CFD Trading Strategies Using Market Index David James Norman

marketindex

CFD Trading Strategies David James Norman

rbs.co.uk/marketindex

Make it happen

2 CFD Trading Strategies

CFD Trading Strategies 3

Contents

Preface

The book is made up of four main sections:

1 Introduction to CFDs (pages 4–8) 2 CFD Trading Logistics (pages 9–17) 3 CFD Trading Strategies (pages 18–37) 4 Dealing with risk and psychology (pages 37–55)

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 and builds an understanding of a trader’s overall 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 i n 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 trading strategies for different market market conditions • Managing a CFD account, risk control methods

The views below represent the opinion of independent analysts The Trader Training Training Company Limited. These views are based on technical analysis including but not limited to price action, volume and market breadth studies.




How does a CFD compare to its underlying Instrument?

Introduction to CFDs Before 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 line with their price changes. As an introduction then, let’s go through the main characteristics of CFDs.

Trading CFDs differs from trading the underlying instrument in that:

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%).

• The CFD is traded 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 contract short while he may not be able to with a cash underlying • There’s no UK Government stamp duty tax on trading CFDs in the UK

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 trader’s buy or sell order and the difference between the purchase price of the CFD and the price at which it is sold is credited or debited to the trader’s 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.

Initial Init ial FTSE FTSE 100 Price Price @ 4500 4500

Long Lo ng 1 FTS FTSE E 100 100 In Inde dex x Pr Profi ofitt (£)

Long Lon g 10 FTS FTSE E CFD Profi Profitt (£) (£)

+10 pips

£10

£100

+20 pips

£20

£200

+30 pips

£30

£300

+50 pips

£50

£500

As the table shows, the CFD trader enjoys a protable trade that costs 5% of the underlying value of the FTSE 100 Index with 10 times the profitability.




Contents

Preface

The book is made up of four main sections:

1 Introduction to CFDs (pages 4–8) 2 CFD Trading Logistics (pages 9–17) 3 CFD Trading Strategies (pages 18–37) 4 Dealing with risk and psychology (pages 37–55)

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 and builds an understanding of a trader’s overall 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 i n 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 trading strategies for different market market conditions • Managing a CFD account, risk control methods

The views below represent the opinion of independent analysts The Trader Training Training Company Limited. These views are based on technical analysis including but not limited to price action, volume and market breadth studies.







Leverage









+10 pips

£10

£100

+20 pips

£20

£200

+30 pips

£30

£300

+50 pips

£50

£500








Leverage









+10 pips

£10

£100

+20 pips

£20

£200

+30 pips

£30

£300

+50 pips

£50

£500





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.

Below is a table of the current marketindex pip values: Product

Pip Value

Mini FTSE 100 Index

£1

Gold CFD

£0.01

Corn CFD Sugar CFD

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 traded instrument 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 prot. Interest payments over the 5 day period are charged at 2% above LIBOR at 0.475% plus a dividend adjustment bringing the overall financing rate to 3.09%.

This trade is summarised in the following table: 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 prot

Interest paid at

3.09% x 4 overnights x £45,140/360 = £15.50


£45,140

Profit /Loss

62.4 pips x £1.00 x10 - £15.50 = £608.50

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 then buys 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 positionattracts 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 Prot and the Loss on the long and short transactions represent a high proportion of the margin capital because of the 20 x gearing


FTSE 100 CFD

Day 5

FTSE 100 CFD

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 at

1.09% x 4 x £45, 140/360 = £5.47

£44,516


£45,140

Profit /Loss

- 62.4 pips x £1.00 x 10 +£5.47 = -£618.53

CFD Price

£0.01

£0.06

Mini S+P 500

£0.62

Mini EuroSTOXX 50

£0.88





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.

Below is a table of the current marketindex pip values: Product

Pip Value

Mini FTSE 100 Index

£1

Gold CFD

£0.01

Corn CFD

£0.01

Sugar CFD

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 traded instrument 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 prot. Interest payments over the 5 day period are charged at 2% above LIBOR at 0.475% plus a dividend adjustment bringing the overall financing rate to 3.09%.

£0.06

Mini S+P 500

£0.62

Mini EuroSTOXX 50

£0.88


FTSE 100 CFD

CFD Price

4451.6

Trade

Buy 10 FTSE 100 CFD

Margin used

£2,225.80


£44,516

Day 5 CFD Price

4514

Trade

Sell 10 FTSE 100 CFD = 62.4 pips prot

Interest paid at

3.09% x 4 overnights x £45,140/360 = £15.50


£45,140

Profit /Loss

62.4 pips x £1.00 x10 - £15.50 = £608.50

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 then buys 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 positionattracts 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 Prot and the Loss on the long and short transactions represent a high proportion of the margin capital because of the 20 x gearing


FTSE 100 CFD

Day 5

FTSE 100 CFD

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 at

1.09% x 4 x £45, 140/360 = £5.47

£44,516


£45,140

Profit /Loss

- 62.4 pips x £1.00 x 10 +£5.47 = -£618.53

CFD Price





Permitted CFD order types

Limit order

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 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.

A brief description of the main order types follows:

‘Market if Touched’ (MIT) 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.

A ‘Market if Touched’ order will only transact if 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.

Example

Stop loss orders

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.

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 still might go up.

Market order

CFD Trading Logistics The 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 trader’s risk profile and objectives. The CFD strategies should be seen as trading tools that are available to help t he trader to fulfil their objectives. The first part of this section, then, deals with setting objectives. Establishing a Successful Trading Plan

It is possibly due to the fact that there are not that many sources for trading plan information readily available.

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.

Well, here is some information that might help

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?

The creation of a trading plan

Trading plans form the blueprint for a CFD trader’s trading activity. Each plan needs to have a clear trading objective, an understanding of how much work will be needed 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 can’t anticipate, like unexpected stock market crashes, but there has to be a contingency plan for all market conditions. rbs.co.uk/marketindex



Permitted CFD order types

Limit order

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 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.

A brief description of the main order types follows:

‘Market if Touched’ (MIT) 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.

A ‘Market if Touched’ order will only transact if 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.

Example

Stop loss orders

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.

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 still might go up.

Market order

CFD Trading Logistics The 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 trader’s risk profile and objectives. The CFD strategies should be seen as trading tools that are available to help t he trader to fulfil their objectives. The first part of this section, then, deals with setting objectives. Establishing a Successful Trading Plan

It is possibly due to the fact that there are not that many sources for trading plan information readily available.

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.

Well, here is some information that might help

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?

The creation of a trading plan

Trading plans form the blueprint for a CFD trader’s trading activity. Each plan needs to have a clear trading objective, an understanding of how much work will be needed 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 can’t anticipate, like unexpected stock market crashes, but there has to be a contingency plan for all market conditions. rbs.co.uk/marketindex


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.


of these factors needs to be assessed along with the likelihood that it will influence price movements. Energy products:

• 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

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 and resistance 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.

The main trading goal

Metals:

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 of the 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.

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. Weekly Inventory levels in main industrial enduser 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

Here is an example trading plan summary to give an example of the requirements. In the plan, the following aspects are covered:

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

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 the instruments 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 instrument’s vulnerability to sudden demand 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 trader’s 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



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.


of these factors needs to be assessed along with the likelihood that it will influence price movements. Energy products:

• 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

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 and resistance 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.

The main trading goal

Metals:

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 of the 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.

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. Weekly Inventory levels in main industrial enduser 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

Here is an example trading plan summary to give an example of the requirements. In the plan, the following aspects are covered:

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

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 the instruments 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 instrument’s vulnerability to sudden demand 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 trader’s 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 price movements 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 the success 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?

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.

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. Trader’s 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. Trader’s 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

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.



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 price movements 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 the success 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?

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.

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. Trader’s 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. Trader’s 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

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 the lower 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 w ith 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 long position in a downward moving market.

Trending markets

Summary

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 and is described in more depth in the Trading Strategies section.

• CFD traders need to be able to adapt to all different kinds of market conditions. • A trader’s success will be dened 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.




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 the lower 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 w ith 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 long position in a downward moving market.

Trending markets

Summary

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 and is described in more depth in the Trading Strategies section.

• CFD traders need to be able to adapt to all different kinds of market conditions. • A trader’s success will be dened 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 ri ght 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.

3. Knowledge of Fundamentals

Risk Control

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.

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 trader must 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.

4. Good Information sources

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

2. Reasonably predictable price behaviour

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.

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.

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.

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.




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 ri ght 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.

3. Knowledge of Fundamentals

Risk Control

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.

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 trader must 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.

4. Good Information sources

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

2. Reasonably predictable price behaviour

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.

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.

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.

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 Strategies Once 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 profitable position rather than deploying all his or her trading capital in one hit.

Speculative and hedging trading strategies

• Trading momentum: Coffee A 1-Day chart showing Coffee in a steep downtrend

• 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




Speculative and Hedging Strategies

CFD Trading Strategies Once 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:

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 profitable position rather than deploying all his or her trading capital in one hit.

Speculative and hedging trading strategies

• Trading momentum: Coffee A 1-Day chart showing Coffee in a steep downtrend

• 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 this two 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.

Strategy Summary

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.

• The CFD trader pyramided his positions by selling short CFDs at intervals • He wasn’t 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

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.

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 Value

£14,151

August 17th 2008

Coffee CFD

CFD Price

2161.0

Trade

Sell 10 CFDs


£13,187

October 11th 2008 CFD Price

Coffee CFD

1693.04

Trade

Close 30 Short CFDs

Profit /Loss

£4,941 + £3,821 + £2,857 = £11,619




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 this two 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.

Strategy Summary

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.

• The CFD trader pyramided his positions by selling short CFDs at intervals • He wasn’t 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

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.

Day 1

Coffee CFD

CFD Price (US Dollar)

2502.0

Trade

Sell 10 CFDs (1 Pip = £6.10)


£15,268

July 14th 2008

Coffee CFD

CFD Price

2319.0

Trade

Sell 10 CFDs


£14,151

August 17th 2008

Coffee CFD

CFD Price

2161.0

Trade

Sell 10 CFDs


£13,187

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.

Scenario 1: Normal Market Conditions Lower Sugar CFD Price

Upper Sugar CFD Price

Lower 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

A chart showing increased volatility in the Sugar price

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 loss in 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 premium increases 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 inthe-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 of overall 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.



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.

Scenario 1: Normal Market Conditions Lower Sugar CFD Price


Lower 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

A chart showing increased volatility in the Sugar price

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 loss in 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 premium increases 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 inthe-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 of overall 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 don’t have the same constituent stocks.

1-Day chart of the mi X-Tec-DAX


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 underpriced 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-DAX

What are the risks involved?

Strategy notes

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.

• 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

5249.13

659.4

Trade

Sell 10 CFDs

Buy 10 CFDs


£45,401.97

£5703.43

CFD Price (EUR)

CFD Price

Trade Profit/Loss

5219.73

642.4

Buy 10 CFDs

Sell 10 CFDs

£254.29

- £47.04

The table shows a relative value trade involving the mi X-DAX and the mi X-Tec-DAX



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 don’t 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 underpriced 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

What are the risks involved?

Strategy notes

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.

• 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

5249.13

659.4

Trade

Sell 10 CFDs

Buy 10 CFDs


£45,401.97

£5703.43

5219.73

642.4

Buy 10 CFDs

Sell 10 CFDs

£254.29

- £47.04

CFD Price (EUR)

CFD Price

Trade Profit/Loss

The table shows a relative value trade involving the mi X-DAX and the mi X-Tec-DAX



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 1-Day chart showing the Corn price falling steeply


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.

Trade summary table Day 1

Corn Future (expiry 9th September 2009)

Corn CFD

Price

450 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

Price movement

(Loss 50 pips)

(Profit 50 pips)

Trade

Maintain Short position of 100

Maintain Long CFDs

Price movement

(Loss 20 pips)

(Profit 20 pips)

Trade


Sell 150,000 CFDs

Profit/Loss

-$24,500

£18,160

Day 10

Day 20



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.

1-Day chart showing the Corn price falling steeply

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.

Trade summary table Day 1

Corn Future (expiry 9th September 2009)

Corn CFD

Price

450 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

Price movement

(Loss 50 pips)

(Profit 50 pips)

Trade


Maintain Long CFDs

Price movement

(Loss 20 pips)

(Profit 20 pips)

Trade


Sell 150,000 CFDs

Profit/Loss

-$24,500

£18,160

Day 10

Day 20




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

Example

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.

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. June 2009

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

End June 2009

CFD Price (USD)

68.35

CFD Price

70.90

Trade

Buy 1000 Crude Oil CFDs

Trade

Sell 1000 Crude Oil CFDs


£41,720

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.

1- Hour chart of Crude Oil showing oil price strength

1-Hour chart of US Dollar versus the Canadian Dollar showing US Dollar weakness




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

Example

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.

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. June 2009

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

End June 2009

CFD Price (USD)

68.35

CFD Price

70.90

Trade

Buy 1000 Crude Oil CFDs

Trade

Sell 1000 Crude Oil CFDs


£41,720

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.

1- Hour chart of Crude Oil showing oil price strength

1-Hour chart of US Dollar versus the Canadian Dollar showing US Dollar weakness



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 trade will 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.

Chart showing sudden break out in the US T-Bond price

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 direction to movements in interest rates Therefore, if the belief is that interest rates are due to rise, then the expectation is that bond prices will fall and yields will rise The effect of interest rate moves are felt more 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.

1-Day chart of the US T-Note

Trade summary table: US T-Bond MIT Trade 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



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 trade will 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.

Chart showing sudden break out in the US T-Bond price

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 direction to movements in interest rates Therefore, if the belief is that interest rates are due to rise, then the expectation is that bond prices will fall and yields will rise The effect of interest rate moves are felt more 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.

1-Day chart of the US T-Note

Trade summary table: US T-Bond MIT Trade 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



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 between the two instrument prices does not occur.

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 ratio’d 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. • A strategy of this kind can also be risky as correlations can break down temporarily between instruments like this Financing costs have not been included in the trade summary but would also be deducted / credited.

Trade Summary 1-Day chart of the US T-Bond Day 1

US T-Note

US T-Bond

116.084

115.404

Trade

Buy 1200 CFDs

Sell 1000 CFDs

Per pip movement

£7.32


£85,084

£70,488.31

Day 5

US T-Note

US T-Bond

CFD Price

115.944

115.214

Trade

Sell 1200 CFDs

Buy 1000 CFDs

Profit/Loss

-£102.48

CFD Price (USD)

£6.11

£116.05



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 between the two instrument prices does not occur.

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 ratio’d 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. • A strategy of this kind can also be risky as correlations can break down temporarily between instruments like this Financing costs have not been included in the trade summary but would also be deducted / credited.

Trade Summary 1-Day chart of the US T-Bond Day 1

US T-Note

US T-Bond

116.084

115.404

Trade

Buy 1200 CFDs

Sell 1000 CFDs

Per pip movement

£7.32


£85,084

£70,488.31

Day 5

US T-Note

US T-Bond

CFD Price

115.944

115.214

Trade

Sell 1200 CFDs

Buy 1000 CFDs

Profit/Loss

-£102.48

CFD Price (USD)

£6.11

£116.05




1-Day Chart of the Wheat price

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.

Example 1-Day Chart of the Gold price

The CFD trader buys Wheat CFDs and sells Gold CFDs in the expectation that the spread between the two instruments will narrow.

Day 1

Gold

Wheat

CFD Price (USD)

949.40

5.031

Trade

Sell 100 CFDs

Buy 10,000 CFDs


£57,989

£30,729

CFD Price

911.30

4.759

Trade

Buy 100 CFDs

Sell 10,000 CFDs

Profit/Loss

£2,328

Day 30

-£1,663.20




1-Day Chart of the Wheat price

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.

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 Gold price

Day 1

Gold

Wheat

CFD Price (USD)

949.40

5.031

Trade

Sell 100 CFDs

Buy 10,000 CFDs


£57,989

£30,729

CFD Price

911.30

4.759

Trade

Buy 100 CFDs

Sell 10,000 CFDs

Profit/Loss

£2,328

Day 30

-£1,663.20



Strategy notes

• The relative value trade worked well with the increase in the short Gold trade prot exceeding the loss from the long wheat trade. • A strategy of this kind can also be risky as correlations can break down temporarily between the commodity prices Financing costs have not been included in the 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.

1-Day chart of the mi X-DAX CFDs

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.

Example trade

1-Day chart of the mi EuroSTOXX CFDs

10.45am

mi EuroSTOXX

mi X-DAX

CFD Price

2522.10

5087.53

1 Pip

12.80 GBP

1.28 GBP

Trade

Sell 15 CFDs

Buy 15 CFDs

12.45pm

mi EuroSTOXX

mi X-DAX

CFD Price

2549.10

5119.03

Trade

Buy 15 CFDs

Sell 15 CFDs

Profit/Loss

-£349.93

£408.17

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 prots • A strategy of this kind can also be risky as correlations can break down temporarily between the index prices

Financing costs have not been included in the trade summary but would also be deducted /credited.



Strategy notes

• The relative value trade worked well with the increase in the short Gold trade prot exceeding the loss from the long wheat trade. • A strategy of this kind can also be risky as correlations can break down temporarily between the commodity prices Financing costs have not been included in the 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.

1-Day chart of the mi X-DAX CFDs

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.

Example trade

1-Day chart of the mi EuroSTOXX CFDs

10.45am

mi EuroSTOXX

mi X-DAX

CFD Price

2522.10

5087.53

1 Pip

12.80 GBP

1.28 GBP

Trade

Sell 15 CFDs

Buy 15 CFDs

12.45pm

mi EuroSTOXX

mi X-DAX

CFD Price

2549.10

5119.03

Trade

Buy 15 CFDs

Sell 15 CFDs

Profit/Loss

-£349.93

£408.17

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 prots • A strategy of this kind can also be risky as correlations can break down temporarily between the index prices

Financing costs have not been included in the trade summary but would also be deducted /credited.




Risk and Trading Psychology While 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 t o combine risk management with a better understanding of the trader’s 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 doesn’t.

The following aspects of a trader’s 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 Condence and consistency Erratic behaviour

Individual Expectation and Self-Illusion

An additional consideration before a trader starts to trade electronically is to assess whether the trader’s 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, trader’s 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 be isolated and encapsulated, and the behaviour before and after linked irrevocably to that event. Reaction to stimuli metrics can be positive and negative. Here’s 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 closing an 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 Psychology While 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 t o combine risk management with a better understanding of the trader’s 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 doesn’t.

The following aspects of a trader’s 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 Condence and consistency Erratic behaviour

Individual Expectation and Self-Illusion

An additional consideration before a trader starts to trade electronically is to assess whether the trader’s 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, trader’s 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 be isolated and encapsulated, and the behaviour before and after linked irrevocably to that event. Reaction to stimuli metrics can be positive and negative. Here’s 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 closing an 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.



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 trader’s 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 two particular 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

Decision-making biases

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.

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.

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 following particular 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?

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. Quite inexplicably, he had to have negative profit & loss statistics before he was able to focus his energies in pulling himself out of loss and into prot. 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 Prot 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 wasn’t so certain. We tried the obvious and took away the trader’s 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 trader’s perception of his own weaknesses can influence 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



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 trader’s 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 two particular 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

Decision-making biases

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.

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.

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 following particular 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?

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. Quite inexplicably, he had to have negative profit & loss statistics before he was able to focus his energies in pulling himself out of loss and into prot. 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 Prot 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 wasn’t so certain. We tried the obvious and took away the trader’s 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 trader’s perception of his own weaknesses can influence 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 couldn’t. 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 tried several 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 prot 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 trader’s 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 one’s 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 prearranged 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 protability. 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 one’s 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 are somewhat 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.



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 couldn’t. 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 tried several 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 prot 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 trader’s 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 one’s 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 prearranged 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 protability. 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 one’s 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 are somewhat 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 trader’s 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 maximumadvantage 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 trader’s 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 trader’s 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 the trader allowed the position to drift then he will have a negative average drift metric and a maximum negative drift metric of 7. The trader’s 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 between 2-3 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 don’t recognize or that don’t suit them.



The trader’s 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 maximumadvantage 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 trader’s 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 trader’s 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 the trader allowed the position to drift then he will have a negative average drift metric and a maximum negative drift metric of 7. The trader’s 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 between 2-3 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 don’t recognize or that don’t suit them.




A chart showing Crude Oil trending strongly upward

In this example, Crude Oil is showing a very distinct trending pattern. It can be surprising however, how some traders may see the pattern emerging but insist on taking an opposite trading position by going short in the expectation of a downward turn in the price. This is known as a contrarian view and it relies on prices reverting to the mean or falling back to previous levels. Coupled with averaging, that is, the practise of adding short positions as the oil price increases in an effort to reduce the overall short price of the strategy, being a contrarian can result in large losses.

The Alpha Trade

Open outcry pit traders understand what an Alpha Trade is. The Alpha Trade is a catalyst trade performed perhaps once or twice a day that sets off a series of profitable events and sequences. When the market shows signs of positive acceleration and the trader starts to pyramid or gun successfully, the Alpha Trade becomes recognizable because of its rapid profitability and, occasionally, its longevity. The Alpha Trade is closely associated with Pyramiding and Gunning, and can be undertaken in a sharply downward moving or upward moving market. Traders will line themselves up all day long for the Alpha Trade and then when they recognize it, they will latch onto it and ride it for as long as they can. Traders who have consistently high Breakout or Reversal Market Class Recognition scores tend to do better with identifying and riding an Alpha Trade.

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 trending markets. 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 times of 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.




A chart showing Crude Oil trending strongly upward

In this example, Crude Oil is showing a very distinct trending pattern. It can be surprising however, how some traders may see the pattern emerging but insist on taking an opposite trading position by going short in the expectation of a downward turn in the price. This is known as a contrarian view and it relies on prices reverting to the mean or falling back to previous levels. Coupled with averaging, that is, the practise of adding short positions as the oil price increases in an effort to reduce the overall short price of the strategy, being a contrarian can result in large losses.

The Alpha Trade

Open outcry pit traders understand what an Alpha Trade is. The Alpha Trade is a catalyst trade performed perhaps once or twice a day that sets off a series of profitable events and sequences. When the market shows signs of positive acceleration and the trader starts to pyramid or gun successfully, the Alpha Trade becomes recognizable because of its rapid profitability and, occasionally, its longevity. The Alpha Trade is closely associated with Pyramiding and Gunning, and can be undertaken in a sharply downward moving or upward moving market. Traders will line themselves up all day long for the Alpha Trade and then when they recognize it, they will latch onto it and ride it for as long as they can. Traders who have consistently high Breakout or Reversal Market Class Recognition scores tend to do better with identifying and riding an Alpha Trade.

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 trending markets. 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 times of 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.




A chart of a strong down move in the US T-Bond showing the opportunity to enact an Alpha Trade

could not bring themselves to cover their long positions even after they acknowledged that the basis for their original trading decision where they established long open positions was obviously incorrect. This stubborn inability to accept defeat after the market continued to move against their open positions immediately eroded the trader’s confidence and led to fewer orders being placed for a considerable length of time, shown in the time taken metrics, after the original loss-making position was eventually closed out. The moral

of this is that after a prolonged market downturn it is statistically difficult to judge the bottom and is often better to close a long losing position than to hope that the market will recover to take it into profit. Timing is everything. The market may well recover over time, but the likelihood that a prolonged losing trade will eventually recover within a satisfactory timescale to make it profitable is not so strong. In such a situation a trader’s Negative drift is normally high as the trader is taking a lot of heat carrying the loss making open position.

A chart showing a series of price reversals in the S&P 500 Index

Dealing with unexpected price reversals in market activity

With price reversal activity we are looking at the way in which directional traders or position traders attempt to establish a bottom or top in a market after a prolonged move by placing open orders against the flow of the market, and then how successfully they cope if the market continues to move against them. When we established this metric we had seen several traders in the research simulation place purchase orders rapidly in succession when the market had moved consistently down for a length of

time. This activity was characterized as negative pyramiding or negative gunning. The trader’s theory was that the prolonged downward move in the market must trigger an upward move at some point purely because of the law of averages, the corrective nature of markets and the bias towards mean reversion. However what interested us was what happened when the expected upward move did not occur. In our research, open positions were either hastily covered (which proved to be the most effective trade) or were let to run a long time without revision. In fact a reasonably large percentage of traders




A chart of a strong down move in the US T-Bond showing the opportunity to enact an Alpha Trade

could not bring themselves to cover their long positions even after they acknowledged that the basis for their original trading decision where they established long open positions was obviously incorrect. This stubborn inability to accept defeat after the market continued to move against their open positions immediately eroded the trader’s confidence and led to fewer orders being placed for a considerable length of time, shown in the time taken metrics, after the original loss-making position was eventually closed out. The moral

of this is that after a prolonged market downturn it is statistically difficult to judge the bottom and is often better to close a long losing position than to hope that the market will recover to take it into profit. Timing is everything. The market may well recover over time, but the likelihood that a prolonged losing trade will eventually recover within a satisfactory timescale to make it profitable is not so strong. In such a situation a trader’s Negative drift is normally high as the trader is taking a lot of heat carrying the loss making open position.

A chart showing a series of price reversals in the S&P 500 Index

Dealing with unexpected price reversals in market activity

With price reversal activity we are looking at the way in which directional traders or position traders attempt to establish a bottom or top in a market after a prolonged move by placing open orders against the flow of the market, and then how successfully they cope if the market continues to move against them. When we established this metric we had seen several traders in the research simulation place purchase orders rapidly in succession when the market had moved consistently down for a length of

time. This activity was characterized as negative pyramiding or negative gunning. The trader’s theory was that the prolonged downward move in the market must trigger an upward move at some point purely because of the law of averages, the corrective nature of markets and the bias towards mean reversion. However what interested us was what happened when the expected upward move did not occur. In our research, open positions were either hastily covered (which proved to be the most effective trade) or were let to run a long time without revision. In fact a reasonably large percentage of traders




Learnt Experiences and Adaptation Levels

Repeat Scenario Success Level

Restoration and Recovery Metrics

It is true to say that some people are better at learning than others. We have all met people who seem to be consistently good at understanding what is required of them and who are able to translate practical experience very quickly and accurately into effective action. We have undoubtedly also met people who have difficulty learning. There are those who require several run-ups to a task before they understand what it is that they need to do to succeed at it. Learning a task by performing it is, arguably, the most valuable educational experience a person can have. Experiencing and learning about a task in real life is likely to harden successful behavioural responses to it that can then be repeated. However, having to work out how one should respond to a given task from the confines of a classroom setting may make it harder to imagine what kinds of effective behaviour should be deployed to complete the task successfully. I nterestingly, simulated environments having increased in sophistication and quality over the last decade can now produce near-to-real-life experiences that help people to learn tasks effectively that can then be transferred to the real world. Hence the use of various intricate simulated environments to train air force pilots, astronauts, tank commanders, surgeons and police officers. Now we see the burgeoning use of simulated electronic market environments to train new electronic traders. It is fundamental to any learning environment, however, be it real or simulated, to understand how effectively a person learns.

The degree to which a trader has the ability to repeat previously successful and profitable behaviour while trading in market scenarios that are similar or the same as those he has encountered before ultimately determines his long-term level of success. Equally the way in which a trader is able to automate profitable performance will influence his overall trading success. Ultimately, traders should try to automate as much of their successful trading behaviour as possible through the use of automated scripts and programs, if not merely to reduce the more mundane order entry tasks they undertake in their trading activity. A simple example of this would be the use of trailing stops. Traders invariably forget to put stops in play when they are most needed or tamper with them when they are in place. An automated tool that places trailing stops in the market following the opening up of new positions is a very useful addition to a trader’s arsenal of tools. Through an accurate understanding of their trading behaviour, traders will be able to automate many more of their trading functions leaving them time to concentrate on other aspects of trading including analytics and strategy creation.

It is well known in sporting circles that a good indication of fitness is the amount of time it takes an athlete to recover from physical exertion. Recovery time is an important measure of trader fitness as well. What we are looking for here are indications of quick and effective recovery from a losing position or a losing trade. For example, if a trader is able to turn a losing open position into a winning position and does so by reading market conditions successfully rather than through luck, then he or she is likely to be able to repeat such behaviour successfully in the future. Often, traders find themselves in temporary losing positions even though they may have solid reasons for taking such a position. How well the trader deals with this losing open position, however, determines how in control they are of their trading. Restoration metrics indicate how quickly and effectively a trader has restored a losing position to that of a winning position, while recovery metrics quantify how effectively a trader turns a set of losing trades into new winning trades. The difference then between Restoration and Recovery metrics is merely the difference between restoring to profitability or creating new winning trades.

The important thing to point out is that these metrics have to be viewed in conjunction with other metrics that show the market conditions at the time of the open position or trade, namely Drift, Pattern Recognition, Repeat Success scenario level, Consistency and Erratic Trading Performance. It is important to ascertain if the trader has accurately read the market conditions leading to the restoration or recovery of his profitability rather than on luck. By comparing the Restoration and Recovery metrics with the Drift metrics for example, it can be ascertained if the trader merely let the position drift in the market and took a great deal of heat with it before closing the position for a large loss. The number of ticks loss that the open position experienced before it was closed is a good indication if the trader had, or did not have, a plan of action for dealing with this loss-making position. If the trader can show through the Consistency metrics that he has a successful habit of letting losing open positions Drift a certain degree before cutting his losses, and that more often than not, when he does let open positions Drift they tend to restore themselves to become profitable open positions, then this would be a good sign.




Learnt Experiences and Adaptation Levels

Repeat Scenario Success Level

Restoration and Recovery Metrics

It is true to say that some people are better at learning than others. We have all met people who seem to be consistently good at understanding what is required of them and who are able to translate practical experience very quickly and accurately into effective action. We have undoubtedly also met people who have difficulty learning. There are those who require several run-ups to a task before they understand what it is that they need to do to succeed at it. Learning a task by performing it is, arguably, the most valuable educational experience a person can have. Experiencing and learning about a task in real life is likely to harden successful behavioural responses to it that can then be repeated. However, having to work out how one should respond to a given task from the confines of a classroom setting may make it harder to imagine what kinds of effective behaviour should be deployed to complete the task successfully. I nterestingly, simulated environments having increased in sophistication and quality over the last decade can now produce near-to-real-life experiences that help people to learn tasks effectively that can then be transferred to the real world. Hence the use of various intricate simulated environments to train air force pilots, astronauts, tank commanders, surgeons and police officers. Now we see the burgeoning use of simulated electronic market environments to train new electronic traders. It is fundamental to any learning environment, however, be it real or simulated, to understand how effectively a person learns.

The degree to which a trader has the ability to repeat previously successful and profitable behaviour while trading in market scenarios that are similar or the same as those he has encountered before ultimately determines his long-term level of success. Equally the way in which a trader is able to automate profitable performance will influence his overall trading success. Ultimately, traders should try to automate as much of their successful trading behaviour as possible through the use of automated scripts and programs, if not merely to reduce the more mundane order entry tasks they undertake in their trading activity. A simple example of this would be the use of trailing stops. Traders invariably forget to put stops in play when they are most needed or tamper with them when they are in place. An automated tool that places trailing stops in the market following the opening up of new positions is a very useful addition to a trader’s arsenal of tools. Through an accurate understanding of their trading behaviour, traders will be able to automate many more of their trading functions leaving them time to concentrate on other aspects of trading including analytics and strategy creation.

It is well known in sporting circles that a good indication of fitness is the amount of time it takes an athlete to recover from physical exertion. Recovery time is an important measure of trader fitness as well. What we are looking for here are indications of quick and effective recovery from a losing position or a losing trade. For example, if a trader is able to turn a losing open position into a winning position and does so by reading market conditions successfully rather than through luck, then he or she is likely to be able to repeat such behaviour successfully in the future. Often, traders find themselves in temporary losing positions even though they may have solid reasons for taking such a position. How well the trader deals with this losing open position, however, determines how in control they are of their trading. Restoration metrics indicate how quickly and effectively a trader has restored a losing position to that of a winning position, while recovery metrics quantify how effectively a trader turns a set of losing trades into new winning trades. The difference then between Restoration and Recovery metrics is merely the difference between restoring to profitability or creating new winning trades.

The important thing to point out is that these metrics have to be viewed in conjunction with other metrics that show the market conditions at the time of the open position or trade, namely Drift, Pattern Recognition, Repeat Success scenario level, Consistency and Erratic Trading Performance. It is important to ascertain if the trader has accurately read the market conditions leading to the restoration or recovery of his profitability rather than on luck. By comparing the Restoration and Recovery metrics with the Drift metrics for example, it can be ascertained if the trader merely let the position drift in the market and took a great deal of heat with it before closing the position for a large loss. The number of ticks loss that the open position experienced before it was closed is a good indication if the trader had, or did not have, a plan of action for dealing with this loss-making position. If the trader can show through the Consistency metrics that he has a successful habit of letting losing open positions Drift a certain degree before cutting his losses, and that more often than not, when he does let open positions Drift they tend to restore themselves to become profitable open positions, then this would be a good sign.




Loss to Profit Momentum

Success and Failure Clouding

Positive and Negative Biases

Accepting Losses and Moving on

Loss to Prot Momentum and Prot to Loss Momentum metrics simply measure the pace at which a trader moves from being in a loss position to being in profit or vice versa. These metrics have useful applications when used in conjunction with Erratic behaviour and Consistency measures, Pyramiding and Gunning and other metrics signalling increased, or decreased, confidence in a trader.

With Success and Failure Clouding I assess how a trader reacts to high levels of success or failure. Is the trader’s judgment and ability adversely influenced, or clouded, by unusually profitable or loss-making behaviour? If so, how quickly does the trader recover from such clouding? If the trader does not recover significantly quickly then he is in a position to lose much of his profit or to exacerbate losses further. Trader Psychometrics picks up this erratic behaviour with regard to high levels of profit or loss.

Positive and negative biases in a trader’s activity betray the intervention of emotion into trading decisions. While not altogether a bad thing, negative emotions take many different forms and traders need to be able to recognize when their trading is losing its objectivity.

Traders on the whole make peace with their losses and move on to open new positions. However, undergoing excessive post-mortem on loss making trades is not advisable. Some traders betray their inability to accept loss and to move on through the following characteristics that are identified by Trader Psychometrics: over trading and reckless, or erratic, order entry leading to further loss-making behaviour. The true objective of any trader is to attempt to treat losses and profits with the same degree of disdain. Only then can the trader concentrate on the task of creating good trades rather than bemoaning losses or becoming overly distracted with profits.

Sudden Breakout Scenario

One of the important aspects of trader assessment is to assess whether a trader recognizes (and how quickly he recognizes) a breakout scenario in the market. Breakouts provide traders with very good trading opportunities to benefit from exaggerated market movements and it is in the best interests of traders to try and learn how to spot them. When traders do spot breakouts and trade them effectively, they must then learn to anticipat e future scenarios that create the same basis for excellent performance. In time, assistive trading tools will provide traders with clues regarding breakouts.

Throwing in the Towel: Abandonment

Closely associated with success and failure clouding is a sense of abandonment that some traders experience when they have made significant losses or profits. The sense of abandonment is obviously more dangerous with regard to losses although some level of profitability can be lost due to this destructive quality. Trader Psychometrics recognizes the sense of abandonment in traders by mapping a rapid string of small but increasing losses to increasingly erratic, non-consistent order entry behaviour that includes a high level of successive cancel/replace orders in a short space of time. This is a very dangerous moment for a trader and needs to be identified as quickly as possible so that the trader can be controlled and assisted.

Negative biases that affect trading success include the following:

• Trade hunger leading to over trading • Over reacting to market moves • High level of emotional involvement in adverse market moves • Disturbed levels of concentration • A heightened level of frustration • An unsustainable level of overcondence • Fear of loss/fear of prot • Lack of consistency in trading behaviour • Change blindness and the inability to preempt market moves • Behavioural changes that are erratic depending on the level of profitability or loss • Order frequency changes and the frequent input of cancel/replace orders

Fitting the Market to a Strategy

Successful trading is, in a large part, about being able to find the best strategy for each market scenario that presents itself. Good futures traders tend to flip between long, short and spread positions depending on the way that the market is behaving and have the exibility to be versatile. However, finding a strategy that fits the market rather than trying to fit the market to a strategy is not always an easy thing to do and less experienced traders find it difficult to achieve on a regular basis.




Loss to Profit Momentum

Success and Failure Clouding

Positive and Negative Biases

Accepting Losses and Moving on

Loss to Prot Momentum and Prot to Loss Momentum metrics simply measure the pace at which a trader moves from being in a loss position to being in profit or vice versa. These metrics have useful applications when used in conjunction with Erratic behaviour and Consistency measures, Pyramiding and Gunning and other metrics signalling increased, or decreased, confidence in a trader.

With Success and Failure Clouding I assess how a trader reacts to high levels of success or failure. Is the trader’s judgment and ability adversely influenced, or clouded, by unusually profitable or loss-making behaviour? If so, how quickly does the trader recover from such clouding? If the trader does not recover significantly quickly then he is in a position to lose much of his profit or to exacerbate losses further. Trader Psychometrics picks up this erratic behaviour with regard to high levels of profit or loss.

Positive and negative biases in a trader’s activity betray the intervention of emotion into trading decisions. While not altogether a bad thing, negative emotions take many different forms and traders need to be able to recognize when their trading is losing its objectivity.

Traders on the whole make peace with their losses and move on to open new positions. However, undergoing excessive post-mortem on loss making trades is not advisable. Some traders betray their inability to accept loss and to move on through the following characteristics that are identified by Trader Psychometrics: over trading and reckless, or erratic, order entry leading to further loss-making behaviour. The true objective of any trader is to attempt to treat losses and profits with the same degree of disdain. Only then can the trader concentrate on the task of creating good trades rather than bemoaning losses or becoming overly distracted with profits.

Sudden Breakout Scenario

One of the important aspects of trader assessment is to assess whether a trader recognizes (and how quickly he recognizes) a breakout scenario in the market. Breakouts provide traders with very good trading opportunities to benefit from exaggerated market movements and it is in the best interests of traders to try and learn how to spot them. When traders do spot breakouts and trade them effectively, they must then learn to anticipat e future scenarios that create the same basis for excellent performance. In time, assistive trading tools will provide traders with clues regarding breakouts.

Throwing in the Towel: Abandonment

Closely associated with success and failure clouding is a sense of abandonment that some traders experience when they have made significant losses or profits. The sense of abandonment is obviously more dangerous with regard to losses although some level of profitability can be lost due to this destructive quality. Trader Psychometrics recognizes the sense of abandonment in traders by mapping a rapid string of small but increasing losses to increasingly erratic, non-consistent order entry behaviour that includes a high level of successive cancel/replace orders in a short space of time. This is a very dangerous moment for a trader and needs to be identified as quickly as possible so that the trader can be controlled and assisted.

Negative biases that affect trading success include the following:

• Trade hunger leading to over trading • Over reacting to market moves • High level of emotional involvement in adverse market moves • Disturbed levels of concentration • A heightened level of frustration • An unsustainable level of overcondence • Fear of loss/fear of prot • Lack of consistency in trading behaviour • Change blindness and the inability to preempt market moves • Behavioural changes that are erratic depending on the level of profitability or loss • Order frequency changes and the frequent input of cancel/replace orders

Fitting the Market to a Strategy

Successful trading is, in a large part, about being able to find the best strategy for each market scenario that presents itself. Good futures traders tend to flip between long, short and spread positions depending on the way that the market is behaving and have the exibility to be versatile. However, finding a strategy that fits the market rather than trying to fit the market to a strategy is not always an easy thing to do and less experienced traders find it difficult to achieve on a regular basis.



Rather than objectively assessing each different market scenario and choosing strategies based on their topicality and merit, novice or inexperienced traders prefer to stick to preconceived notions of the way they think the market is supposed to behave rather than relying on the evidence of how the market is behaving when choosing strategies. This is obviously not a good recipe for long term success. It is vitally important that traders can rely on their perception of the markets to choose the correct strategies to trade and although it is difficult to be flexible in choosing the correct types of strategy when a market is volatile and directionless, it is nonetheless important to build that flexibility into trading. If a trader finds it hard to pick the right strategy in a directionless market then he will probably benefit from staying out of the market for the short-term and reassessing his strategy once some direction or pattern can be found. Traders can fool themselves into believing that certain conditions are showing themselves in the market even when they are not and then, mistakenly, convince themselves that certain strategies are right even though the evidence suggests these strategies will not work.


Novice traders rarely use more than one clue to confirm that they are in the right trade. Believing in a single isolated instance of confirmation, where several are needed to verify the particular strategy, can lead to higher than reasonable levels of confidence which increases the frequency of loss-making behaviour. In the Trader Psychometrics research we undertook, some test traders tended to try and match their preconceived ideas and strategies to the market rather than assessing the market and creating strategies based on its expected movements. Those traders with an unsubstantiated bullish or negative bias waited for market rises or falls beyond what we termed the action/reaction point; that is, the point before which a decision should have been made to open a new position, a point when the market was unmistakably rising or falling. After the action/reaction point has passed it is likely to be too late to enter the market with a new open position in the hope of making a profit. In short-term bullish scenarios the average action/reaction spectrum was between five and eight seconds. That is, the time decay period during which a potential trade starts to lose its appeal and changes from being a positive selection to a potentially negative one. Traders who had a firmly rooted, but unsubstantiated, bullish bias required only a single confirmation of their strategy before they joined the market with an new open position which 80% of the time turned into a losing position.

Information and Memory Bias

When deciding on the likelihood of certain events taking place, people tend to search their short-term memories for relevant information that supports their expectations. However, because not all memories are equally retrievable or “available” this can lead to biases. Memories that are the results of more recent events, or that provoke strong feelings, will influence the person more readily and distort the estimate of the likelihood of these events occurring. Kahneman and Tversky call this “Availability bias,” that is, using, or “over-weighting,” only recent, or easily retrievable, information in the decision-making process. In trading, this bias can also create a failure to recognize the redundancy of information, a tendency to misinterpret information and a problem with incorrectly correlating sets of data with each other. Although Trader Psychometrics cannot tell what memories are being used to choose between certain courses of action, degrees of hesitation leading to inaction can provide clues that the trader does not have the right information to hand to make positive decisions.

There is nothing to say that decisions based on information gleaned from short-term memories or information clues are in any way inferior to those of a longer term nature. Some traders work very effectively in the short term, sometimes as short as a matter of seconds, and are not likely to take a longer term view on any information they come across. Such traders are normally CFD scalpers working to make very small incremental profits out of the action at the bid and offer spread in the market. I can normally tell from looking at a trader’s workstation, and how he has arranges his trading GUI, whether he is making decisions based on short-term clues or is relying on longer term information. Apart from the obvious set-up of his futures trading screen, the windows that have news items or other products associated with the core trading product provide evidence of the time span the traders deems necessary in order to trade effectively. Traders that take longer term positions obviously rely on longer term information clues and, perhaps, more technical analysis indicators showing past market movements.



Rather than objectively assessing each different market scenario and choosing strategies based on their topicality and merit, novice or inexperienced traders prefer to stick to preconceived notions of the way they think the market is supposed to behave rather than relying on the evidence of how the market is behaving when choosing strategies. This is obviously not a good recipe for long term success. It is vitally important that traders can rely on their perception of the markets to choose the correct strategies to trade and although it is difficult to be flexible in choosing the correct types of strategy when a market is volatile and directionless, it is nonetheless important to build that flexibility into trading. If a trader finds it hard to pick the right strategy in a directionless market then he will probably benefit from staying out of the market for the short-term and reassessing his strategy once some direction or pattern can be found. Traders can fool themselves into believing that certain conditions are showing themselves in the market even when they are not and then, mistakenly, convince themselves that certain strategies are right even though the evidence suggests these strategies will not work.


Novice traders rarely use more than one clue to confirm that they are in the right trade. Believing in a single isolated instance of confirmation, where several are needed to verify the particular strategy, can lead to higher than reasonable levels of confidence which increases the frequency of loss-making behaviour. In the Trader Psychometrics research we undertook, some test traders tended to try and match their preconceived ideas and strategies to the market rather than assessing the market and creating strategies based on its expected movements. Those traders with an unsubstantiated bullish or negative bias waited for market rises or falls beyond what we termed the action/reaction point; that is, the point before which a decision should have been made to open a new position, a point when the market was unmistakably rising or falling. After the action/reaction point has passed it is likely to be too late to enter the market with a new open position in the hope of making a profit. In short-term bullish scenarios the average action/reaction spectrum was between five and eight seconds. That is, the time decay period during which a potential trade starts to lose its appeal and changes from being a positive selection to a potentially negative one. Traders who had a firmly rooted, but unsubstantiated, bullish bias required only a single confirmation of their strategy before they joined the market with an new open position which 80% of the time turned into a losing position.

Information and Memory Bias

When deciding on the likelihood of certain events taking place, people tend to search their short-term memories for relevant information that supports their expectations. However, because not all memories are equally retrievable or “available” this can lead to biases. Memories that are the results of more recent events, or that provoke strong feelings, will influence the person more readily and distort the estimate of the likelihood of these events occurring. Kahneman and Tversky call this “Availability bias,” that is, using, or “over-weighting,” only recent, or easily retrievable, information in the decision-making process. In trading, this bias can also create a failure to recognize the redundancy of information, a tendency to misinterpret information and a problem with incorrectly correlating sets of data with each other. Although Trader Psychometrics cannot tell what memories are being used to choose between certain courses of action, degrees of hesitation leading to inaction can provide clues that the trader does not have the right information to hand to make positive decisions.

There is nothing to say that decisions based on information gleaned from short-term memories or information clues are in any way inferior to those of a longer term nature. Some traders work very effectively in the short term, sometimes as short as a matter of seconds, and are not likely to take a longer term view on any information they come across. Such traders are normally CFD scalpers working to make very small incremental profits out of the action at the bid and offer spread in the market. I can normally tell from looking at a trader’s workstation, and how he has arranges his trading GUI, whether he is making decisions based on short-term clues or is relying on longer term information. Apart from the obvious set-up of his futures trading screen, the windows that have news items or other products associated with the core trading product provide evidence of the time span the traders deems necessary in order to trade effectively. Traders that take longer term positions obviously rely on longer term information clues and, perhaps, more technical analysis indicators showing past market movements.



Extreme Focus, Application and Practice

Trading doesn’t start when the market opens or end when it closes. Successful traders live and breathe the market even out of market hours, constantly analyzing strategies, practicing trading scenarios and thinking about how they will make better trades. Conclusion

CFDs are flexible trading instruments that enable traders to put together a variety of useful trading strategies that capitalise on relative value differences, breakouts, trends and short term volatility. Marketindex also provides the opportunity for traders to undertake trades on a technical charting basis or through the study and implementation of inter-market analysis.


Because marketindex hosts CFDs on instruments from a range of different asset classes, cross asset strategies are also popular. The CFD trader must capitalise on the price movements between related and unrelated asset classes to fully benefit from the trading opportunities. Most important of all, however, is that the CFD trader must manage his risk exposure. The objective is to stay in the game, so carefully controlling money management and risk management aspects of trading are vitally important.

The views above 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.

The contents of this marketing communication are solely the opinion of The Trader Training Company Limited and neither ABN AMRO Bank N.V. nor any member of The Royal Bank of Scotland Group plc take any responsibility whatsoever for the contents of this marketing communication. The contents of this marketing communication are not intended to, nor do they, provide any financial, investment or professional advice and nothing in the marketing communication shall be regarded as an offer or provision of financial, investment or other professional advice in any way. Access to the marketing communication or the retrieval of any information set out in the marketing communication by a user does not mean that the user becomes a client of ABN AMRO Bank N.V. or any member of The Royal Bank of Scotland Group plc.

This marketing communication may discuss services, securities and investments that may not be suitable for all investors and has no regard for the specific investment objectives, financial situation or needs of any specific entity. In particular, you should make your own investment decisions based upon your own financial objectives and financial resources and, if in any doubt, you should seek advice from an investment advisor. This marketing communication has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. This document should not be relied upon as being an impartial or objective assessment of the subject matter and is not deemed to be “objective research” for the purposes of the FSA rules. This marketing communication has been issued by The Trader Training Company Limited for information purposes only and should not be construed in any circumstances as an offer to sell or solicitation of any offer to buy any security or other financial instrument, nor shall it, or the fact of its distribution, form the basis of, or be relied upon in connection with, any contract relating to such action.



Extreme Focus, Application and Practice

Trading doesn’t start when the market opens or end when it closes. Successful traders live and breathe the market even out of market hours, constantly analyzing strategies, practicing trading scenarios and thinking about how they will make better trades. Conclusion

CFDs are flexible trading instruments that enable traders to put together a variety of useful trading strategies that capitalise on relative value differences, breakouts, trends and short term volatility. Marketindex also provides the opportunity for traders to undertake trades on a technical charting basis or through the study and implementation of inter-market analysis.


Because marketindex hosts CFDs on instruments from a range of different asset classes, cross asset strategies are also popular. The CFD trader must capitalise on the price movements between related and unrelated asset classes to fully benefit from the trading opportunities. Most important of all, however, is that the CFD trader must manage his risk exposure. The objective is to stay in the game, so carefully controlling money management and risk management aspects of trading are vitally important.

The views above 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.

The contents of this marketing communication are solely the opinion of The Trader Training Company Limited and neither ABN AMRO Bank N.V. nor any member of The Royal Bank of Scotland Group plc take any responsibility whatsoever for the contents of this marketing communication. The contents of this marketing communication are not intended to, nor do they, provide any financial, investment or professional advice and nothing in the marketing communication shall be regarded as an offer or provision of financial, investment or other professional advice in any way. Access to the marketing communication or the retrieval of any information set out in the marketing communication by a user does not mean that the user becomes a client of ABN AMRO Bank N.V. or any member of The Royal Bank of Scotland Group plc.

This marketing communication may discuss services, securities and investments that may not be suitable for all investors and has no regard for the specific investment objectives, financial situation or needs of any specific entity. In particular, you should make your own investment decisions based upon your own financial objectives and financial resources and, if in any doubt, you should seek advice from an investment advisor. This marketing communication has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. This document should not be relied upon as being an impartial or objective assessment of the subject matter and is not deemed to be “objective research” for the purposes of the FSA rules. This marketing communication has been issued by The Trader Training Company Limited for information purposes only and should not be construed in any circumstances as an offer to sell or solicitation of any offer to buy any security or other financial instrument, nor shall it, or the fact of its distribution, form the basis of, or be relied upon in connection with, any contract relating to such action.



The information contained in this marketing communication is based on materials and sources that The Trader Training Company Limited believes to be reliable, however, The Trader Training Company Limited makes no representation or warranty, either express or implied, in relation to the accuracy, completeness or reliability of the information contained herein. Opinions expressed are The Trader Training Company Limited’s current opinions as of the date appearing on this material only. Any opinions expressed are subject to change without notice and The Trader Training Company Limited is under no obligation to update the information contained herein. None of The Trader Training Company Limited, its affiliates or employees shall have any liability whatsoever for any indirect or consequential loss or damage arising from any use of this marketing communication. Investments in general involve some degree of risk, including the risk of capital loss. Past performance is not a guide to future performance and an investor may not get back the amount originally invested. The directors and employees of The Trader Training Company Limited and/or any connected persons may have an interest in the securities, warrants, futures, options, derivatives or other financial instrument referred to in this marketing communication and may from time-to-time add or dispose of such interests.


This marketing communication is intended for UK investors. This warning notice draws your attention to some of the high risks associated with contracts for difference (CFDs). You should not buy CFDs with money you cannot afford to lose. CFDs may involve a high degree of ‘gearing’ or ‘leverage’. This means that a small movement in the price of the underlying asset may have a disproportionately dramatic effect on your investment. A relatively small adverse movement in the price of the underlying asset can result in the loss of the whole of your original investment and in some cases you may owe more money than originally invested. Past performance is no guarantee of future results. You should be aware of counterparty risk against the operator of marketindex. Changes in rates of exchange may have an adverse effect on the value or price of any investment in sterling terms. As with other investments, transactions in CFDs may also have tax consequences and on these you should consult your tax adviser.”



The information contained in this marketing communication is based on materials and sources that The Trader Training Company Limited believes to be reliable, however, The Trader Training Company Limited makes no representation or warranty, either express or implied, in relation to the accuracy, completeness or reliability of the information contained herein. Opinions expressed are The Trader Training Company Limited’s current opinions as of the date appearing on this material only. Any opinions expressed are subject to change without notice and The Trader Training Company Limited is under no obligation to update the information contained herein. None of The Trader Training Company Limited, its affiliates or employees shall have any liability whatsoever for any indirect or consequential loss or damage arising from any use of this marketing communication. Investments in general involve some degree of risk, including the risk of capital loss. Past performance is not a guide to future performance and an investor may not get back the amount originally invested. The directors and employees of The Trader Training Company Limited and/or any connected persons may have an interest in the securities, warrants, futures, options, derivatives or other financial instrument referred to in this marketing communication and may from time-to-time add or dispose of such interests.


This marketing communication is intended for UK investors. This warning notice draws your attention to some of the high risks associated with contracts for difference (CFDs). You should not buy CFDs with money you cannot afford to lose. CFDs may involve a high degree of ‘gearing’ or ‘leverage’. This means that a small movement in the price of the underlying asset may have a disproportionately dramatic effect on your investment. A relatively small adverse movement in the price of the underlying asset can result in the loss of the whole of your original investment and in some cases you may owe more money than originally invested. Past performance is no guarantee of future results. You should be aware of counterparty risk against the operator of marketindex. Changes in rates of exchange may have an adverse effect on the value or price of any investment in sterling terms. As with other investments, transactions in CFDs may also have tax consequences and on these you should consult your tax adviser.”


For more information: Visit us at rbs.co.uk/marketindex Call us on +44 (0)20 7078 3520 Email us on [email protected]

CFD Trading Strategies Using Market Index David James Norman

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