CFDs Trading Strategies

The difference between the buying price and selling price is one of the key costs of trading. Tangible costs such as commission and stamp duty are easy to quantify and can easily be calculated, as they appear clearly on contract notes. However speak to any hedge fund manager and he will spend two minutes talking about fixed, controllable costs such as commission and two hours talking about bid-offer spreads, market liquidity, price slippage and impact and VWAP. This is because the bid-offer spread is the active trader's biggest enemy, and the one over which he has least control.

Explanation of VWAP

VWAP or volume-weighted average price is a term that has now entered everyday trading language. A simple example should illustrate how it is calculated. If a stock trades only twice in one day, say 10000 shares trade at 140p and later 10000 shares trade at 150p, the mean price for the day and the VWAP is 145p. However if 10000 shares trade at 140p and 100000 shares trade at 150p, although the mean is still 145p, the VWAP is now around 149.09p. In other words, the VWAP gives an indication of average price dependent on size traded. This is of importance to a number of market participants, particularly in portfolio trading or where an order is 'worked' throughout the day, as it gives the client an idea as to how well the transaction has been executed in terms of slippage. VWAP is also important in evaluating opportunities in the postmarket auctions where 'at-market' orders can create liquidity imbalances and force prices up or down.

Strategies

Technical analysis plays a big part in short term trading and has been extensively written up elsewhere. Many CFD traders like to specialise in a small universe of stocks, say 10-15, typically high volatility stocks like Colt Telecom, ARM Holdings, TeleWest, Logica and CMG. These are popular trading stocks due to their high volatility, moving up to 10% a day and good liquidity. Here we will examine some of the more opportunity-driven trades that can present themselves to the alert trader.

Auctions

In the summer of 2000 the LSE introduced three main types of auction: closing, opening and intra-day, as a refinement to the SETs order book, that had successfully replaced the market-making based system of trading for the top 200 or so stocks.

A number of opportunities for CFD traders regularly occur in these auctions, particularly the closing auction, which occurs for a five-minute period from 16:30 to 16:35 after the close of normal trading. The reason for this is that the auction process suspends trading for five minutes and allows participants to submit orders to buy and sell at a stipulated price. Throughout this five-minute period, a theoretical 'uncrossing' price is calculated continuously and dynamically and displayed. At the end of the fiveminute period, any orders that can be completed are matched up and executed at one specific price, the uncrossing price.

The key difference between the auction period and normal trading is that participants can input orders to buy or sell 'at market'. This instruction can create short-term imbalances in liquidity that in turn forces stock prices up or down. CFD traders can take advantage of these imbalances by submitting orders in the opposite sense to secure the best prices; quite regularly the daily high or low for a stock will occur in the auction. Those traders not accessing these prices are missing out on optimum dealing prices, an important factor for short-term traders.

The charts in this chapter illustrate the kind of surge in stock price that can occur in the auction when 'at market' orders are placed where there is a limited amount of liquidity available.

The two-day chart for RMC Group (RMC) at the end February above is a good example of what can happen when a large 'at market' buy order is placed in the post-market auction. Here the price is forced up and 81500 shares uncross at 570p. This presents two potential opportunities to the CFD trader. Firstly, if he was long the CFD in RMC originally, he can sell his long position at an extremely favourable price in the context of the day's trading rage (547p-560p) .

Secondly, and perhaps more importantly, he can elect to open a CFD short position by selling in the auction (to open) at 570p, providing liquidity to offset the 'at market' buying order. If he was comfortable selling down to say 560p, he could submit an order to sell at this level, increasing his chance of execution.

As all uncrossing takes place at the same price, if the uncrossing price were still 570p, he would complete his order at 570p, an improvement on the 560p level submitted. If however, the uncrossing price were 558p, he would not end up executing at all, as his sell order was submitted above this. This demonstrates quite well the balancing act that CFD traders must perform to extract the best price while ensuring a fill.

As can be seen, RMC reverted back to its previous day's trading range the next morning, providing ample opportunity to close the short position between 550p and 555p. Three or four percent may not sound much to a long-term investor but to a CFD trader it provides a useful return on a relatively short-term overnight trade.

A similar situation can be seen to occur in United Business Media (UBM) on the same day in late February. The two-day chart below shows the spike in the price of UBM when an 'at market' buy order for 240,000 UBM was submitted in the closing auction forcing the uncrossing price up to 585p.

Having traded during the day between 560p and 572p this proved an attractive level at which to sell or short the CFD, and the next day the stock reverted to a more normal level, providing those CFD traders prepared to take overnight risk, a healthy return. Stocks that should possibly be avoided in this strategy are those involved in special situations (takeover talks for instance), those companies reporting results the following trading day or those going 'ex-dividend' (usually only on Wednesdays). A list of stocks reporting and ex-dividend dates are easily obtained from a number of financial websites.

Another recent example occurred on 17 January when Wolseley, the specialist trade distributor of plumbing and heating products, issued its trading statement for the five months to 31 December. The favourable figures were released at 7am. The market reaction was positive and traders with DMA were able to capitalise on this during the opening auction, which saw the stock rise from its Friday close of 988p to open on the Monday at £10.15. The positive reaction to the trading statement was such that it persisted past the opening auction and into the trading day itself. Opening on 17 January at £10.15, the price went on to rise to just under £10.55 a little after 10am before finishing the day at £10.46-£10.4750.

Although at first sight, placing 'at market' orders in the auction may seem an inefficient means of execution, there can be a number of reasons for their use. Firstly, the client, for whatever reason, may stipulate that he wishes to trade in the closing auction only, thereby ensuring dealing at the closing price for the stock on the day. Secondly, the order may be part of a bigger, 'worked' order that is being executed in tranches throughout the day, a third in the morning, a third in the afternoon and a third in the closing auction for instance.

Thirdly, and most interestingly, funds may want to deal at the closing price in a stock when it is being re-weighted in an index or there is a constituent change. With the increasing use of tracker funds, this is becoming an increasingly important influence on stock prices on certain dates. As well as the quarterly FTSE constituent reviews, stocks may also be re-weighted in an index due to an issue of new equity or after the take-over of another company involving the issuance of shares. When this happens, the tracker funds may need to increase their weighting in that stock to guarantee correlation with the appropriate index. These re-weightings can be easily followed at www.ftse.com

Index reviews

The FTSE quarterly reviews are also followed closely by CFD traders. A majority of tracking funds seek to replicate the FTSE 100 or FTSE All-Share indices so changes to these indices can be more important than say the FTSE 250.

In June 2001, it was announced that Railtrack would be removed from the FTSE-100 to be replaced by Next. These changes would take effect after the close of business on Friday June 15th. The two-day charts below illustrate the dramatic short-term effects that tracking funds can have on a stock price. By dealing in the auction the tracking funds can ensure they are buying the new constituent at the same price that it will be entering the index, and selling the leaving constituent at the same price that it will be removed from the index, thus guaranteeing close tracking.

However, CFD traders took advantage, typically buying Next during the Friday, selling their position in the auction at the high of the day at 973p and then selling short more Next also in the auction. On Monday, Next's first day in the index, the traders were about to buy back their shorts between 925p and 955p. A similar strategy in a reverse sense was applied to Railtrack, the stock leaving the index. CFD traders sold the stock short during the Friday, bought their short back in the auction at 298p, the low of the day, and then bought again, running a long position over the weekend. On the Monday, the stock rallied throughout the day allowing the stock to be sold out anywhere up to 325p.

Exciting though these strategies may seem, it is important to be aware that they are far from risk-less. Anticipating short-term fluctuations in share prices can be rewarding but it must be borne in mind that a stock can be subject to many other influences, including systemic market risk and unexpected news.

Stock reclassifications and re-ratings

The FTSE 100 Quarterly reviews have been well documented above. In addition, the FTSE All-Share Index is reviewed annually in December, although quarterly reviews can occasionally take place when a stock has recently joined the market. It is important to remember that tracking funds generally follow the FTSE 100 or the All-Share Index, FTSE 250 Index changes are less significant. A good example is shown below where Glenmorangie was booted out of the All-Share due to liquidity issues. Tracking funds were obliged to sell the stock, having a significant impact on the share price. Over the next couple of months, a good recovery ensued. The changes to the Index are effective on expiry day, usually the third Friday of the month, so the strategy is to sell the stock after the announcement but in advance of its removal and then buy the stock after its removal, anticipating a recovery in share price. Other opportunities can occur when a stock is reclassified from one sector to another, with that sector enjoying a higher p/e ratio.

Director's Dealings

Following directors' dealings can be a rewarding occupation. More significance is often given to purchases rather than sales as this demonstrates a higher degree of commitment. Directors are not allowed to buy or sell shares in their own company in the two months preceding results, so a cluster of buying just before or after this period can be a very bullish signal. The point being, that the results refer to an accounting period that has probably closed some several weeks before, whereas the directors will have a good idea how trading is progressing since that time. A particularly bullish sign is when good results are published, the stock goes up, and the directors still buy stock, even after the rise! CML Microsystems (CML) was a particularly good example where a cluster of directors bought shares after the results came out in June 2000. The stock continued to rally strongly over the next few months as can be seen in the chart below.

A similar situation that could be worth watching is First Active (FTA). Strong results were out at the end of February 2002, followed by a share price rise and a cluster of director buying. One to watch.

Stock splits

Traditionally viewed as a bullish signal, stock splits have established an almost cult following in the States. More likely, is that stock splits exaggerate a current stock trend. So a stock in a strong uptrend that splits its stock from say £30 to £3 for liquidity issues is very likely to re-list at above £3 after the split. However a stock that is performing indifferently, is less likely to outperform after the split. Of course stock splits do not in any way change the value of a company, however, human perception being what it is, stocks that have experienced a cataclysmic fall in value rarely consolidate their stocks. Say Marconi was trading at 7p and consolidated its stock on a 100 to 1 basis and relisted at 700p. The suspicion must exist that the stock would immediately suffer weakness. There is psychologically a much bigger gap between 700p and 0p than 7p and 0p. There will always be ready buyers for 'option' money!

SMG announced a stock split in April 2000 which became effective at the end of June, the chart below makes interesting viewing. During the same period, the FTSE 100 dropped from 6600 to 6300. As with most similar situations, anticipation is everything. It is better to travel than to arrive.

Stock buybacks

After seeking shareholder permission, companies that find themselves over capitalized can buy back some of their shares in the marketplace. Like directors dealings, these buybacks must be suspended during the closed period of two months leading up to their results. This can provide an opportunity for traders to take advantage of. For example by establishing a short position just as the buy-back is finishing, closing the short during the anticipated share weakness leading up to the results and perhaps establishing a long position in readiness for renewed share price support when the buyback recommences.

In summary, many opportunities can present themselves to the lazy trader simply by following the actions of established shrewd investors such as Jack Petchey, Peter Webb, Jon Moulton or Bob Morton. These individuals have a good reputation for accumulating stakes in undervalued companies and acting as a catalyst for extracting shareholder value. Certain Internet sites specialize in following the movements of these individuals such as www.citywire.co.uk.

Breaking news

Major share price movements often stem from important, unexpected company news that breaks during market hours. A broker upgrade or trading results out of line with forecasts can lead to a material re-rating of the shares. One of the highest-profile examples last year was when Sir Philip Watts resigned his chairmanship of Shell soon after revealing that the company had materially overstated its 'proven' oil and gas reserves. The shares surged when this news was released on 3 March.

Some news items such as broker upgrades or bid announcements will clearly create positive sentiment towards a stock, but not all newsflow is as straightforward to assess. Directors' dealings, although valuable and widely watched, do not always create the reaction that one might expect, while trading statements and annual results can be quite difficult to assess.

Most online CFD providers include complimentary news feeds in their platforms to enable traders to take advantage of these opportunities. The streaming news feeds in particular are very powerful. Trading breaking news can come down to a case of fastest finger first. Those who see the announcement straight away may have the time to get in early and capture a large part of the move. This is more likely to be the case with those CFD traders who use a direct market access service but it is sometimes feasible with quote-driven providers too.