Monday, August 31, 2009

How to Maximize Profits from the Coming Crude Oil Pullback


Crude has been a great instrument to trade, because it often amplifies movements in global stocks and other risk asset markets. With global stocks and other risk assets already pricing in a recovery, and likely overpriced, they are ripe for a pullback. Like many pullbacks during a long term bear market, the coming one could easily be well over 10%.

Trading crude oil has often been one of the best ways to play a strong trend, since it often amplifies movements in global markets.

Often one of the best ways to play crude oil movements is by trading Contracts for Difference, an instrument frequently unknown to retail investors.

The Best Way to Trade Crude Oil—Contracts for Difference (CFDs)

Oil ETFs may be easy to trade, but they don't always give you the full benefit of crude oil's movements.

Here's an easy, highly liquid way to trade AND capture the full movement in crude oil price swings—via Contracts For Difference (CFDs). Not widely used by the most popular online brokerages, these instruments allow traders capture the full movement.

What is a CFD?
A CFD, or Contracts for Difference, is a financial instrument similar to an index or share which allows you to trade an underlying index, share or commodity contract without having to own the underlying asset itself.

The CFD price is the same as the price of the underlying asset (whether it is a share, index, or commodity futures contract). If the price of the underlying asset goes up, so will the price of the CFD. A major benefit over ETFs or stocks is that there are no exchange fees and many of the inefficiencies of trading the underlying shares on the exchange are eliminated.

Note the following example of trading oil via the popular USO ETF vs. trading with contracts for difference

Example: Gain from Trading Crude Oil via CFDs, 2/12/09—6/29/2009

Note how a trader captures the full price movement. Dates Chosen did not capture the full movement in crude during since the beginning of 2009, in order to simulate what a savvy but not overly luck or prophetic trader might have done.

Trading with CFDs

February 12 Crude Oil Price $33.55

Chart Courtesy of AVAFX

June 29 Price $73.36

Chart Courtesy of AVAFX

Gain with CFDs

June 29 high 73.36
Less: February 12 low (33.55)
Difference 39.81

Percent Gain: 39.81/33.55= 118.65% Gain

By trading oil using CFDs, a trader buying and selling at these dates (neither of which is the high or low of the whole move) would have captured the full gain that crude made during the trade.

Trading with the Popular Crude Oil ETF, USO

With USO, a trader would barely have gotten less than a 48% gain, barely 40% of the profit using CFDs.

Feb 12, 2009 USO Price $26.13

June 29, 2009 Price $38.67

Gain with the Crude Oil ETF, USO

June 29 high 38.67
Less: February 12 low (26.13)
Difference 12.54

Percent Gain: 12.54/38.67= 47.99%
Comparing Gains with CFDs vs. USO

47.99/118.65 = 40.44%

In sum:
During the trade period of February 12—June 29 2009:
USO produces barely 40% of the full move in crude
CFDs give 100% of the gain over the same period.

Additional Benefits of CFDs

The brokers (online and offline) allow you to use the power of leverage which is often not available in equity products. For example, 50:1 leverage lets you control $50K of crude with just $1000. That can amplify both profits and losses by 50 times, basic risk management is even more essential than with other kinds of trading if one uses leverage. For example:

--Always plan your trades in advance, and decide what will be your entry and exit points, including using stop loss orders to control the maximum likely loss in a given trade

--Never commit more than a predetermined percentage of your capital to a given trade

Many of these brokers charge no fees or commissions, making their money as market makers, on the difference on the spread (the difference between the bid and ask price). Thus it's critical to be aware of the spreads your broker is giving, as well as any other fees involved.

Researching the Right CFD Broker For You

Typically one trades CFDs through brokers that deal in forex, commodities, and stock index trading. For individual "retail" traders, most of these are found online.

As with any other broker or professional service relationship, traders must do their homework. Brokers come in different styles and flavors. Some focus on large institutions or high net worth individuals. Others, like AVAFX, focus on more mainstream individual investors with less background. Even within that niche, there are many, and each broker tries to occupy a specific niche by offering certain specialties or advantages over others. These can be in variety of instruments offered, costs, level of service, ease of use, multi-lingual support, etc.

Unfortunately, I've yet to find an objective AND informed clearinghouse for information comparing the various online brokers. Most have a chat room online forum feel, so it's hard to feel confident about the information given.

I'd be grateful for any recommendations of online sites that make a serious effort at evaluating online forex/commodity/stock index trading sites.

Disclosure and Disclaimer: The author is Chief Analyst for AVAFX, an online forex, commodity, and stock index trading site, and makes no specific broker recommendations herein.

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