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3 CFD strategies to help you trade a volatile market…

by , 23 May 2016
3 CFD strategies to help you trade a volatile market…
Last week, we published the kind of recommendation I prefer not to put into the public domain.

• First, it was a short-recommendation.
• Second it was a short-recommendation on an established, stable and, what most people would consider, blue-chip company.
• Third, it used a fairly advanced trading instrument that's often misunderstood by the general public.

But, in spite of these very good reasons for me to remain silent, I chose to share a trade idea with you.

The company in question was Vodacom. The market was looking for Headline Earnings per Share (HEPS) of R9.05 and revenue of R82.34bn. On Monday, Vodacom released its full year results and missed on both the top and the bottom lines. Revenue came in light at R80.08bn and the group only managed HEPS of R8.83. As a result, the share price fell.

This “fundamental” type of trade is just one way in which you can use long/short trading instruments. Today, I'd like to dispel some of the myths around these geared instruments and explain how they can be used in responsible ways.

So today, let's look at three ways traders use geared products to profit from short-term market movements.

Strategy #1: “Fundamental” trading (around an event)

The Vodacom trade above was a “fundamentally” driven trade. I believed, not only the share price had run ahead of itself compared to the company’s underlying intrinsic value, but also that the market misunderstood and had overestimated its upcoming earnings figures.  You can find the article/analysis here.

Now, many short-term fundamental traders try to trade around an event or an expected event. Events result in quick spikes or dips in share prices and help traders save on their “carry costs”.

Now fundamental trading is a little bit more complicated than trading a technical pattern or a statistical relationship.

First you need to find an event. This can be an earnings announcement, a capital raising, an acquisition or disposal (to name just a few).

Then you need to understand what the market is expecting for the event.

Next, you need to have your own view on what will happen. Finally, you need to have a pretty good idea why the market isn’t pricing the security correctly.

In the Vodacom example:
  • The event was the full year earnings announcement due out on the 16th of May.
  • I knew what the market expectations were i.e. HEPS of R9.05 and revenue of R82.34bn. To get the market expectation I first privately surveyed the larger bank trading desks and then pulled consensus information directly from a “wire feed” terminal. If you don’t have access to a wire terminal, a good broker should either publish upcoming results expectations or be able to supply you with the latest market expectations. For a list of good brokers, you can check out FSPInvest’s preferred supplier list here.
  • I had my own expectations for the results. I believed Vodacom’s results would come in under the market consensus based on an interrogation of a number of fundamental factors including lower subscriber numbers, less falling margins and host of other issues outside the scope of this discussion.
  • Finally, Vodacom had become very expensive compared to other South African telcos. Last week Vodacom, with its 61 million subscribers, became more valuable in “market-cap” terms than MTN, with its 229 million subscribers. But I needed to understand the reason for the recent share price appreciation. A likely explanation would be the flow of funds moving out of MTN (following the Nigerian debacle) and looking for a home elsewhere in the local telco sector. This sectoral switch would explain the market’s acceptance of Vodacom’s share price premium.
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So how did our Vodacom short trade play out?

On Monday the 16th, the results were released, Vodacom's earnings missed expectation and the share price promptly collapsed despite a broad-based general market rally. If you had shorted the share, you would have made a considerable amount of money.

This simple trading strategy works particularly well for events. Of course, there are large swathes of time in which security prices bob around with no fundamental or company specific news flow, which brings me to my next strategy…

Strategy #2: Technical trading: Using “support” and “resistance” (and some momentum)!

Now, I could point out, even when you feel like you’re trading in the doldrums, when news is scarce and there seems like little reason for price action, the constant movement of fundamental price inputs i.e. changing currency cross rates, commodity prices, etc. should keep stocks fluctuating. Sophisticated fundamental trading models can be applied in these situations, but more often than not, in the absence of news, the market begins to trade technically.

There are literally thousands of technical trading strategies. They range from complex, signal-generating algorithms to dirt simple “Day Trading Breakout Strategies”. This strategy is so simple I can explain it fully in a single sentence: A “Day Trading Breakout Strategy” tells you to ride daily momentum by drawing two horizontal lines, one through the “high price” and one through the “low price” of the first 30 minutes of open trade and then buying (or selling) depending on the direction of the next break.

Now, when it comes to “no news” trading strategies, the simple ones generally work the best. After all, the market is just a collection of buyers and sellers and we’re all looking at the same historical chart patterns. So, when you look at something like a “support” and “resistance” line, you can believe every other trader, portfolio manager, asset manager is looking at the same two lines.

When a company like Bidvest reaches its upper support, as you can see on the chart below, the tendency is for traders to begin to sell. And, it’s, because everyone looking at this chart is selling, so it becomes a self-fulfilling prophecy. 
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Stock prices can bounce between the support and resistance levels for a long time before they breakout to set new limits. If the support and resistance levels are clear, and you feel confident locating them, you can trade to ride between the levels, alternately going long and short. These movements can be fairly short-term and suited to CFD traders.

Now if I take your support and resistance lines and add in a few momentum indicators you’re well on your way to having a half decent technical trading strategy.  I would try RSI, Stochastic Oscillators and the ever-popular MACD.

Another good rule of thumb is to trade in the direction of the trend. In the chart above you might only be buying at the lower support line, rather than selling/shorting the upper resistance. As the old, tired and too often ignored saying goes: “The trend is your friend”.

There are several ways of defining an uptrend, and it can be as simple as inspecting a long-range chart for a steady upward movement. Find a chart that is continually making higher “highs” and higher “lows”. Or, if the chart is exceptionally “noisy”, you can add something like a simple moving average over 200 days and then check if it is rising or falling.
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Now, finally let’s look at my third, and probably favourite, trading wisdom, philosophy or strategy.

Strategy #3: Market-neutral trading

This is a simple strategy that is far too often ignored by retail traders. In my mind, it really is one of the cornerstones of making consist returns off leveraged trading. It’s a methodology followed by many professional asset managers and hedge funds. And yet, it’s amazing to see how few retail traders apply it.

The basic premise is to limit the overall net exposure on your account. Local leveraged CFDs will give you up to 20x gearing in the equity market. Technically, you could increase your exposure on a R100,000 account to R2 million. A market neutral trader will make sure the account’s net exposure (the sum of long and short exposures) is equal to zero.

The results of market neutral trading, is a dramatic reduction in the risk on the trading account. Of course many traders are seeking to do the opposite. They would prefer to increase their risk and thus increase their potential reward. But if you’re uncovering real opportunities (both long and short) you will still make very decent returns without having to rely on high risk strategies. To illustrate this strategy its worth looking at a quick “pairs trade”.

A trader will use a “pairs trade” when they want to build a single market-neutral position. This can be done by taking opposing views on two securities in the same sector. For example, a trader would buy Shoprite and simultaneously short Woolworths, matching exposures on each position. This immediately puts the trader in a market neutral. The net exposure on the traders account is effectively zero. So, if the market collapses by 40% tomorrow, your portfolio isn’t thrown out with the bathwater! 
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As market conditions change, the relative relationship between your two securities will start to reprice. So, in this case, if you’ve bought Shoprite but sold Woolworths,and your valuation of the two companies is correct, you will see Shoprite gradually outperform Woolworths. This is true whether both are rising or both are falling. As long as your valuations and view on the relative is correct, your net position will start to move into the money.

The benefits of market neutral trading:

  • It doesn’t make any difference what happens to the general index level. You can have a 40% market correction and you’ll sleep like a baby. All that matters is you’ve correctly evaluated the relative security prices.
  • The “carry cost” offsets. Because you’re going both “long” and “short”, your funding cost is offset to some degree. This makes it cheaper to hold longer-term leveraged positions.
  • Remember, you are paid interest on a leveraged position if you’re short, while you pay interest if you’re long.You’ll reduce your risk dramatically. Keeping a more neutral bias will increase the predictability of the returns on your trading portfolio. 

Now, you have three strategies to trade this volatile market, what next?

If you would like to discuss these trading strategies further, please contact me at investorsclub.co.za. Geared instruments are fantastic trading products but they must be treated with caution. I always advise traders to discuss potential trades with their broker first!

Gary Booysen 
for The South African Investor

3 CFD strategies to help you trade a volatile market…
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