Part 2: Instruments to Trade
You can follow trends using whatever instrument you like.
You are merely following price in the hope of achieving profit, so it does not matter whether the prices you follow are those of exchange traded funds, any other type of financial fund (e.g. closed end, mutual), individual stocks, futures, CFDs (contracts for differences), spread bets, or indeed any other asset class (numismatics, stamps, real property and so on).
In its usual and most convenient sense, however, trend following entails trading liquid financial instruments.
Liquidity (trading volume) matters. High levels of turnover mean you can enter or exit a position in size without moving the market by dint of your own transactions. High turnover means tight bid/offer spreads, which will save you money on entries and exits. Trend followers must usually hit bids and accept offers rather than taking advantage of the spread for themselves. Lower levels of liquidity lead to greatly increased cost and risk, and lower profitability. At worst, you may find yourself stuck in an illiquid instrument as the price gaps against you and your losses multiply.
Most newcomers tend to think about trading individual stocks to begin with.
For an excellent approach to trend following on stocks see Eric Crittenden’s paper ‘Does Trend Following Work on Stocks’.
There are advantages to trend following on stocks. The biggest is granularity. If you have little capital, stocks are the ideal way to trade as you can trade in very small size.
The disadvantages are lack of adequate diversification. I’m not talking about single stock risk (which you can avoid obviously and easily), but the tendency for almost all sectors to move largely in the same direction at the same time. The majority of stocks go up in bull markets and down in bear markets. By all means play with sector rotation, but you are unlikely to find it helps much in a crash.
In my view, trend following on ETFs is a better proposition than using individual stocks and much easier to manage.
ETFs are funds in the form of listed stocks: they trade like stocks and are listed on regulated exchanges, but they are collective investment vehicles. The big advantage is the same – they are ideal for the small player who cannot afford to trade futures. Another big advantage is that they offer much more effective and direct diversification than single company stocks.
Diversification is about trading non-correlated instruments. You hope that in a well diversified portfolio one instrument will zig at the same time that another will zag and that the result will be a smoother equity curve. ETFs give you the opportunity to trade not just stocks but also bonds and commodities in small size and at relatively low commission.
The most liquid ETFs are those which are based on major stock market indices or the major commodities. The top ETFs in terms of liquidity therefore include the following:
- SPY SPDR S&P 500
- EEM iShares MSCI Emerging Markets
- EWJ iShaares MSCI Japan
- QQQ Nasdaq 100 ETF
- GLD SPDR Gold Trust
- SLV Silver Trust
- USO United States Oil Fund
You will encounter problems with liquidity, however, if you want to trade ETFs based on exotic stock indices or less widely traded commodities. Take a look at ETFs based on wheat, sugar or stock markets like those of Egypt or the Irish Republic to see what I mean.
Don’t forget potential problems with shorting too – you will need to discuss borrowing availability with your broker before shorting either ETFs or individual stocks.
There are quite a few useful articles at Traders Place about ETFs and these include the following:
I also cover the advantages of trading index tracking and commodity ETFs in my book A Practical Guide to ETF Trading Systems.
Some ETF databases are listed at Traders Place:
Futures are my weapons of choice and have been for many years. There are at least 150 futures instruments with sufficient liquidity on major, regulated futures exchanges to satisfy most traders. Most sectors are covered and that is essential for diversity: agricultural products, metals, bonds, interest rates, energies, currencies and stock indices.
There are two major problems with futures:
Both of these can be overcome but neither are trivial obstacles.
Let’s take granularity first.
Many futures contracts are massive beasts. Take the Eurex traded Dax futures contract. The big point value is €25 per point. The index stands (at the time of writing) at 8,035. If you are long and the index drops 5% (by no means an uncommon occurrence) then you will lose 402 index points * €25 = €10,000 on a single contract.
Take another example: Nickel on the London Metals Exchange, where the big point value is $6. The current price is $13,430 a tonne and a 5% drop in price would lose you 672 points * $6 = $4,032 on a single contract.
The answer for the small trader is to stick to those contracts with a smaller risk per point. CME Wheat is currently $633 and the big point value is $50. A 5% drop would cost you $1,583 on a single contract – this is far less risk than with the other two examples quoted above. There are quite a number of lower octane instruments around.
There are also some reasonably liquid mini contracts for those who cannot afford to trade the full size contracts: the e mini Crude Oil contract on Globex is 500 barrels (half the size of the full contract).
Complexity is a lengthier topic and not one to be dealt with in depth here. Make no mistake about it though, understanding the complexity of the futures trading world is a steep, uphill learning curve.
Some contracts involve the danger of physical delivery. Contracts usually only last a few months and you therefore have to learn how to stitch together individual contracts to obtain a long dated price series for back testing.
What on earth is a short-term interest rate (STIR) contract all about? How does its price move in relation to changes in interest rates? How do STIRs relate to long-term bond contracts? How and when should you roll your positions over from the expiring to the new contract?
Those not prepared to study very hard for a considerable period of time would be well advised to avoid futures altogether and stick to stocks or ETFs which are (on balance and by comparison) relatively simple instruments.
Spreadbets and CFDs
The last instruments I want to cover here are spread bets and CFDs. Spread bets in particular are badly misunderstood and underrated, but both these tools are ideal for the smaller player since they have far finer granularity. You can play these instruments for a fraction of the risk per contract of that in the futures market and can therefore play the trend following game and gain good diversification with a far lower capital base.
The ignorant and the uninitiated are convinced that spread bets are the equivalent of betting on the 2.30 at Epsom Racecourse. Wrong; entirely wrong.
The dumb gambler can misuse any instrument, be it futures, stocks, spreadbetting or CFDs. The difference is the approach taken.
Here are a few useful resources for learning about spread betting and CFDs:
- The Financial Spread Betting Handbook
- The Definitive Guide to Contracts for Difference
Let’s say you want to follow the trend in the oil market. You can use an ETF (USO United States Oil Fund), the big contract on the CME for Crude Light (1,000 barrels), or a CFD or spread bet.
The dumb gambler will go long crude or any other instrument based on a trading tip or some other equally insane approach. His success or failure will be based on luck, which will inevitably run out. But he can and does use exactly the same instruments as the sophisticated trader who bases his decisions on rule base algorithms or rigorous fundamental analysis.
The only real difference in instruments, when trading the same thing, is the big point value (and the credit risk of the exchange or provider).
Here is the differing risk profile three types of instrument can provide:
- USO United States Oil Fund Current Share Price $36.77 (assume your broker allows single share deals).
- Mini Crude Oil on CME September contract $104.725, 1 contract is for 500 barrels.
- Spread bet on Crude at IG Index (spread 4 points), assuming the offer is at $104.75 at £200 per “big” point (the minimum bet size for Crude at IG Index).
Now let us assume you go long at the above prices at the minimum size possible and let’s look at your losses for a 5% decline in price.
So where is the difference with spread betting? It is merely a way of achieving a lower bet size and therefore it makes trend following practical for the smaller player. CFDs work in much the same way and again offer lower risk per big point move than futures.
Don’t be put off by the title spread bet: it is no more (and no less) betting than using the futures market or the stock market. Period.
Credit risk is a different matter but then following the MF Global collapse credit risk is a concern whichever way you trade.