
The strategy works well as the spread between
the two indices widens as the mi EuroSTOXX
loses less than the mi X-DAX prots
A strategy of this kind can also be risky as
correlations can break down temporarily
between the index prices
Financing costs have not been included in the
trade summary but would also be deducted
/credited.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
38CFD Trading Strategies CFD Trading Strategies 39
rbs.co.uk/marketindex
Individual Expectation and Self-Illusion
An additional consideration before a
trader starts to trade electronically is to
assess whether the traders expectation
of his profitability is reasonable. Traders
must exemplify a sufficiently balanced
understanding of their own strengths and
weaknesses, and therefore their expectations,
in order to avoid creating unnecessary
risk. Interestingly, traders preliminary
expectations are rarely accurate indications
of their subsequent performance as they
often suffer from delusions of success.
Much of this however, can be put down to
enthusiasm and a touch of naivety, but it is
important that the trader quickly realizes his
shortcomings and the extent to which he can
fail if he suffers from self-illusion.
Improving reaction times to market
price movements
Reaction to stimuli measures indicate how
quickly a trader picks up on a positive trading
scenario. This is measured as a combination
of time taken ratios, momentum and data
recognition qualities. Measuring how well a
trader follows a previously successful event in
the market is complex as the event must beisolated and encapsulated, and the behaviour
before and after linked irrevocably to that
event. Reaction to stimuli metrics can be
positive and negative.
Heres an example of a snapshot of the time
taken metrics analysis of a trader research
participant:
a) The trader was slow in recognizing that
the market was trending upwards and that
he should have remained net long for the
majority of the time. The frequency and
longevity of the short positions, which
invariably turned into a loss, also suggest this.
b) The trader should learn to hold his winning
positions for longer.
c) It takes him longer to take his losses than to
run his profits.
The use of trailing stops may be advisable so
that the trader does not run losing positions
indefinitely.
Inaction
Another important time sensitive element in
trading is inaction. Inaction often speaks
louder than action in that hesitancy over a
potential move in or out of the market can be
construed in a number of positive or negative
ways. If the trader shows increased profitability
through running open positions profitably, or
avoiding opening loss making positions, then
his or her inaction has been worthwhile. If,
however, a trader hesitates to enter a new
open position either following the closing of a
previous open position or has difficulty closingan open position that has been running for
some time and is not profitable, then they are
hesitating and letting inaction takeover. The
more confident a trader is in his trading
actions, the more frequently he or she wants
to be active in the market. It is seldom more
profitable to remain out of the market than it
is to be in it, although as discussed below, the
timing of entering a trade is vitally important.
Risk and Trading PsychologyWhile traditional forms of risk management, like pre-set loss limits
are necessary in order to safeguard traders from themselves, other
forms of risk analysis deal with the more complex issue of trader
behaviour. Known as Trader Psychometrics, the objective is to combine
risk management with a better understanding of the traders unique
trading psychology. This is a complex undertaking but one which
provides a much more accurate risk assessment.
Trader Risk Management
A trader who understands his risk profile and
recognises how he performs under certain
market conditions has a better chance of
being successful than a trader who doesnt.
The following aspects of a traders risk
profile and trading psychology need to be
understood:
Individual Expectation and Self-Illusion
Reaction times
Inaction
Trade Theta
Use of time
Weighting
Decision making biases
Condence and consistency
Erratic behaviour
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
40CFD Trading Strategies CFD Trading Strategies 41
rbs.co.uk/marketindex
Although there is some logic to standing
back from the market in times of complete
turmoil, a trader needs to have a presence
in the market as often as possible, needs
to have his rubber to the road. Trader
Psychometrics provides evidence of traders
unwillingness to take on new positions and
records inactive time.
Trade theta
Time taken metrics are also important
measures of risk, as all potential trades have
a shelf life or theta. In fact, every trade, let
alone potential trade, has a lifecycle and a
sell by date as timing an exit is as important
as timing an entry. Hesitancy can destroy a
potential trade and the longer that a trader
takes to act, the less likely the trade, if
undertaken, will prove to be a success. The
obvious reason for this is that depending
on how the market is moving, the set of
circumstances that formed the basis for the
potential trade may not be the same after a
particular length of time has elapsed. Market
conditions can change rapidly so it follows
that the trader should amend his trade
selection accordingly. The correct theta of a
potential trade then, depends largely on twoparticular qualities: the current volatility of
the market and the pattern of the preceding
market move. If a trader cannot convince
himself to take the plunge, then it is far
better for him to abandon the notion of a
potential trade with a lengthening theta
than to wait until a more conducive market
scenario presents itself. Trying to fit the
market to the trade never works.
Use of time
Along with time taken metrics Trader
Psychometrics also categorizes a range
of Use of time metrics. The trader is being
assessed here as to how well he or she
maximizes the profitability of a winning
trade or minimizes the loss of a losing trade.
Use of time in winners and Use of time in
losers are important metrics because they
show how much conviction a trader has for
his open position as well as how well he
deals with a losing position. A skilled trader
demonstrating good performance will have
impressive Use of time scores indicating that
when he has an open long or short position
he is maximizing its profitability and making
best use of the time in that trade.
Weighting
Weighting is a term given to a group of
metrics that determine the success with
which a trader backs his winning trades
while reducing exposure to losing trades.
We discover if a trader weights his trades
proportionally well and is able to balance
and leverage his resources. It is also useful
to observe if a trader places his resources
behind certain types of trade followingparticular events in the marketplace. Does
a trader, for example, consistently follow an
upward moving breakout scenario with a
long open position at the apex of the market
move when he should be looking to short it
instead? In other words, does he place his
resources too readily behind the wrong type
of trade and too seldom behind the right ones
given different market scenarios?
Decision-making biases
Decision-making biases form a complex area
of behavioural study and are at the root of
the broader discipline of behavioural finance.
In applying Trader Psychometrics what we
are looking for are clues as to why a trader
makes a decision to go long or short, to close
an open position or run a series of open
positions given particular market scenarios.
We are particularly interested to see if
decision-making biases occur systematically
following a single stimulus or a series of
stimuli. If we can locate the stimulus, we
can then work on the prevention or the
encouragement of such behaviour.
As an interesting example of this, during
part of the Trader Psychometrics research I
studied the metrics of a trader who had what
I thought was a unique problem. Although a
very astute and well-rounded trader, he found
it difficult to maintain a trading position in
trading arcades because his profit and loss
statistics were always erratic. Strangely,
when most traders are conscious of making
profits from the outset, this trader could
not make a profit from trading without
first being in a loss making position. Quiteinexplicably, he had to have negative profit
& loss statistics before he was able to focus
his energies in pulling himself out of loss
and into prot. However, he almost always
managed this successfully and finished
most trading sessions with good profits.
Nonetheless his trading managers did not
feel comfortable with his insistence on loss
making in the initial opening stages of the
market. He came to us looking to nd out
why he was not able to trade consistently and
how to rectify the problem.
Once we hooked the trader up to Trader
Psychometrics however, we realized his
problem. By observing a combination of
metrics we discovered that he consciously
chose to make losses in early trading only
then to turn his losses round into profitability
once he had reached a certain loss-making
level. His Loss to Prot Momentum metrics
were always very good and his Use of time
in winning trades consistently improved
throughout each trading session. However,
I questioned his need to make losses before
he could garner the energy and conviction to
make money. As he was a profitable trader
nonetheless, he viewed his own idiosyncratic
behaviour as inevitable. However, I wasnt so
certain. We tried the obvious and took away
the traders P&L window so that he could
not tell if he was in a profit or loss and (not
surprisingly) the bias he had for making a
loss before he could move into profitability
disappeared.
What this shows is that the traders
perception of his own weaknesses caninfluence his behaviour negatively and
interfere with normally healthy decision
making processes. At the opening of the
market each day, the trader was consciously
trying to make a loss by trading poorly
so that he could then react positively to
the loss and begin to make profits. This
behaviour is akin to a form of survivalist
instinct, and a term we sometimes use when
we marvel at the ways in which people are
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
42CFD Trading Strategies CFD Trading Strategies 43
rbs.co.uk/marketindex
able to overcome adversity is apt: strength
in adversity. The trader was presenting
himself with a challenge and willing himself
to overcome the adversity of loss. If instead
of subjecting himself at the open of each
trading day to the same loss making
behaviour he was encouraged to change that
behaviour through altering his environment,
he would be more consistent in his trading
and more in tune with making profits.
However, once we had cured this decision
making bias, we found another one.
The trader became very uncomfortable when
he started to make substantial profits and,
over time, we found that he preferred to
stay within a narrow corridor of prosperity,
limiting his upside profit potential. Again
we hoped that this limitation to his success
might be attributable to the visible P&L
window but it was the reverse. He felt better
about his trading and his profitability if he
could see his P&L window than when he
couldnt. With his P&L window turned off,
he mentally added up his winning positions
and tended to overestimate his profitability
thus making himself uneasy even though
there was no reason to feel this way. We triedseveral ways to alleviate his fear of making
substantial profits and kept his P&L window
out of sight. We substituted the mini futures
product he was trading for a heavier product
so that it had greater leverage and therefore
higher prot making potential. He was used
to trading a much lighter product and judged
his level of profitability on the assumed per
tick increases on this product. However, this
only worked for a short while. We then tried
him on spreads.
The trader had been scalping single product
CFDs for a few years but had never tried
trading CFD spreads. I felt that he might have
a natural bias towards trading spreads in
that he traded consistently well in trending
markets and preferred to stay out of breakout
and strong reversal conditions. His trade class
scores were always better, or at least second
best, in the trending markets category. The
combination of spread trading and not being
able to see his P&L eventually worked. The
trader felt comfortable with spreads in that
he perceived they limited his downside loss
making capacity and upside profit potential.
However, he went on to make substantial
profits through trading spreads and became a
very successful trader. The interesting thing
is that this traders behaviour would have
gone entirely unnoticed had we not hooked
him up to Trader Psychometrics.
How do CFD Traders recognise and control
their Trading Psychology?
Confidence and Consistency
Confidence with regard to trading does not
just mean believing in oneself and ones
abilities. The confidence metrics provide
evidence of pattern recognition, accuracy
of expectation, consistency of activity, level
of follow through, and focus. If a trader
displays evidence of sustained confidence
in his trading then he is likely to be more
consistently successful. Those traders that
have inconsistent confidence metrics tend
to have erratic profitability scores. They
often show little evidence of having a pre-
arranged trading plan and instead rely in
sporadic interpretations on the fly of ever
changing market conditions. Those that are
successful are normally able to recognize
and follow trends in the marketplace. Those
that are not successful have little more
success than a coin flipper. Traders who have
planned their responses to various market
conditions and are able to methodically
execute their plans are usually more
consistently profitable over time.
Consistency
Consistency in trading is vital because it
creates a level of control that a trader can
feel confident in exercising. Consistency
of action, and subsequently performance,however takes practice. When a trader
practices a range of responses to market
scenarios in simulated trading conditions,
and uses Trader Psychometrics to measure
that performance, he has a greater chance of
repeating the successful responses once he
is back trading in the real market. Deviation
from consistent behaviour takes a number
of forms and is normally brought on by
sudden exposure to unexpected events.
However, there is one certainty. Consistently
excellent trading performance is a planned
endeavor. Traders that have a plan of action
and have prepared themselves to meet a
number of different market scenarios during
the trading session are likely to be more
consistent in their trading behaviour and
protability. More often than not, abrupt
deviation away from planned responses
leads to underperformance. Through Trader
Psychometrics we can tell if a trader is
following a planned trading approach or not.
Erratic Behaviour
On the flip side of the coin to Consistency
is Erratic Behaviour. Why do some traders
show signs of trading erratically and how can
we isolate these conditions and deal with
them? The main tangible influences behind
erratic trading performance stem from a
lack of familiarity with the trading tools
the trader is using, a lack of understanding
of ones own reasoning behind putting on
successful trades and the lack of a well
thought out trading plan. Other influences
that lead to erratic trading behaviour aresomewhat intangible in that they seem
to interrupt a pattern that the trader has
created over time and are out of character.
For example, consistently performing
traders can experience temporary blips in
their performance when they meet certain
market conditions or a string of disruptive
circumstances suddenly present themselves.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
44CFD Trading Strategies CFD Trading Strategies 45
rbs.co.uk/marketindex
The traders skill in being able to adapt his
trading behaviour to circumstances he has
never before experienced is what we are
looking for in positive Erratic Behaviour
statistics. It seems counter intuitive to have
positive statistics for Erratic Behaviour but
the metric is a mixture of different variables
some of which move between the negative
and the positive.
Degree of Follow Through
One way of explaining the importance of
follow through to a CFD trader is that you
have to own a trade after you have placed it
and by following through you show that you
are taking the trade seriously. Merely placing
a trade, or group of trades, and waiting to see
if it is, or they are, successful is not enough.
The trader has to believe in his trade before
he places it and to follow it through while it
is open in the marketplace. Trading is like
bowling in as much as the bowler owns his
bowl enough to follow it through 20-30 yards
down the lawn. I find that traders who own
their trades and follow through exemplify
greater concentration and accuracy. They
also place fewer trades but those trades on
average are more successful.
A similar level of focus is applied to the
Alpha Trade. The Alpha Trade is a maximum-
advantage trade that occurs infrequently
but is worth lining oneself up for. In the open
outcry pits there were traders that waited
all day for this type of trade and then threw
all their resources behind it. The act of
pre-Alpha Trade posturing is reminiscent of
a golfer addressing the golf ball before he
hits it, the rifle marksman actively reducing
his breathing before he shoots and Jonny
Wilkinson centering himself before he takes
a place kick at goal. There has to be a level of
concentration and focus that borders upon
obsession. The trader is waiting patiently for
the Alpha Trade, posturing in order to take
maximum advantage of it, because he or she
knows that it is a winner.
Pyramiding and Gunning
Pyramiding determines how well a trader
recognizes a potentially good trade, having
placed an order in the marketplace, and
supports his decision by increasing leverage
and exposure to it in the form of additional
orders in the same format. Conversely,
negatively pyramiding a trade means that
the trader is leveraging his losses and adding
to a losing position, known as averaging.
Gunning is akin to pyramiding but instead of
following an open position with a new open
position of the same contract size, the trader
exponentially increases his open position
from a single contract to two, then to four,then to eight and so on. A trader who guns
his position has made a strongly positive
decision about its potential profitability and
is backing that decision with all his available
resources. The trader has recognized a
particular trading scenario, possibly the
Alpha Trade that has high potential for
profitability, and has thrown all his resources
behind it. Gunning is the hallmark of an
experienced trader.
Performance Taper and Drift
Trading performance is seldom uniform and
performance taper refers to the positive or
negative slope of that performance. A positive
performance taper signals an increase in
profitability and consistency and a negative
performance taper reveals a decreasing
slope in profitability and consistency. Drift
metrics are useful in determining how much
heat a trader takes when he has an open
position. An example will clarify the uses
of drift metrics. If a trading company relies
upon the level of a traders P&L alone as an
indication of how well he or she is doing,
they miss a vital statistic that indicates
how many negative or positive ticks the
traders open positions experience before
they are closed. For example, if a trader
takes a long open position at 100 and then
allows the position to lose several ticks to
93 before closing it out for a small profit at
102, in P&L terms the trader has performed
averagely well. If however, we take into
consideration the negative 7 ticks that thetrader allowed the position to drift then he
will have a negative average drift metric and
a maximum negative drift metric of 7. The
traders performance does not look so good
when the drift metrics are examined. There is
little excuse for a trader in electronic markets
not to cut a loss making trade because
the current bids and offers normally have
reasonable volume associated with them.
Drift metrics are useful in conjunction with
average time in trade metrics, and Use of
time metrics in that they alert a trader or
his manager to the fact that the trader has
no real trading plan and therefore is running
losers for far longer than he should. What
can be an issue for some traders, however,
is the ability to run winners and to cut
losers frequently. Average positive drift and
maximum positive drift metrics address
this ability and form the antithesis of the
negative drift metrics. A trader can be as
guilty of inconsistent trading by not running
his winners for long enough as he is if he ran
his losers for too long.
Pattern Recognition
Successful Pattern Recognition is of great
value to CFD traders and forms the basis for
many of the trades made during the trading
day. Patterns can form themselves over long
periods of time or over much shorter periods,
sometimes seconds. CFD scalpers look for
patterns that occur in market prices over
very short periods of time, even between2-3 market price changes, and expect to be
able to capitalize on these price movements
instantaneously. Pattern Recognition skills
enable traders to concentrate on particular
types of market conditions and good traders
tend to avoid conditions that they dont
recognize or that dont suit them.
-
5/21/2018 CFD Trading Strategies Using Market Index David James Norman
46CFD Trading Strategies CFD Trading Strategies 47
rbs.co.uk/marketindex
The Alpha Trade is recognizable through the
following market circumstances:
A prolonged slowdown and a narrowing
price movement range in a market trend
(often identified through technical analysis
by the formation of a Wedge, Pennant
or a Flag pattern) that then leads to a
sudden Reversal or Breakout along with an
increase in directional velocity.
If the trader recognizes the Alpha Trade,
he takes a position at the outset of the
formation and continues to hold, or add
to that position, until the market velocity
diminishes
The sudden sharp increased per tick
profitability of the winners/losers ratio
The setting of the daily record for the
highest per-tick profit
A heightened degree of positive trading
activity in the form of small incremental
increases in double tick profits
A reversal of the negative winners/losers
ratios
An increase in Implied volatility, Kurtosis
and skew and a positive market move from
negative trending markets, to sideways,
and ultimately to positively trendingmarkets. The reverse scenario works for
downward moving markets.
The degree to which a trader recognizes the
Alpha Trade determines his ability to take
advantage of developing patterns in the
market movements. Taking correct Alpha
Trade positions can make traders very rich
and those that can recognize them are gifted
indeed. The build up to the Alpha Trade is
often a long intricate process that can last
several hours with many twists and turns
in the market. The trader who has the focus
and determination to be patient can often
be rewarded with large tick profitability
especially if the trader guns the position by
adding exponentially to the size of the open
position.
An example of an Alpha Trade can be seen
in the US T-Bond chart on page 48. The CFD
suddenly broke on the downside between
2.30pm and 3.15pm giving the CFD trader
the opportunity to short the CFD and to
add to his winning position as the price
continued to drop.
Because traders are normally very sure
about an Alpha Trade before they create an
open position, they are encouraged to back
it with all their available resources. The art
of recognizing the Alpha Trade is in being
able to see the combination of a number of
market elements coming into line, including
subtle changes in volume traded, changing
velocity in directional momentum, less
than obvious pattern signals in technical
analysis charts, the impact of certain timesof the day, month or year, the shifts in the
mood of the market, the current news and
the supply/demand ratio. Observing these
subtleties obviously demands a great deal
of concentration and it is interesting to see
how well a trader postures before the advent
of an Alpha Trade.
In this example, Crude Oil is showing a very
distinct trending pattern. It can be surprising
however, how some