Hedging using Index CFDs

Stock index CFDs provide a useful way to hedge existing stock positions in volatile markets – as CFDs can be traded long or short traders are able to open a short position on an index that is representative of their stock portfolio, knowing that any losses in their stock portfolio will be offset by their index CFD position.

For example, an investor might hold a balanced stock portfolio valued at $100,000. For simplicity’s sake, let’s assume the portfolio consists of stock from 20 Australian companies, each position he holds is of 1,000 shares, and the average value of each share is $5 (20 companies x 1,000 shares = 20,000 shares x $5 per share = $100,000 portfolio value).

He is worried about short-term volatility and his assets falling in value, but doesn’t want to sell his positions as he expects the market to trend up over the long-term.

Instead, he decides to offset possible losses by opening a short position on the Australia 200 Index – as an index is a statistical measure of the value of a group of stock, it will rise and fall with the changing value of individual shares. Again for simplicity’s sake, we’ll assume that a ten point movement the Australia 200 moves corresponds with a $1 movement in his stock (or a $20,000 movement across his portfolio).

A CFD position on the Australia 200 costs or pays $25 per index point movement per contract. As he is trading short, he would have to sell 80 contracts to hedge his current portfolio:

10 point Australia 200 movement = $20,000 portfolio movement

1 point Australia 200 movement = $25 payment/loss from the index position

Therefore $20,000/$25/10 = 80 Australia 200 contracts required to hedge the position

He sells, or goes short on, 80 contracts, knowing that now his share position is hedged if the market fluctuates. For every dollar he loses on his stock portfolio, he will gain a dollar on his Australia 200 position. Likewise, for every dollar he loses on his index position, he will gain a dollar on his stock portfolio.

From here there are three possible scenarios – the stock and index go up in value, the stock and index go down in value, or the stock and index trade sideways.

The stock and index go up in value

The market continues trending upwards, and his portfolio is soon worth $110,000. However, as the trader had sold the Australia 200 with the hope that it would fall, he has made a $10,000 loss on that position. If he believes the market will continue to go up, he could close his Australia 200 position and continue to enjoy to profits of his stock portfolio. If he still thinks there are volatile times ahead, he could keep that position open, knowing that any possible losses will be offset by his stock portfolio.

The stock and index fall in value

If the trader loses $2 per share, or $40,000 across his portfolio, he will make a $40,000 profit on his index CFD position, which would cancel out those losses. Once he believes the price has bottom out, he could close the index position, taking those profits and holding onto the stock until its price rises again.

The stock and index remain flat

The investor will not have made a profit or loss on either trade.

Index CFDs are a useful tool for protecting existing investments against price fluctuations. That being said, this strategy is a market-neutral strategy, meaning that although you will not make a loss, you will not make a profit either for as long as both positions are open. Hedging can lower profit potential, but as it also limits losses, it can reward traders with a steadier flow of profit over time.

Options styles

Different styles of options include European options, American options, Bermudan options, Barrier options, Exotic options and Vanilla options (a vanilla option being any option that is not exotic).

American and European options

European options are options that may only be exercised on their expiration date, while American options can be exercised on or before that date. American options expire on the third Saturday of every month and are closed for trading the Friday before, while European options expire the third Friday of every month and are closed for trading on the Thursday before.

For both styles of options, the pay-off is calculated as:

The maximum of the strike price minus the spot price or zero, for a call option

The maximum of the spot price minus strike price or zero, for a put option

Where an American and European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European option. If it is worth more, the difference in value can be used to determine whether or not it should be exercised before the expiration date.

Options contracts traded on exchanges are mainly American, whereas options traded over the counter are mainly European.

Bermudan options

A Bermudan option is an option that may be exercised on specific dates on or before expiration. This option is half-way between European (which allow exercise at one time) and American (which allow exercise at any time) options. Most exotic interest rate options are Bermudan style options.

Barrier options

Barrier options can only be exercised once the underlying asset’s price has passed a certain level, or barrier. Barrier options are always cheaper than non-barrier options, and were created to allow investors to hedge with options without having to pay as high a premium.

The two types of barrier options are ‘in’ options and ‘out’ options – in options start their lives worthless and become active when a set barrier is reached, while out options start their lives active and become worthless once a barrier is broken. Both in and out options can be divided into two more categories – up-and-out or down-and-out, or up-and-in and down-and-in.

• Up-and-out: the spot price starts below the barrier and has to rise for the option to expire
• Down-and-out: the spot price starts above the barrier level and has to fall for the option to expire
• Up-and-in: the spot price starts below the barrier level and has to rise for the option to become activated
• Down-and-in: the spot price starts above the barrier level and has to fall for the option to become activated

Exotic options

Exotic options can have both standard and non-standard exercise styles, as well as standard and non-standard pay-off calculations.

Exotic options with standard exercise styles can be exercised either in the European or American style, the only difference being the calculation of their pay-off value:

• A cross option is an option on an asset in one currency with a strike price denominated in another currency – one example would be IBM, which is denominated in US dollars. Trading on IBM in Japan would involve converting the pay-off into Japanese Yen, meaning the pricing of these options needs to take forex volatility into account. A quanto option is another version of this, but the exchange rate is set from the outset of the trade.
• An exchange option is the right to exchange one asset for another.
• A basket option is an option on the weighted average of several underlying assets. A rainbow option is a basket option where the weighting depends on the financial performance of each asset.
• A low exercise price option is a European call option with a low exercise price of USD0.01.

Some exotic options can use the same pay-off values as American and European options, but the early exercise can occur differently:

• A Canary option is an option with exercise styles between European options and Bermudan options – typically the holder can exercise the option at quarterly dates, but not before a set time period (usually 12 months) has passed.
• A capped-style option is a conventional option with a profit cap written into the contract – capped-style options are automatically exercised when the underlying asset reaches that price.
• A compound option is an option on an option, giving the holder two separate exercise dates and decisions.
• A shout option allows the holder two exercise dates – during the life of the option the holder can ‘shout’ to the seller that they want to lock-in the current price, and if this gives them a better deal than the ay-off at maturity they can use the shout date price rather than the price at maturity to calculate the pay-off.
• A swing option gives the holder the right to exercise only one call or put on any one of a number of specified exercise dates, with penalties imposed with the holder has a net volume higher or lower than specified upper or lower limits.

Other exotic options have pay-offs that are calculated quite differently, alongside their exercise styles varying:

• A look-back option is an option where the holder has the right to buy or sell an underlying asset at its lowest or highest price over a preceding period. A Russian option is a type of look-back option that has an infinite preceding period.
• An Asian (or average) option’s payoff is determined by the average price of the underlying asset over a predetermined period of time.
• A game (or Israeli) option is an option where the writer can cancel the option offered, but must pay that point’s pay-off as well as a penalty fee.
• A cumulative Parisian option has a pay-off dependent on the total amount of time the underlying asset value is above or below a certain strike price, while a standard Parisian option is dependent on the maximum amount of time the underlying asset value spent consecutively above or below a strike price.
• A re-option occurs when a contract has expired without having been exercised, and the owner of the underlying asset may then re-option the asset.
• A binary (or digital) option pays a fixed amount, or nothing at all, depending on the price of the underlying asset at maturity.
• A forward start option is an option with a strike price to be determined in the future, and a cliquet option is a sequence of forward start options.

What is a market bubble?

A bubble is when an economy, market or asset has a large price spike, exceeding what is considered to be its fundamental value by a large margin. Bubbles are usually identified in hindsight, generally after there has been a crash of the price of the economy, market or asset in question.

The damage caused by the burst of the bubble depends on the economic sector or sectors involved – the bursting of the US housing bubble in 2008 caused a global financial crisis, because most banks and financial institutions in the US and Europe held billions of dollars worth of subprime mortgage-backed securities.

The five steps of a bubble

Economist Hyman P Minsky identified five stages in a credit cycle – displacement, boom, euphoria, profit taking and panic – and this general pattern is fairly consistent across bubbles in varying sectors.

Stage 1 – Displacement

Displacement occurs when investors become infatuated with something new – new technology in the dot-com bubble, tulips in tulip mania (a bubble in the 17^th century where the popularity of tulips shot up so quickly that tulips started selling for over ten times the annual income of skilled craftsmen. Within months of the bubble bursting, tulips were selling for 1/100^th of their peak prices), or historically low interest rates, as in the US in June 2003, which started the build-up to the housing bubble.

Stage 2 – Boom

Following a displacement, prices begin to rise slowly. They gain momentum as more participants enter the market, causing the asset to attract widespread media coverage, then panic buying, which forces prices to record highs.

Stage 3 – Euphoria

Prices skyrocket – in the 1989 real estate bubble in Japan, land in Tokyo sold for up to USD139,000 per square foot. At the height of the internet bubble in March 2000, the combined value of the technology stocks on the NASDAQ was greater than the GDP of most nations.

During the euphoric phase, new valuation measures are promoted to justify the jump in prices.

Stage 4 – Profit taking

By this time, skilled traders start selling their positions and taking profits – sensing that the bubble is going to burst. However, determining the moment of collapse can be very difficult and, if you miss it, you have likely missed your chance to take profits for good.

Stage 5 – Panic

At this point, prices fall as quickly as they originally rose. Traders faced with margin calls and the falling values of their assets start panic selling – getting out of their investments at any cost. Supply soon overwhelms demand, and prices plummet.

In the 1989 Japanese real estate bubble, real estate lost nearly 80% of its inflated value, while stock prices fell by 70%. Similarly, in October 2008, following the collapse of Lehman Brothers, and the almost-collapse of Fannie Mae, Freddie Mac and AIG, the S&P 500 plunged almost 17% in that month. That month, global equity markets lost USD9.3 trillion, or 22% for their combined market capitalisation.

Conclusion

Being familiar with the steps of a bubble, whether it’s in the stock, forex, commodities or bonds market, may help you identify the next one, and get out before your profits vanish.

CFD Providers

Not all CFD providers are created equal. In Australia, there are three types of business models: market maker model, direct market access (DMA) model, and exchange-traded model.

Market Makers

CFD providers who are market makers provide their own prices for the underlying assets (shares, indices, commodities, forex, etc.) on which CFDs are traded. The price they offer may or may not differ significantly from the market price. 

Market makers may or may not hedge the CFDs they offer, but these arrangements are usually less transparent than DMA providers. If they don’t hedge all CFD trades, they may have a business model that allows them to benefit if you lose.

Direct Market Access

DMA CFD providers place your order into the market for the underlying asset; hence your price will be determined by the underlying market. DMA CFD providers do not carry any market risk from the trade, so they will only offer CFDs on an asset if there is sufficient trading volume in the market.

DMA providers hedge all client trades in the underlying market, meaning that if you place a CFD trade, the provider will make a corresponding trade in the market. In the case of shares, if you pay a margin to go long on share CFDs, the provider will buy the corresponding shares. This makes the CFD pricing and trading process more transparent, though it means the number and types of CFDs that are offered are more limited than those of market makers.

Both Market maker and DMA models are both provided over-the-counter, meaning there is no central exchange, so CFDs are traded directly between the provider and the client. Over-the-counter also means that there is no central regulation, and each CFD provider has its own terms and conditions. 

Many CFD providers offer both market maker and DMA CFDs.

Exchange Traded Model

CFD providers who use an exchange-traded model offer CFDs that are listed on the ASX – this model is unique to Australia. ASX-listed CFDs can only be traded through brokers authorised to trade them.

The terms and conditions of these CFDs are standardised by the ASX, which may reduce some risk. ASX 24 is responsible for registering, clearing and processing all trades in ASX exchange-traded CFDs, and the seller and the buyer contract with ASX 24 rather than each other. This means that ASX exchange-traded CFDs have a lower level of counterparty risk than over-the-counter CFDs.

 The market for these CFDs is separate to that of the underlying assets, which means that CFD prices are determined by trading activity, rather than by the price of the underlying assets. Usually the CFD prices closely follow the market price of the asset, though there can be divergence if liquidity dries up.

Which is best?

Market makers and DMA providers are quite similar in that they are both over-the-counter CFD providers. However, the main difference between them is transparency. DMA providers are much clearer about the breakdown of the cost of trading, and you know that your trades will be hedged in the market. I prefer DMA providers, or providers who offer both DMA and market made CFDs, as market makers may profit from their clients’ losses, and I’m uncomfortable trading with a provider whose business model makes profits from my losses.

The exchange-traded model is a different matter to consider, and may suit those who want to trade with higher regulation and security. However, as this style of CFD trading is only available in Australia, if you decide to trade from another country at some point you won’t be able to continue using the same model.

Debunking share trading myths

Myth 1 – what goes up must come down

A share entitles the owner to a fraction of the net profit of a company – the net profit being what is left over once the company has paid employees, suppliers, energy costs, debts and all other stakeholders. This makes the return for shareholders more volatile than the return for employees, bond holders and suppliers.

As the shareholder is last in line to be paid, and although the returns will be volatile, the shareholder expects them to be positive and permanent over the long run, and higher than the return on bonds, treasury bills, and other ‘safer’ investments. Despite share prices having their ups and downs, they have trended steadily higher over the years and, and at a faster pace than vehicles like bonds and Treasury bills.

This steady upward progression shows that the laws of physics do not apply to share trading. As they continue trending upward, at some point they will advance so far that they will never reach their previous levels.

In January 2003, Commonwealth Bank shares fell below $25, following their 2002 high of nearly $35. Over the next five years they trended up above $60 per share, before falling to the previous low of $25 in the 2008-2009 Global Financial Crisis. Since January 2009, the share price has had a much steeper climb, reaching $55 in just over a year – this fast rise indicates that the investors got a bit skittish in the crisis, but that the value of the company held. Between January 2010 and July 2011 (the time of writing) CBA shares have steadily traded between $45 and $55.

When CBA was first publicly listed in 1991, shares were $5 each. The share price will never reach $5 again, and it is unlikely to fall back below the $25 point. As it continues to trend, the share price will one day never fall below $45, and then never fall below $55.

Share price trends consist of a series of ups and downs, but typically result in a net increase over time.

Myth 2 – what goes down must come back up

For new traders who know that shares usually trend upward over time, there is a prevailing belief that whatever goes down must come back up. This leads new traders to buy a share that has fallen from $30 to $10, believing that it is more likely to return to $30 than a stock that has risen from $10 to $15.

The opposite is true – over time, shares develop trends. They can be downward trends as well as upward trends. If a share is going to rise from $10 to $30, it needs to pass through $15, $20 and $25. It does not need to pass through $8, $7 or $6.

To get an idea of the wider trend in a market, it can be useful to study historical chart patterns – if investors had looked at the CBA charts in 2008, they would have realised that after the initial panic sell-off of shares in the financial crisis, the share price would return to its former upward trend.

When examining charts, find shares that have made positive moves of 300%-1,000%. Although share prices will inevitable have drops, most of the time these drops don’t exceed 30% of the share’s peak price (this excludes exceptional circumstances, like the financial crisis, which are usually temporary).

Myth 3 – you need to predict the share market’s movements to profit

Many assume that shares bounce within the same range forever, meaning that, to make a profit, traders must be able to predict the share market’s movements. This has resulted in brokers selling their abilities to predict share market movements to clients, along with successful traders writing best sellers.

Although this can be the case in short-term trading, the share market trends upward over the long term – even when it fluctuates between support and resistance levels, these levels are often also trending upwards. Consequently, investors with a buy-and-hold strategy can make a profit without being able to predict intermittent price movements.

Myth 4 – you need a degree to trade shares

Anyone can trade shares anywhere, at any time. That being said, you can’t be a successful trader if you go in blind.

It is crucial that traders educate themselves about the share market, especially the companies in which they own shares. The investors that do their research are the ones that succeed – this includes keeping up-to-date with company announcements and economic news, as well as studying chart patterns.

Day trading techniques for new traders

Day trading is when you open and close positions on the same trading day, with trade durations ranging from a few minutes to several hours. Day traders may buy and sell several times in a single day.

One of the benefits of day trading is that you can take advantage of intermittent price dips and spikes, and you won’t need to factor over-night financing costs into your profits.

Choosing trading instruments

As day trading involves making profits in very short time-frames, most day traders choose assets that have high liquidity, and high volatility.

Liquidity means that it is an asset that many people trade – if you were trading forex, the EUR/USD pair would be more liquid than the GBP/HUF pair as more people trade it. Very liquid assets have lower bid/offer spreads, which will increase your profits.

Volatility is the measure of the range in which an asset moves over a period – assets that are very volatile have a greater range of movement. As traders profit on the price movements of financial instruments, the greater the movement the greater the profit (or loss).

Entry strategies

So now that you’ve chosen a liquid and volatile asset to trade, when do you open your trade? Depending on whether you want to be a fundamental or technical trader, this can be a combination of a number of factors:

Fundamentals include economic, political and social events, and the impact they will have on an asset price. If you want to trade on Commonwealth Bank shares and you know that the CEO is going to be holding a press conference, this might be a good time to enter a trade. The expected announcements of the press conference would affect whether you trade long (buy in the hope that the share price will go up) or short (sell in the hope that the share price will go down).

Technical trading involves examining charts arguing that, as patterns repeat themselves; past patterns can indicate future price movements. Some simple technical tools to use include support and resistance, swing points, and indicators.

Support and resistance are the points at which an asset price will change directions – support being the lowest point it will reach before going up and resistance being the highest point it will reach before turning down. If you mark support and resistance lines on your charts, this can be a good indicator for when to enter a trade, and whether to go long or short.

Swing points are useful when looking at assets charted using candlesticks – either the first candle hits a low, the second hits a lower-low, and the third hits a higher low; or the first candle hits a high, the second hits a higher-high, and the third hits a lower high. This is an indication that the asset price will likely reverse.

Slightly more advanced is plotting the price of an asset against an indicator, or another statistical measure. One example of this is having one chart that measures momentum (the rate of change of an asset price) against the chart of the asset prices. If there is a divergence, when the asset price makes a new high or low and the momentum does not, this could be a warning of a change in trend direction.

Exit strategies

Now you have entered your trade using fundamental or technical analysis – when to exit?

Most exit strategies fall into the following categories – loss limits, profit targets, and timed exits.

A loss limit is the amount you are willing to lose on a single trade, with the general rule being never to risk more than 2% of your capital. Stop loss orders enable you to set automatic closing levels on your trade, which takes the emotion out of trading, and also enables you to limit your losses even if you aren’t able to constantly monitor your open positions.

A good stop to use is a trailing stop – like stop losses, a trailing stop is when you set an automatic closing level on your trade. However, a trailing stop will automatically follow the market when it moves in your favour, meaning that you will protect your profits if the market changes directions again.

Profit targets can also be set automatically at the time you open the trade – you simply set the level at which you want your trade to exit if the market moves in your favour.

A timed exit is determining a time at which you want your trade to close – this could be timed with personal restrictions, economic or political news, or the end of different trading sessions.

Performance evaluation

It is essential for beginning traders to monitor and evaluate their trading performance. A good evaluation should cover your trading profit and loss, your trading performance (the way your trades behave, including the amount of profit made, the percentage of profits and losses, whether your trades were short or long, etc.), and your trading process (your trading preparation, your entry and exit rules, your risk management and your trading evaluation).

Once you have determined which aspects of your process will help your trading and which performance criteria you want to measure, you need to decide how to measure these elements. Tools could include performance monitoring packages available with your trading software; or spreadsheets recording the profit, loss, volume and volatility of your trades; or a journal recording your trading decisions.

As this article discusses day trading, it would be valuable for traders to evaluate their progress on a daily, weekly and monthly basis.

Conclusion

These considerations should help a beginning day trader. Remember to automate entries and exits wherever possible, as this will help you remain level headed and make informed decisions, and start with small investments as you test your trading system. Then keep good records to monitor how your trading system performs!