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Strategies with a difference

Created:
25 April 2008
Updated:
19 November 2008
Written by:
Rakesh Shah

CFDs are the perfect tool for nipping in and out of markets for quick profits at low cost. In this article, we'll look at several simple but effective strategies for making money in this way.

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A good understanding of the particular trading features of a certain asset can throw up lots of interesting opportunities. Image 1, below, shows the Level 2 screen for Impax Environmental Markets, the 230th largest company in the FTSE 250.

Image 1

We can see that there is limited liquidity here, with an average daily turnover of 400,000 shares. At the bottom of the screen, we can see that there are approximately 60,000 shares on the bid and the offer, roughly equating to £75,000-worth of stock. The image shows how limited liquidity adds to volatility.

Chart 1 (below) shows the effect of liquidity on trading prices. It shows Impax's price chart, telling us that once selling starts at the 135p level (points 'A' and 'B'), there is only limited buying support. This continues for many days as investors are looking to exit their long positions. The range of between 134p and 108p is in excess of 15 per cent. So, we could enter a short position upon the exhaustion of a sustained rally at point 'B'.

Chart 1

Index reviews

Index reshuffles can provide nice opportunities for private traders to get one over on the big boys.

Every three months, the FTSE 100 and FTSE 250 indices are reshuffled, with companies promoted and demoted according to their market capitalisation. In the most recent review, Eurasian Natural Resources Corporation, Tate and Lyle and Cobham entered the FTSE 100 at the expense of Taylor Wimpey, Rentokil Initial and Yell Group.

A trader could observe that Eurasian Natural Resources Corporation (ENRC) is a dead cert for entry to the FTSE 100, as its market capitalisation is greater than that of half of the FTSE 100 at the beginning of March.

So, a trader could purchase the stock a few days before inclusion and sell up either a few minutes before the close of the markets the day before the changeover or as early as possible on the day after the changeover. I have marked the entry point with a green arrow and exit point with a red one.

In Chart 2 (below), we can see in the red circle a volume spike that occurred during the auction where a large number of traders have exited at the optimum price on the day.

Chart 2

Chart 3 (below) is the ENRC two-day chart – the day before its entry into the FTSE 100. This chart shows us how the stock performed in the days following its entry. A number of funds will have to purchase this stock now that it has entered into the FTSE 100 and they may do so in the next few days after entry. They cannot purchase it beforehand as they are mandated to trade specifically in FTSE 100 stocks or by other rules that prevent them from dealing in non-index stocks.

Chart 3

Chart 3 shows the sustained rally. In some cases, a company's market capitalisation will place its shares somewhere in the range of 90th to 110th largest index members, making a tight race for it to get into the FTSE 100. All will depend on the closing price on the review date. In this situation, a calculated guess will be required to estimate if the share price in question will be sufficiently highly valued for inclusion. The competition between shares is often so tight as to generate price volatility in the run-up.

VWAP Trading strategies

Whatever signals you are using to establish CFD trades, understanding the volume weighted average price (VWAP) on the day and how it is used by professional investors will help you to make better entry and exit decisions and may even play a part in your execution strategy.

VWAP is the name given to the average price weighted according to the volume traded at each price. This is very important to fund managers and other institutional traders that are trading in big volumes intraday.

Calculating VWAP

Say there are just two trades in a particular share on a particular day. The first is for 100 shares at 50p and the second for 100 shares at 54p. Both the mean price for the day and the VWAP is 52p.

However, if 100 shares trade at 50p and 1,000 shares trade at 54p, the mean is still 52p but the VWAP is 53.64p, as the size of the trades at each price level is factored in.

As a rule of thumb, if the price is trading close to the VWAP and the volume numbers are significant, it means that the probability of institutional participation is high. VWAP is also important to understand if you are going to trade in pre- and post- market auctions where market orders by institutions push prices to daily extremes creating trading opportunities for short-term traders.

VWAP gives the fund manager an idea as to how well a large trade has been executed in terms of slippage. Slippage is where the price at which an order is actually executed is less favourable than the one at which the order was placed.

VWAP can also be used as a simple trend indicator to figure out if there is bullish or bearish momentum. If the current price is moving away from the volume weighted price, there's increasing momentum and if it’s getting closer then there’s decreasing momentum. This can be used to make a rough-and-ready estimate of the current demand at that price in a particular stock.

If the price moves higher but the VWAP remains at the same level, we can see that the market is making a bullish move to the upside, but the participation from professional money may be waning. Unless the VWAP moves to a higher level, we can say that the big players are not interested in paying those higher prices.

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Dividend Plays

When shares start trading ex-dividend, it can create a nice little opportunity for CFD traders. Dividends are usually paid out on a Wednesdays and a list of stocks going ex-dividend can be found on the IC website. So, you can purchase the stock the day before and collect it on the ex-dividend day, selling the stock at the highest price possible for a profit.

There are a number of reasons this strategy works. Sometimes private investors simply forget that there is a dividend payout and buy the stock at higher prices the next day. Technical analysis may play a part in offering support just below the current price. And the fact that income from dividends is taxable at a different rate from capital gains may also play a part.

Take the example of HBOS.

The bank's shares went ex-dividend on 12 March, with a payout of 32.3p. The close on 11 March was 589.5p. The opening price the next day should, in theory, have been the previous closing price of 589.5p, less the dividend of 32.3p, or 557.20p. From chart 4 (the 10-minute price chart for HBOS on 12-13 March) we can see that the market opened at 593p (point A), rallied to 595p and then subsequently fell to 570p (point B) 50 minutes later.

Here, the optimum strategy would be to buy the shares on 11 March at the close for 589.5p and to exit the next day as soon as the market opens. The exit at the opening price is 593p but, taking into account some slippage – which will be inevitable due to the fast nature of the market on an ex-dividend morning – 585p is a more realistic exit price. Total profit will be 585p (exit price) – 589.5p (entry price) + the dividend 32.3p which equals 27.8p. This gives a gross return of 23.6 per cent on a CFD trade with a 20 per cent margin requirement. Of course, as with all trading you will get some winners and some losers.

The dividend play is best avoided in bearish markets. So, if Wall Street closed down the night before or the general mood in the markets is negative, think twice before doing this. It’s probably also best to steer clear of stocks with low liquidity, as you need an active stock to get in and out quickly. Make sure you check out the charts to see how well the dividend play has worked in the past. Pick stocks with high dividends, as these offer a better margin of safety. Lastly, if the market does open below the breakeven point, cut your losses quickly as your first loss is often your best loss.

Chart 4

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