Discussing contracts for difference (CFD)

Hello all!

From my point of view, one of the most interesting advantages provided by financial derivatives is the "infinite" possibilities of investment strategies ranging from simple to highly complex approaches. In this post, I discuss contracts for difference (CFD) which is a fashion form of investment, mainly for retail investment in platforms like Etoro, CMC markets, Plus500, IG, and many others (notice that I'm not recommending any of them).

Basic stuffs

As July 2019, an Amazon share costs around 2k USD. An investor that intends to profit from the good health of this company could dispose of multiples of this value to buy a certain amount of shares. However, depending on the strategy of the portfolio (short or long term, hedging periodicity, and so on), holding shares may block a considerable amount of resources of the portfolio that could be used for maneuvers or take advantage of sudden opportunities in the market. In another situation, an investor might not even have access to the market into which she wants to invest, this is the case of commodities and foreign markets for instance.

Both situations might be overcome by the appropriate use of derivatives whose underlying is the paper the investor was holding initially or that would intend to hold. Here contracts for difference can be  used (actually several more complex situations also fits the use of CFDs as discussed later. I'm still warming up.)

In the case of Amazon cited above, an investor could consider the use of CFD (contracts for difference) that can present a certain amount of leverage embedded in the contract. Using a 20x leverage, an investor could buy a CFD on Amazon for 100 USD and magnifies his/her returns using the 20x factor.

CFDs have a symmetric and simple payoff. Entering "long" you profit from ups, in contrast entering "short" you profit from downward movements. CFD's usually have no maturity, but I have seen some stats that this kind of contract is usually hold for no more than a week.

Structured bets

Most of CFDs are built over shares of a single company. But these are far from holding the majority of the notional of the global CFD market. In fact, CFDs can be built over baskets of equity shares, indexes, or even compound of commodity quotes. As mentioned before, leverage is also common, meaning that most of the contracts are actually operated by margins. Therefore, one should observe that a high leveraged operation can entirely disappear if not closed out when appropriately. Put in other terms, not only the profits can be magnified but losses as well. This is why is so important to quantify risks of this and other similar instruments.

Strategies

Once we understand the basic features of CFDs, it is possible to discuss some possible basic strategies using them.

First, one could use leveraged CFDs to increase the volatility of determined assets. This approach can be particularly interesting for short term investments and requires a close attention as well risk control (stop losses) suitable for the desired operation.

A second approach involves combination of positions in different assets, meaning create an operation involving short and long positions in different assets. This strategy is based on the identification of a mean reversion behavior of the difference between the prices of some assets. Additionally, this strategy can also be built for assets whose returns present negative correlation. More on mean reversion strategy can be found here, here, here, and here.

The third strategy applies for situations of stability at which a trend is not clear (meaning not statistically significant. Some corresponding tests can be found here). In this case the investor enters both long and short in the same underlying. Once a trend is identified (according to some previous determined criteria) the investor closes out the "wrong" position, keeping the one that bets in the correct direction. Although it looks like simple, this strategy only profits if the trend is strong enough and prices moves deeply in the corresponding direction.

I hope you enjoyed the post. Leave your comments and share.

Peace profound for all of you.

#=================================

Diogo de Moura Pedroso

LinkedIn: www.linkedin.com/in/diogomourapedroso