cfd trading strategies using market index david james norman

5/21/2018 CFD Trading Strategies Using Market Index David James Norman

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CFD Trading StrategiesDavid James Norman


2CFD Trading Strategies CFD Trading Strategies 3


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.




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




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:




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.




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




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.




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.




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.




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




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




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.




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




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




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.




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




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.



between instruments like this


trade summary but would also be deducted /

credited.

Day 1 US T-Note US T-Bond

CFD Price (USD) 116.084 115.404


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


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




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




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


12.45pm mi EuroSTOXX mi X-DAX

CFD Price 2549.10 5119.03


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.



between the commodity prices


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



between the index prices


trade summary but would also be deducted

/credited.




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




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




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.




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.




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

cfd trading strategies using market index david james norman

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