During the last few years many Forex brokers have given investors the option to day trade “stocks” through the use of contracts for difference a.k.a CFDs. The offer seems very appealing, you get to use the leverage and software used in FX trading (which is a huge repository by the way) with the advantage that your minimal capital requirement drops from 25,000 USD to day trade US stocks, to about 10 USD on some Forex brokers. You can take trades with up to 1:50 (sometimes 1:200) leverage as well, something you would never dream of doing when trading real stocks in the usual manner. However it is important to realize that contracts for difference (CFDs) are not stocks and that trading them as if they were real stocks carries a huge risk. Through the rest of this post I want to explain why this is the case and in which ways you can actually take advantage of CFDs to compliment your actual trading (if you’re still interested after reading about their disadvantages).
Let us start by defining what a real stock is. A real stock represents a real stake within a given company, it constitutes a form of ownership. It means that you will benefit from both the company’s positive value creation (its growth through time) as well as any eventual profit that the company chooses to distribute to shareholders (through dividends). As a group, stocks benefit from these two fundamental factors: long term positive bias (a consequence of this being a positive sum game) and dividend payments. This means that if you own something like the S&P500 (which you can easily do through an ETF like the SPY), your long term growth prospects are positive and you will – in addition – receive dividend payments on a certain time basis. When you day trade stocks, you still enjoy these two benefits, only that you can enter/exit positions on an intra-day basis (on the same day).
When you talk about CFDs, you’re talking about an entirely different thing. Contracts for difference are derivatives where you are promised to be paid the difference between the price of an asset when you purchased the contract and when you want to sell it. In essence the contract stipulates that if you buy a stock at 1.5 and then you exit it at 1.6 you are paid 0.1 for whatever lot quantity you chose. Why is this any different from buying a stock at 1.5 and selling it at 1.6 ? Aside the trading costs – which can in some cases be lower or CFDs, as sometimes only the spread is paid – there doesn’t seem to be anything wrong. Well, think again ;o)
In CFDs, there is a counter-party to your contract – the one who makes the deal to pay you the difference and they are aware that they are at a disadvantage due to the fundamental positive bias and dividend payments on real stocks. This means that you could buy the S&P500 CFD with leverage and you could profit from the long term tendency of the index to move up while the contract issuer would absorb all the loss. In essence a CFD contract issuer is not willing to let this be a positive sum game for you, so they need to turn it into a negative sum game for the trade. How do they do this? Well, they charge you interest on a daily basis that largely eliminates the long term bias advantage (almost completely in some cases). If you held a CFD for the S&P 500 the index could go up and you would still lose money because your CFD contract requires interest payments that are aimed at reducing any long term positive bias by a large margin. It is therefore extremely important that you hold a CFD only between the open/close of a day (for longs) because failing to do so (having a stock CFD trade opened for longer) will lead to large and negative interest charges that will eat significantly through your profitability. Most brokers also charge you triple swap if you keep a CFD position across the week-end!
Could you just buy on open and sell on close to benefit from the long term bias? Actually you cannot because gaps are incredibly important for stock trading. As a matter of fact, most of the positive bias in the S&P500 isn’t generated during trading hours but it’s generated during gaps that happen across trading sessions. If you look at the skewness and mean of the SPY (as we did have done within our Using R in Algorithmic trading series) you will notice that the values for the 100*(Close[n]-Close[n-1])/Close[n-1] returns are 0.1257 and 0.034 while for the 100*(Close[n]-Open[n])/Open[n] returns are -0.00011 and -0.00071. When you remove gaps from stock trading you are faced with an almost neutral (slightly negative) scenario. This means that you will not be able to make any money by opening/closing trades just to be in during the trading session.
The above however doesn’t mean that CFDs are useless, it just means that they should not be viewed as real stocks are. In essence CFDs eliminate all the positive sum game nature of stock trading and you’re faced what in essence is a negative sum game, all alike Forex trading. In addition stocks – without their attractive positive bias and dividends – are terribly hard to trade instruments with a very large degree of kurtosis (>7 in most cases, even when not considering gaps) making profitable trading from long term edges a really difficult endeavor. However, if you found an intra-day system you would like to trade, you would benefit from trading CFDs Vs real stocks, because on real stocks you would lack large leverage, your capital requirements would be higher and you would also probably pay higher commissions. The advantage goes to CFD trading whenever you want to attempt to exploit trading edges that do not require trade holding after a day’s close. However it’s worth considering that CFD trading without commissions also carries a larger spread when compared to real stock trading. Do you use CFDs in your trading through your FX broker ? What are your experiences and uses for these instruments ? Leave a comment :o)
In my view, the problem in the end is that profitable CFD trading requires a long term statistical edge derived solely from market timing without the benefit of the positive sum game, a difficult thing to achieve especially when involving high kurtosis instruments. Kantu can be used as a first approach to attempt to develop such edges. If you want to learn more about market characteristics and how you too can develop your own historically profitable trading strategies please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)