CFDs - Long Term Positions
Contracts for Difference (CFDs) are most closely associated with short-term trades of anything from a few minutes to a few days but it is also possible to use them to take longer-term positions lasting several weeks or months. The beauty of this sort of approach is it gives the market more time to move in your favour.
This longer-term strategy is known as position trading. The idea is to identify an important trend or valuation anomaly and then open an exposure to take advantage of it. In view of the extended timescale, most people would look at both the fundamental and technical analysis to give them the best possible chance of getting it right.
A seasoned hand
Position trading is not dissimilar to a buy-and-hold strategy you might use when making an investment in the underlying, except that with a margined exposure you need to pay a lot more attention to the performance. This is because if it does not go according to plan you have to be prepared to re-evaluate and get out.
Anyone trading CFDs should always have a clear idea of the downside exit level at which they will close out their position. The easiest and safest way of implementing this is to put in place a sensible stop loss.
It is more debatable whether a longer-term trader would want to use a limit order to take profits. The main advantage is such a mechanism would close you out to the good. This can be helpful if the gain is only transitory but the risk is it could cut a winning position too early.
Financing
One factor which favours CFD trading is the absence of the 0.5% stamp duty which is levied on regular share trades, but one cost to bear in mind when longer-term position trading is the impact of financing.
Although headline interest rates remain at record lows of 0.5%, exposure of £10,000 to a FTSE 100 blue-chip like Vodafone (VOD) via a £500 deposit in an account would incur an interest charge of just under £1 a day. Such a cost would eat in to any potential profits.
This is because the interest charge on a CFD position is generally based on the three-month London Interbank Offered Rate (Libor) plus a fixed mark up of 1% or 2%. At time of writing Libor was 0.75% so a service provider that charges a 2% premium would apply an annual rate of 2.75%. This means UK equity CFDs will work out cheaper than the underlying shares when held for less than 66 days as the stamp duty saving would outweigh the cost of financing.
The most popular way to use CFDs is for short-term trades where the leverage serves to magnify the potential return on capital. This same feature can also be big advantage when taking longer-term positions.
Identifying longer-term trades
Clear-cut position trades do not come along all that often, but can be highly lucrative when they do. Barclays (BARC) shares suffered along with the more vulnerable banks when the credit crisis was at its height. The shares spent part of the first quarter of 2009 languishing below 100p, after falling from almost 800p. They have since established a more sensible level around 300p. BP's (BP.) rally from its 302.9p summer 2010 low back to the 500p mark would also have thrown up lucrative trades for the more patient player as the oil major finally got to grips with the Macondo oil disaster in the Gulf of Mexico.
Managing the exposure
Whenever trading with CFDs you always need to have a clear idea of where to exit to take a profit and what sort of stop you should use to cap the possible loss. Longer-term position trades need more room to breathe so as not to get closed out prematurely by the normal market noise. This may necessitate scaling back the position size so as to keep the monetary risk to an acceptable level. Stops and limits should be reviewed on a regular basis.
With longer-term trades it can also be advisable to pay a bit extra for a guaranteed stop. These always close out the trade at the stipulated level and eliminate the risk of slippage that you have with a normal stop.
CFDs can be rolled over for as long as you want to maintain the position, assuming you keep sufficient funds in your account to avoid any margin calls. Those who fail to do so may find they are prematurely closed out of the market.
This ‘How to’ guide is produced by Shares Magazine and is only for general information and use, and is not intended to address particular requirements.
The value of investments and the income derived from them can go down as well as up. Past performance is not necessarily a guide to future performance.
You should get professional financial advice before making any investment decisions.