CFD Trading Systems

CFD systems: An introduction for the newbie

CFD traders typically trade with a trading system.

This is not to say that all CFD trading strategies are mechanical and that discretionary systems don’t perform as well. In fact there are many types of systems around. Some are purely mechanical and can be designed and backtested over historical data.

When you’ve backtested say 10 to 20 systems, you choose the best one - one with a good profit and not too large a drawdown as well. Some other systems on the other hand, are part discretionary, though this doesn’t mean that there is no systematic approach. Though these systems may not be 100% mechanical, there is still a step by step systematic approach that has been shown to be profitable. These systems may be learnt from someone else who have already traded the system successfully.

It is through trading with a system, including CFD trading is an instrument that can be used to create profits on a consistent basis.

Almost in a business like manner, where you apply a system, earn money, and monitor your performance to see that you’re on track. And ideally, the emotion is kept out of the marketplace :)

So what really defines a CFD system?

A trading system is basically a set of rules.

With purely mechanical systems, you can literally write the entire plan down (since it is mechanical, and a CFD either passes your rules, or it doesn’t), and can even have someone else follow the system precisely.

In fact, you can program the system into trading software such as Metastock and TradeSim, AmiBroker, TradeStation or WealthLab and backtest them to see their performance over the past 10 years for example. And then you’d choose the most profitable and consistent system that has an acceptable drawdown.

This can be helpful because it means that traders can design their own system and backtesting it (with some education this becomes a lot faster), instead of trading with a system that's totally unknown in how it will perform :) Of course, past results as shown by backtesting programs do not guarantee future performance.

What a CFD system actually does

A good trading system does these three important things:

1. Cuts your losses short

That is, if a trade goes against you, you exit at a small loss, not a large loss. This is done with a stop loss, which is in contrast to some people who put money into stocks or even CFD and have no plan for exiting, and see their losses get bigger and bigger until they lose a significant portion of their float. In fact, the stop losses in a CFD trading system should be not too small to exit you out of trades with minor movements of the CFD price, and not too large in that your losing trades become too large in comparison to your winning trades. An optimal stop loss is in its happy medium.

2. Lets your profits run

That is, if a trade goes in your direction, your trailing stops is spacious enough for the CFD to run and your profits to become large, but close enough to allow you to exit later on when the trade eventually does go against you. With a trading system where the profits are allowed to run, your profits are bigger (usually much bigger) than your losses, although they are typically not as frequent. Both of these points 1 and 2 above leads to...

3. A good profit-loss ratio

The profit-loss ratio is the size of the average profit compared to the size of the average loss. For example, if your average profit is $820 and you average loss is $205 your profit loss ratio is 4 (820/205).

Note that there’s a similar term called the win-loss ratio, which is how many wins there are compared to losses. Even if you only have 35% winning trades and 65% losing trades, resulting in a modest win-loss ratio of 0.54 (35/65), a system is profitable, if the profit-loss ratio is nice and high.

You multiply the profit-loss ratio, with the win-loss ratio, to get the “profitability ratio”. As long as this number is greater than 1, the system is considered profitable. In this case, the number is 2.15 (0.54 x 4). What we’ve just gone though is very important. It is the basic principle as to why a system is profitable or not. Again, with backtested results, remember that past results does not guarantee future results.

4. Low drawdown

While we all think we are invincible, a low drawdown makes a CFD trading strategy easier to trade when we're trading live. If the historical drawdown is a certain amount, there is no guarantee that future drawdown will be the same or less, as it can be more. So finding and trading a system with a reasonable drawdown can be very helpful and in many cases help you to choose a system or narrow down the choice of systems to the one that you would like to trade.

5. Consistency

Consistency of results is another characteristic of a good system. When results are consistent, the equity curve is smoother and in many cases, the drawdown is smaller as well. If you are wanting cash flow from trading, then this is even more important. In longer term buy and hold type systems, there may be more volatility in the equity curve. In mean reversion systems, it may be smoother as ther may be more trades and a relatively high win loss ratio. But each system is different, so look at the consistency of the equity and see that you are happy with it.

What a CFD system specifies

So let’s have a look what a trading system specifies:

1. What instruments you’re trading

For example, you may be trading UK CFDs (FTSE), Australian share CFDs (ASX), or the US CFDs (NASDAQ, S&P500), CFDs on commodities, index CFDs, etc.

2. What the entry conditions are

That is, what has to happen for you to enter a CFD. For example, systems may use price action or indicators to signal that a CFD is trending in a certain direction, and therefore has a higher chance of success on the trade. Other systems use chart patterns that are either mechanical (black and white) or discretionary.

3. What your exit conditions are

That is, what has to happen for you to exit a trade. For example, you may use an initial stop and a trailing stop. When you enter a long trade at say $5.50, you may set an initial stop at say $5.30, so that if the trade goes against the direction of the trade and trades at or below $5.30, then you would be exited from the trade. This cuts your losses. In this hypothetical example, the loss is 20c per CFD entered, plus costs and commissions.

The trailing stop is a stop which moves as the trade goes in the direction of your trade (up for long trades), to protect your profits, and also eventually exit you when the trade eventually turns back against the direction of the trade. It therefore lets profits run and preserves the profits.

4. The risk management rules

That is, how much of your total float you are going to place into each trade.

Money management is important because if you have no money management rules, and put proportionally too much funds into each trade, a small number of losses may cause you to lose your account.

There are going to be both winning and losing trades, so good money management is vital to ensure that the losing trades will not affect your account too adversely, and so will enable you to keep trading to make those profits that the system was designed to make. With a profitable system, the equity curve goes up, but it doesn’t go up is a perfectly straight line!

In fact during backtesting you would have tested your system with a specific money management model, to see the effects on historical profits and drawdowns, and chosen a risk model that was suitable for the system.

You should seek your own financial advice before trading.

5. When to review the system

Part of trading is deciding when to review your system to check that it's performing as expected. After a period of time, or after a certain drawdown or other criteria, it's time to evaluate the performance. If necessary, you may need to figure out why the system has not performed as expected and if there's a reason for it. Self appraisal is important to keeo yourself on track.

Learn about how CFD brokers and providers have an impact on whether you'll be able to properly trade your system.