CFD Trading: Seasonal Weakness and Contracts for Difference (CFDs)
Seasonal Weakness – Historical Patterns
The markets have certainly been weak lately, falling to new lows day after day into the end of the financial year. This drop is not unusual, with seasonal weakness showing up during June each year. Maybe it is investors realising losses before the year end or raising funds to prepay interest on investment loans that has this downward effect on the market. If we take a look at the history of seasonal tendencies then this year is right on track with previous years and the pattern they play out. Look at the chart below which shows the regular pattern of the markets that have occurred historically. Weakness through May and June is normal and not something unusual at all. Even the bounce in mid June played out as expected from studying these historical patterns.
On the bright side however, July and August look much stronger from a seasonal perspective. Newly invested funds and superannuation are often put to work in early July, giving the stock market a lift at this time. But is it different this year?
Currently global growth is suffering and governments world wide are loaded with debt. Are we going to see a strong rally through July as we have in the past?
The best clues to this will be the price action going forward. Seasonal patterns are what “typically happen”, but are not a guarantee of future performance. If there is a significant deviation from this road map then that is sign of a bigger cycle in play and that the challenges facing the world’s economy may be more serious than first thought.
Consider 2008 (brown line on the chart below) when the July – August rally failed to materialise, and falls continued into early July, before moving sideways through August and gathering downside momentum in September and October 2008.
While hindsight is a wonderful thing, the seasonal patterns here were known well in advance, in fact since January this year. So what can you do when the seasonal patterns turn negative or, more importantly, if the expected rally fails to materialise? This is when you could consider using Contracts for Difference (CFDs) to protect your portfolio or profit during these periods of market weakness.
Contracts for Difference (CFDs)
One of the key advantages of Contracts for Difference is the ability to short sell easily and efficiently. If you currently own shares you can short sell a CFD on the index to protect the value of your shares. Even though your shares go down in value, the value of the CFD increases. A portfolio of $100,000 worth of shares could have been hedged by selling 20 contracts of the XJO index.
During the recent fall the Aussie market peaked just above the 5000 point level on the ASX 200 and fell to 4300, for a drop of 14%. Assuming your portfolio lost 14% then it is now worth $86,000. By selling 20 contracts short on the index at 5000 and if you were to cover them at 4300 you would make a profit of $700 per contract or $14,000 on the CFD position. This completely offsets any loss in value on your share portfolio and while the gain on the CFDs is taxable, there are no capital gains tax implications that would be incurred if you sold your shares.
Alternatively you can short sell individual shares using CFDs to profit from falling prices. While the seasonal patterns may be looking up for July, if the expected rally fails to materialise now might be a good time to sharpen up your skills and add CFDs to your portfolio as protection against any future drops.
By Jeff Cartridge
Be aware that CFDs are leveraged products which carry a high level of risk to your capital, as it is possible to incur losses that exceed your initial investment. Therefore CFDs may not be suitable for your level of acceptable investment risk. Before proceeding with CFD trading, ensure you fully understand the risks involved, otherwise seek independent financial advice.