2Bull Forex Blog

If there is one area that is regularly ignored by CFD traders it is that of volatility, which is often confused with risk. Certainly in terms of grading different types of asset classes, the two are connected, and both the risk and volatility of a government stock for instance will usually be much lower than say a dot.com or emerging market smaller company.

But the bottom line is that risk is related to reward, and it simply measures the amount that it is possible to lose within each investment or trade. Volatility however measures how much prices rise or fall over a set time for each investment issue, sector or share, and this is very useful when constructing portfolios, assessing margin requirements and position sizing.

Standard Deviation – the basic measure of volatility

Standard Deviation is the basic statistical measure of the dispersion of a population of data observations around a mean (average), and is widely used in stockmarket trading, forex and commodity analysis. It is simply the square root of the variance, and is calculated as follows:

1. Establish the mean value over the chosen time period.
2. Measure the deviation of each data point from that mean.
3. Square each deviation (this ensures all the deviations are positive).
4. Total up the squared deviations.
5. Divide that figure by the number of data points less one.
6. The Standard deviation is the square root of that figure.

There are some variations on the way the STD can be constructed, but the above is the usual formula supplied with most trading software systems.

Problems with standard deviation

1. If using short term action, the validity of the STD becomes less certain due to the usual short term randomness in the market.

2. It is a retrospective measurement, and is of little use if there is a major change in volatility due to outside news. Having said that, there are certain technical buy and sell indicators which search for changes in volatility to establish potential new trading opportunities, and here it is very useful.

Implied Volatility

Many traders in the options markets will be aware of the use of implied volatility in terms of option pricing, and here the trader can use both the underlying price of the security and the prices of puts (rights to sell) and calls (rights to buy) to establish an expectation of future or implied volatility.

This creates arbitrage possibilities if the stock, or market, is incorrectly priced compared to underlying options available in it, and these disparities often occur after big price moves or panicky action. The formula for implied volatility is much more complex, but it is an interesting area for more sophisticated players to analyse, as it also includes dividend payments and interest rates.

What is beta?

Beta is another measure of volatility, and whilst totally different from standard deviation, it nevertheless provides another angle in portfolio or trade construction.

Standard deviation determines the volatility of a fund, market, sector or stock according to the disparity of its returns over a period of time, whereas beta determines the volatility in comparison to an index or other benchmark.

If an investor has a portfolio of shares with a beta of 1, this means that the list should generally match the underlying movement in that benchmark over time. It doesn’t mean that it will naturally perform better or worse on an individual stock basis, but if the FTSE 100 index was to rally by say 10% over one year, the portfolio with a beta of 1 would in total expect to improve by a similar amount.

On a trading level, each stock has its own beta which is important for CFD traders, and a beta of more than 1 suggests greater volatility than the benchmark, with a beta of less than 1 suggesting lower volatility.

A stock with a beta of 2 for instance would be expected to move 2 times more than the benchmark, or double the underlying index move. Clearly if a CFD trader has a balanced list of positions in terms of longs and shorts, the average beta on each side needs to be assessed in terms of the overall risk of big market moves in one direction.

Normally, but not always, the highest beta stocks are those with the greatest volatility as measured by the standard deviation, but also how much they are affected by the business cycle and interest rates. Fund managers, house builders and insurance companies for instance have much higher betas than supermarkets, pharmaceuticals and utility stocks.

In portfolio analysis, the beta coefficient, or financial elasticity (sensitivity of the asset returns to market returns and relative volatility), is a key parameter in the capital asset pricing model and is a way of separating an investor’s profits related to market action as opposed to the willingness to take risk. In essence this means how much added value there has been as opposed to just the luck from being in rising markets.

If one is highly bullish about the underlying market, it makes it easier to beat the market over the term in question by choosing high beta stocks. Equally, if a big fall is expected imminently, a CFD trader might prefer to take low beta long positions and high beta shorts if a balanced trading list was required.

The average true range indicator

This is an important indicator that can be used for setting stops and is also another way of measuring volatility, and is included in most software systems.

The ATR determines a share’s volatility over a set period that can be defaulted as desired. The daily ATR indicator is very simple to calculate and is the highest of:

The difference between the current high and the current low
The difference between the current high and the previous close
The difference between the current low and the previous close

Basically this is the maximum range in which the share has traded from the previous close to the current high and low. The average is then taken over a set number of days (ten is often used), and the stop is then calculated as a multiple of the ATR.

The reason traders like the ATR is that it captures more intra-day information, while the standard deviation only measures the volatility of closing prices (although it can be refined to include highs, lows, etc).

Reasons for volatility and what to look for

On a short term view, shares that have quotes in more than one market or currency may exhibit high volatility, but not necessarily a high beta. This is simply because of arbitrage possibilities, where traders buy the stock on one market and sell in another to take advantage of price discrepancies.

Changes in technology naturally affect the volatility of individual stocks because it takes a while for this information to become available to the wider investment community, so a period of volatility often ensues. Once the stock becomes more mainstream or loses its super-growth tag, volatility can often die down.

News-led events often lead to big changes in volatility, again as traders and investors begin to adjust expectations for future prices. This can include profit upgrades or warnings, unexpected changes in economic policy, natural disasters or geopolitical events.

If the volatility increases for the same investment amount, so does the potential risk and reward and trade sizes/stop losses should be adjusted accordingly for CFD traders.

Albert Einstein – yes, he of “e equals mc squared”, said that compound interest was the greatest mathematical discovery of all time, and this brief summary might just convince you how right he was.

When one first examines a potential investment, it is natural to look at the headline expected rate of return, but it is the compounding of the interest (or profits) on that principal which creates the biggest returns over time.

The compounding of profits, or dividends, or interest applies in all financial markets, so if you are a short term stock market trader, property investor or other short or long asset holder, you may find the magic of compounding interest very interesting. We will see here though how using CFDs and compound interest can provide potentially astonishing returns.

The rule of 72 and long term returns

You might not have learn this at school, but Einstein’s rule of 72 is one of most magical and simple formulas around. What this says is that to work out how long it takes to double the value of an investment, you simple divide the return into 72.

So, if we say that the stock market has returned around 11% on average over the last one hundred years or so, (and property is not far behind for that matter), then to work out on average how long it would take an investment in the market to have doubled, the calculation is 72 divided by 11, which equals about six and a half years.

A few quick points need to be made clear here. First, this rounded figure assumes all dividends are reinvested, and there are no charges for investment, which clearly is not realistic for most investors. It does not include taxes of any sort, which again would have to be factored into potential returns.

Doubling and doubling again

Once we have the time it takes to double your money, this is where the magic of compounding comes in, because it becomes possible then to extrapolate some very tasty figures over the longer term.

If we return to long term equity investment, and say that the real return on shares (that is adjusted for inflation and charges) is say 5%, then you could work out how much would you need to invest and how long to give you a future investment value of say £1m in today’s money.

A simple spreadsheet model can do this, but let’s say you began with £10000 and each year your investment appreciates by 5% in real terms. To double the initial figure would take (72 divided 5 approximately) just over fourteen years. Another fourteen years is what it takes to double again, and after 42 years of working life, your £10000 becomes £77615 in real terms. Now this doesn’t sound much, but of course this does not include any further contributions you make through your working life.

But going back to nominal returns, the story is dramatically different. Assuming a round 10% per annum returns after costs, it takes just over seven years to double your money. After 42 years, your £10000 is now worth £547637 – a quite amazing figure. Now you can see the linkage with the trend of property prices based on these long term returns from the past, but as mentioned before the figures for total return on the stockmarket (not just how much the indices have gone up) is even higher.

Just to show how this sort of compounding works in the real world, Warren Buffett began with $105,000 fifty six years ago – it was a lot of money admittedly then. His fund’s compound returns have been around 25% per annum, and his fortune is currently over £50bn, making him the second richest man on earth.

Monthly returns and hitting the magic million

How then does all this relate to the short term and in particular to CFD trading? The first thing we have to presume is that a good trading methodology is crucial to all traders, whether it is in equities, indices, forex or commodities. It is then possible to leverage short term investments for spectacular gains within just a few years.

Let’s return to our fictional £10,000 starting investment, but this time we’ll measure performance in months, not years. A very good trading system might return 1.5% per month after costs, which compounds to 19.6% per annum. This is not far off the sort of figure that only the best hedge funds aim to match or beat over the long term.

Without leverage, the £10,000 becomes £24432 over five years, which is a pretty good return on its own.

Using just three times leverage however the return jumps to an astonishing £140274 over just five years.

You would theoretically hit a million in less than nine years, and that’s just from £10,000!

A word on risk/reward

All the above simulations (with the exception of Warren Buffett) are based on average long term returns and take no account of short term movements. CFD traders should of course be aware that by increasing your leverage, the risk of major falls in equity increases accordingly.

It is paramount that all traders have applicable money management systems and stop losses in place to protect against potential pitfalls when trading, but by using CFDs with a profitable trading system and leverage, the sky really is the limit.

If there is one area guaranteed to confuse many traders and lead to multiple opinions on the most appropriate approach, it is the subject of stop losses. The science and the art of placing stops is featured extensively in many trading books and guides, but the bottom line is that there is no right or wrong answer, simply the fact that stop losses must be used to limit potential downside exposure when trading. Traders should also be careful not to confuse stop losses with buy stops, which trigger an opening position rather than closing the trade.

It is very important not to package together the placing of stops with money management, as the two represent different strands of trading. Simply put, stops are there to protect profits and limit the potential downside at any time once a trade has been opened, and are part of an exit strategy for trades that are already open. Money management covers position sizing or amounts to be risked within each trade of a portfolio.

Within this potentially complex subject, there are many different types of stops, and it should be added that stops are never guaranteed unless that facility is offered by the broker for an additional charge. Nevertheless, their use is an essential part of any trading strategy. For the examples below share prices are used, but stop losses should also be used when trading CFDs in commodities, forex or indices.

The uses and abuses of stops

Much has been written about the placing of stops and how to avoid them being triggered without too much risk. This of course is the $64m question for most CFD traders and very often causes more consternation than any other aspect of the trading process.

The basic idea behind where to place a stop is by reference to the overall trend or trading range within which the share is moving. As to the actual level of the stop, it depends on several factors including the trader’s overall money management rules, the amount of leverage, the time frame, and crucially the underlying volatility of the share chosen. The stop should aim to be placed at a level which if triggered would confirm the trade was incorrect.

There is no point in trading a highly leveraged CFD account with routine 5% stops as eight losses in a row, which statistically can be expected every few hundred trades, would lead to a minimum 40% drawdown on the account.

Having said that, there is equally no point in attempting to reduce the risk too far by setting 1.5% or 2% stops in highly volatile stocks or takeover situations as each trade needs room to breathe, and stops this tight are likely to be triggered within the normal daily ebb and flow of price movements.

A good rule of thumb is that if you cannot see at least double the potential profit in a trade compared to where you expect to place your stop loss, that trade should be passed over. Indeed some CFD traders look for three times profits achieved against losses as a starting ratio. Consequently an approach like this can be very successful by winning just three or four times out of ten, and is the hallmark of many of the world’s leading traders.

Many losing traders look for an entry point or strategy that wins six or seven times out of ten, but this is very hard to achieve consistently. Although the feeling of winning regularly is certainly warm, the win/loss ratio here very often tends to be very poor as too many winners are taken quickly, so the correct use of initial and running stops placement is crucial.

Types of stops:

The basic maximum loss stop

The maximum loss stop is the starting point for most traders and is triggered when the share price hits a level below or above the opening price of the trade, depending on whether it is a long or short position. It can be measured in percentage points or actual money terms, but for these examples percentages are used. So if a CFD trader buys shares in British Telecom at 330p with a 2% stop loss, then the allowed loss is 6.6p and the position is closed if the bid or selling price falls to 323.4p or lower.

Note that no mention is made of how many shares are purchased or how much is being risked, as this is part of the client’s overall money management.

If the shares gap down below the stop either intra-day or at the open of trading the next day, the closing trade is triggered at the first price available in the market for that size, which is why stops are not guaranteed.

As to the percentage size of the stop to be chosen, that depends on several factors including the trader’s overall money management rules, amount of leverage, time frame and crucially the underlying volatility of the share chosen, which is very important.

Volatility stops and the ATR

Clearly, a percentage based stop is likely to be triggered more quickly in a highly volatile share and one of the ways traders can adjust stop levels is by ratio to the underlying volatility. There are various measures of volatility available, but a simple way is to use a stop related to a multiple of the average true range indicator, which is featured in most software packages.

The ATR determines a share’s volatility over a set period that can be defaulted as desired. The daily ATR indicator is very simple to calculate and is the highest of:

- The difference between the current high and the current low
- The difference between the current high and the previous close
- The difference between the current low and the previous close

Basically this is the maximum range in which the share has traded from the previous close to the current high and low. The average is then taken over a set number of days (ten is often used), and the stop is then calculated as a multiple of the ATR.

The reason this indicator is useful is that it becomes easier to place a stop outside the normal range of trading so that it is not hit by the short term random action of individual shares based on their average volatility.

As to the multiple of the ATR to be used, that is for the trader to decide, but longer term players and seasoned stockmarket investors tend to find a 2.7 to 3.3 multiple (which can equate to 5% to 15% stop losses) is applicable. Shorter term or highly leveraged players need to tighten the stop accordingly by adjusting this multiple.

The breakeven stop

This is a commonly used stop in which the trader closes the position if it reaches a minimum profit and then returns to even or back to a loss. So in the above example, if the price of BT rises say 2% to 336p, the stop is moved up to 330p, which was the opening price of the trade.

Please note that the breakeven stop here is not simply a new 2% stop loss – it’s very slightly different – but very often this approach is used as a rough and ready way to protect the downside. This leads on to the important subject of trailing stops.

Trailing stops

Trailing stops are widely used by professional traders as they provide an element of protection for winning positions without sacrificing too much of the profit.

The idea here is that once the position is opened, the trailing stop runs behind of the best profit achieved throughout the trade and the stop (whether percentage or price) is moved up accordingly.

There are three rules and suggestions (examples here are for long positions):

1. The stop can and must never be lowered

2. The percentage or price of the stop at each stage of the trade does not have to be the same. For example, the trader in the above example may begin with a 2% stop in BT, and then the share price might rise to 346.5p, which represents a 5% profit. At that point, the trader may wish to tighten the stop to 1%, so that a minimum 4% profit can be taken but with more potential upside. This approach is to the discretion of each player, but it is a very useful way of nailing down profits.

3. Another approach is to raise the stop loss with reference to recent action after a certain profit has been reached. Instead of a percentage stop, the trader might move the stop up behind daily lows, thus protecting against a potential trend change.

4. The stop might be triggered if there is a sudden rise in volatility with a reversal in the shares, and some traders use as a trigger if the day’s ATR is double the average ATR of the last ten days. This is very useful where a wider initial stop has been taken and there is the potential for a trend change before the trailing stop is hit, thus protecting the downside.

Finding a suitable indicator that reliably defines a trend is one of the keys to successful investing, whether it is on the stockmarket, in forex trading or commodities. CFD traders are often faced with a bewildering array of trend indicators on their software, and when searching for the elusive holy grail of the perfect indicator, the idea is not to miss a major move but also not being whipsawed too often. There is of course no straightforward indicator, but this paper looks at the less well known TEMA.

The basic moving average

Traders usually begin with a basic simple moving average, which is easy to plot, and here there is a trade off in terms of the amount of data used. Longer term investors tend to begin with the 200 day moving average which is something of a yardstick, and the trend rules are very simple. If the share price is above the 200 dma, and the average itself is rising, this suggests a long term bullish trend or a buy signal. The opposite scenario is often used for selling, and long positions are often closed out if one of the above conditions is breached, but each investor has there own methodology.

The obvious problem here is that such a long term indicator misses the first few months of a change in trend, and whilst this is not such a problem for very long term players, it can result in the giving back of a large chunk of profits at the end of a trend. The benefits though are that very few changes need to be made to a portfolio, and there is a much lower chance of a quick reversal in the trend, which can often last many years.

As the length of a moving average shortens, more signals are giving as the average responds quicker to trend changes, but there is also more whipsaw action. In trading range markets, which can often last far longer than trending conditions, moving averages are of little use.

A quick word on the MACD

One refinement to standard moving average analysis is to use crossovers as signals, and one formula derived from this is the MACD which can be used to identify turning points, the momentum and the trend of any stock or index. The most popular MACD formula starts by subtracting the 26 day exponential moving average from the 12 day exponential moving average.

Crossovers between the moving averages are often used to provide golden and dead cross signals, and that formula provides the basic MACD line and the initial signals to watch for. What then happens is that a 9-day exponential moving average of that line is taken, and this is called the signal line, which gives various useful signals.

MACD has become very popular in recent years, and because of this there are now many false breaks and chaotic action which make its success rate questionable at the very least.

There is though another smoothing indicator which has been tested by some technical analysts to give more precise trend change recommendations. Again it works better in trending markets, but it has uses in spotting turning points, and some analysis suggests that it is better than the MACD as an all round indicator.

TEMA – Triple exponential moving average

TEMA is not that old and was developed by Patrick Mulloy in the early 1990s.
His idea was to try and reduce the time (and profit) lag in moving averages as the moving average length increased, and his solution was a modified version of exponential smoothing but with less lagging.

TEMA is not simply a moving average of a moving average of a moving average, but it is a composite indicator using a single exponential moving average, a double exponential moving average, and a triple exponential moving average. As with any moving average based technique, the trader can use opening, closing, high or low prices, but usually closing process are chosen.

The TEMA formula

1. Establish a simple (exponential is better though) moving average (EMA1)
2. Calculate a double exponential (EMA2).
3. Calculate a triple exponential (EMA3).
4. TEMA equals: (three times (EMA1 minus EMA2) ) plus EMA3

As with all moving average based analysis, the longer the timeframe used, the less responsive the TEMA will be to trend changes, but it appears to work well in steady trending conditions and volatile stocks.

From experience TEMA can be defaulted reasonably well using 14 day or 21 day averages, and for a longer term trend indicator, a 70 day or 100 day TEMA might be appropriate. As with all indicators it is simply a matter of finding an approach that suits each individual trader.

It is possible to actually apply TEMA analysis to MACDs themselves, and some software systems include a custom indicator using this approach, but it is simply a question of trying it out.

After all, finding the underlying trend is just one out of many rules for successful trading.

The FTSE 100 index is used as the benchmark for measuring the strength of the UK stock market, and some commentators have argued it has a natural bias to outperform the wider FT All Share index, because it tends to promote to its ranks those stocks which are in the ascendancy and remove others that are falling away.

From time to time the index can appear to be affected by a high weighting given to one particular sector, and it could be argued that at present the mining sector (Anglo American, Antofagasta, BHP Billiton, Kazakhmys, Lonmin, Rio Tinto, Vedanta Resources and Xstrata) has undue influence. Stock market traders will recall the famous and dramatic year of 2000 when the FTSE 100 list contained such passing technology stars such as Energis, Bookham Technology, Arm Holdings, Freeserve, Baltimore and Psion – great memories!

Given the increasing use of tracker funds, it is important to look at where sector and stock monies are flowing, because these fund managers have to match whatever is in each benchmark index, so new entries and deletions are worth researching by CFD traders before they happen.

The purpose of this paper is not to discuss whether or not it is worth buying or selling a new constituent, as significant academic studies (with some conflicting results) have been made on this subject. It is more a summary of what changes to look for in assessing possible constituent moves, and there are various ways that the FTSE 100 list can be changed.

Quarterly reviews

This is the most common way for changes to be lagged. The committee that oversees the various FTSE indices meets quarterly on the Wednesday after the first Friday in March, June, September and December. Constituent changes are then implemented on the next trading day following the expiry of the LIFFE futures and options contracts, which normally takes place on the third Friday of the same month. The rankings of constituents by value are calculated using close of business prices on the day before the review, and companies must have a minimum trading record of 20 days at the review.

A company is promoted to the FTSE 100 index if it rises to 90th or above when the eligible securities are ranked by market value

It is relegated if it falls to 111th or below.

Where there are more companies qualify to be inserted in an index than those qualifying to be deleted, the current lowest ranking constituents are relegated to ensure there are always 100 companies in the index. If there are more qualifiers for relegation, the highest ranking companies that are not already in the index will be promoted to match the numbers.

The six highest ranking non-constituents of the FTSE 100 Index at the time of the periodic review are known as the reserve list, and are used in the event that one or more constituents are deleted from the FTSE 100 during the period up to the next quarterly review.

Fast Entry

The second way a company can enter the FTSE 100 index is if it is a new issue and larger than 1% of the full market capitalization of the FTSE All-Share Index. In this case it will normally be included in the top 100 after close on the first day of trading, and the lowest ranking constituent is removed.

Eligibility of equities

Only the eligible quoted equity capital is included in the calculation of its market capitalization, so if a company has two or more classes of equity, significant and liquid secondary lines are included in the calculation of the market capitalization of the company, based on the market price of that secondary line.

The committee can decide if a secondary line is to be priced separately if its full market capitalization (before the application of any investibility weightings) is more than 25% of the full market capitalization. If the full market capitalization of a secondary line, which is already a constituent of the Index, falls below 20% of the company’s main line at the quarterly review, the secondary line will be deleted from the index, but this happens rarely.

Convertible preference shares and loan stocks are excluded until converted.

Rights or other issues

If a company issues shares, partly or nil paid, and the call dates are already determined and known, the market capitalisation is adjusted so as to include all such calls, which would reflect the total fully shares in issue.

Mergers and takeovers

If a merger or takeover results in one constituent in the FTSE 100 index (or FTSE 250 for that matter) to be absorbed by another constituent, there is a vacancy in the appropriate index. The highest ranking security in the appropriate Reserve List as at the close of the index calculation two days prior to the deletion is chosen.

If a constituent company in the FTSE 100 or FTSE 250 is taken over by a non-constituent company, the original constituent will be removed and replaced by the highest ranking non-constituent on the appropriate Reserve List.

The company resulting from the takeover is however eligible to become the replacement company if it is ranked higher than any other company on the Reserve List.

Company splits or demergers

If a member of the index is split or demerged into two or more companies, the resulting companies are eligible for inclusion as index constituents in their own right. This is again based on each new company’s market capitalisation (before the application of any investibility weightings).

It may be that the lowest ranking FTSE 100 constituent gets relegated to the FTSE 250, so when GUS demerged into Home Retail and Experian last October, Party Gaming was unfortunately relegated.