Peter Mathers
Peter Mathers, Director of TradingLounge, has been trading since 1982. He started his professional trading career with Japanese futures company Hoei & Shoin, who mentored and taught him the Japanese analysis techniques of Candlesticks and Renko. In these articles Peter gives you all the facts on CFDs - Contracts For Difference. More information

CFDs - WHY? HOW? & WHO?

       

Why Trade CFDs?

If you have been trading shares for a while now and you haven't looked or considered trading CFDs, you may be missing something. Since CFDs were introduced in Australia in late 2001 the number of CFD traders has been growing by the day.

The growth and popularity of CFDs has been tremendous over the past few years and now there are more countries accommodating these financial instruments to be made available and tradeable in their jurisdictions.

What are CFDs? A Contract For Difference (CFD) is a derivative trading instrument that allows you to trade the price movements (when you enter and exit a trade), without owning the underlying instrument, in most cases shares or equities.

Compared to share trading, CFD trading is almost the same except that when you trade a CFD you don't own the actual share. If you trade a CFD on Google or BHP Billiton, you are trading the price difference between your entry point and your exit point. You don't own the Google or BHP Billiton shares; you are only counting on their price going up or down.

The most common type of CFD is a share CFD, but there are also other CFDs for Sectors, Indices and other financial instruments such as commodities and treasuries.

What makes CFDs attractive to trade?

Easy to understand and easy to trade -
Everything you know about shares and share trading applies and can easily be used to trade CFDs because the price of CFDs moves as the actual share price moves. For example, if share ABC is worth $5.00, a share CFD on ABC is also $5.00.

Tradeable on Margin -
You only need a small percentage of your trading capital to open up larger or more positions than you can normally open. CFDs providers require from 1-10% margin depending on the share CFD. Being able to trade on margin is the biggest attraction of CFDs because it increases the opportunity to make profit using a small capital but its a two-edged sword - it magnifies both potential profits and losses.

Can be traded Long or Short -
This is one of the most attractive features of CFDs because it means you can trade long and make money on a rising market or trade short and make money when the market is falling.

Dividend Payment -
Similar to dividend paying shares, CFDs also pay dividends on long positions.

No Expiry -
Unlike other derivatives that have expiry date and that become worthless upon expiry, CFDs don't have expiry date so you can hold CFDs for as long or as short a period as you like.

Low Commission/Brokerage Cost -
Compared to the brokerage fee you pay when you trade with your regular stock broker, commission charges when trading CFDs are relatively cheap. Some CFD providers charge as low as $10 for trades of up to $10,000.

Ability to trade International Markets -
CFDs open up a whole new world of financial markets including those in the US, UK, Europe and Asia which were not accessible to Australian traders before.

Are CFDs for you and where could they fit in your Investment Portfolio? You may already have a healthy share portfolio that you want to keep growing. While CFDs may not be the ideal vehicle for the long term buy-and-hold investing, it definitely has a place in any investors portfolio.

Cheap entry into trading -
You only need to pay a small percentage of the total value of the transaction to open a CFD trade, CFDs can be seen as a relatively cheaper way to get started in trading. Some CFD providers require a deposit amount of only about $5,000. As long as you maintain your leverage exposure to a reasonable level, CFDs can be an efficient entry into trading the markets.

For example, you want to buy 1,000 shares of XYZ company at $8.00 a share. This means you need at least $8,000 to open a trade. If you trade CFDs of XYZ company, you would only need about 5% of the total amount to open the trade.

Here's how it works:


 XYZ COMPANY ACTUAL SHARE CFD

Price $8.00 $8.00
Quantity bought 1,000 1,000
Broker fee/Commission $19.95 $10.00

Total capital outlay $8,019.95
($8.00 x 1000 shares
+ broker fee)
$410
($8.00 x 1000 CFDs x
5% of total amount + commission)

You need quite a substantial trading capital to get into this trade if you buy the actual share and it will limit your ability to open other trades if you have a small capital. Trading CFDs means you can start with a small trading capital at a cheaper price.

Portfolio Diversification -
If you're a long-term buy and hold investor you can use CFDs to take advantage of short-term profitable moves in the market without affecting your long-term investment. This means while your long-term positions are growing over time, you can trade CFDs to deliver profit from short to medium-term trades.

Portfolio Hedge -
Hedging means protecting or trying to minimise any risk that may affect your existing investment portfolio. Many people are now using CFDs as a hedge to protect their share/equity investment.

For example, say you have bought 1,000 BHP shares at $28.00 expecting that the price will go higher in the months to come because of the global demand for resources. You intend to keep your BHP shares as a long-term investment. However, after a few days of buying the shares the price went down and it is now trading at $27.75. You still believe that BHP shares will go higher in the medium to long-term period, but in the mean time the share price has been going down for the past few days. You can short sell 1,000 BHP share CFDs to hedge your share position in the short term. This is because every cent movement in the physical shares (in this case it is going down, therefore you are losing) will be matched by the same movement in the share CFD (in this case, because you have a short position you are making money if the price of the share CFD goes down). This means your losses in the physical shares are being offset by your winnings in your short CFD trade (not withstanding personal tax treatments and brokerage rates applicable).

 

How to Trade CFDs

Today, most, if not all, CFD providers give you a direct link to them through an internet based and electronic trading platform. Like electronic banking and other internet based transactions, the more familiar you become with the electronic trading platform, the better your trading experience.

After opening your CFD trading account with a provider, the first thing you need to know is how to use the trading platform of your CFD provider. Again, this will vary from one provider to another and it pays to learn the features and capabilities of the trading platform to make your trading routine as efficient and smooth as possible. Though there will be differences in the look and feel of each trading platform, your CFD trading software must have all the features and capabilities that will allow you to:

  • open and close trades
  • put in additional orders or trades
  • amend or cancel existing orders and stops
  • manage your trade from entry to exit
  • preferably have quality charts for analysis
  • see your daily account statement

Types of Trades

Going 'Long'
Going 'long' means you open a CFD position by buying it with the expectation that the price will go up and then selling it at a higher price, that's when you make the money.

An example of a 'long' CFD trade
STEP 1: TO OPEN A TRADE, YOU BUY:
300 BHP share CFDs at $28.00 with a (eg) 3% margin and (eg) $10 commission

(300 share CFDs x $28 = $8400) x 3% = $252 + $10 = $262 (margin required)

This means you will be required to have at least $262 in your trading account to open this BHP share CFD trade.

STEP 2: TO CLOSE A TRADE, YOU SELL:
After you bought BHP share CFDs commodity prices jumped in the international market overnight. The following day the price of BHP shares is also expected to go higher and you want to close your BHP share CFD position.

You sell 300 BHP share CFDs at $28.50 (for a 50 cents movement in each share CFD) - $10 commission = closing price

(300 share CFDs x $28.50 = $8550) - $10 = $8540

STEP 3: CHECKING YOUR PROFIT AND LOSS:
Your profit and loss calculation will look like this:

(sell price - buy price) x number of share CFDs - commissions = profit

($28.50 - $28.00 = .50) x 300 share CFDs - $20 = $130 profit or 51.6% return for an initial outlay of $252

NOTE: This calculation does not include the financing charge which is calculated on a daily basis for as long as you hold your CFD position open. Financing charges vary from one CFD provider to another.

GOING 'SHORT'
Going 'short' means you open a CFD position by selling it with the expectation that the price will go down and then buying it at a lower price, giving you the profit even if the CFD price goes down.

Example of a 'short' CFD trade
STEP 1: TO OPEN A TRADE, YOU SELL:
300 BHP share CFDs at $28.00 with a 3% margin and $10 commission

(300 share CFDs x $28.00 = $8400) x 3% + $10 = $262

This means you will be required to have at least $262 in your trading account to open this BHP share CFD trade.

STEP 2: TO CLOSE THE TRADE, YOU BUY:
After you bought BHP share CFDs commodity prices dropped in the international market overnight. The following day the price of BHP shares is also expected to go lower and you want to close your BHP share CFD position.

You buy 300 BHP share CFDs at $27.50 (for a 50 cents movement in each share CFD) - $10 commission

(300 share CFDs x $27.50 = $8250) -$10 = $8240

STEP 3: CHECKING YOUR PROFIT AND LOSS:
Your profit and loss calculation will look like this:

(sell price - buy price) x number of share CFDs - commission = profit

($28.00 - $27.50 =.50 ) x 300- $20 = $130 profit

or 51.6% return for an initial outlay of $252 (margin required)

NOTE: When you have a short CFD position, you will be paid the interest on the total amount of your trade for as long as you hold the position open. This computation does not include the overnight interest you will earn. Interest payment may vary from one CFD to another. Short selling is a great opportunity for traders and money can sometimes be made faster 'shorting' due to the speed prices can retrace.

Types of Orders

Market Order -
As the name implies this is an order you place to buy or sell a CFD at the current market price. If you are a buyer, you are willing to pay the price on the Offer, and if you are a seller you are willing to accept the price on the Bid.

Limit Order -
Is an order where you specify the price where you want to buy or sell. A limit order is useful when trying to capture or protect your profit in a certain trade.
For example BHP is now trading at $29.00 and you are long BHP at $28.00. You want to close this position when the price goes to $29.50. You can place a limit order that says: 'Sell BHP at $29.50 on limit.'

Stop Loss Order -
Is an order that tells your CFD provider at what point you want to get out of a trade when the position turns against you. Many CFD providers will allow you to place stop loss orders automatically on the electronic trading platform. You should make sure that your provider offers stop loss orders, which is one of the most basic trade management tools. This will be discussed in more detail in Chapter 4.

Stop Entry Order -
Not all CFD providers may offer this order and this may only apply to sector and index CFDs. This order allows you to open a trade when a certain level is hit.
For example, if the S&P/ASX 200 (Index) is trading at 5000 and you think that with all the volatility in the market it will be falling at about 4990, then you would like to go short when this level is hit. You can place a stop entry order that looks like this: (This will automatically open a trade for you at this level). 'Sell S&P/ASX 200 at 4990 on stop.'

Good 'til Cancelled (GTC) -
this is an order or instruction that you attach to a buy or sell, limit or stop order that will keep the initial order open until you decide to cancel it. This is useful and will save you time instead of reminding your CFD provider to place the order over and over again or placing the order yourself everyday.

Good for the day -
similar to GTC, this is an instruction that you attach to another order that says you only want to keep this order for the day. This means that at the end of the trading day if your initial order was not executed, then it will be automatically cancelled and you may have to place another order for it the next day.

Components of a CFD Trade

Commission -
This is similar to the broker fee you pay to trade physical shares with your stock broker or a discount brokerage company. One advantage of trading CFDs is that commission or broker fees are relatively lower compared to what you pay your stockbrokers. Some CFD providers charge as low as $10 commission for trades of up to $10,000. On the other hand, stockbrokers usually charge at least $30 for each trade and much more for the few that can short sell.

Margin -
A CFD is a derivative product and is traded on margin, which means you only need to put up a fraction of the total position to open a trade. The margin is the amount you need to have in your trading account, which may vary from 3% - 10% depending on the CFD you trade. Index and Sector CFDs and margin FX trades only require 1% margin.

Financing Cost and Benefit -
As a margin traded product CFDs attract financing charges, which is similar to paying interest on a margin loan from a bank to buy shares. Technically, when you open a CFD trade on a margin, your CFD provider is lending you the money for the rest of the amount. Financing cost varies from one CFD provider to another, so it is wise to check what you will be charged.

One thing to note with financing cost is that you have to pay it if you have long CFD positions, but you will be paid an interest if you have short CFD trades. This is because technically, you are lending money to the CFD provider when you open a short trade and therefore you are to be paid interest.

Finance Cost Computation -
For example, the official cash rate is 6% (interest rates are set by each country's central bank) and a CFD provider will charge an administrative premium of say 2-4%. Therefore you will be charged a minimum of 8% on the total value of your CFD trade on a daily basis for as long as you hold the trade.

BHP 'long' position financing cost

($8,400 x 8%) 360* = $1.86 per day

This amount will be reflected in your daily account statement from your CFD provider

NOTE: 360/year is the industry standard for calculating financing costs.

 

Choosing your CFD provider

One of the first and most important things to consider when you're starting to trade CFDs is to know your CFD provider. You only want to be dealing with the most reliable, dependable, trustworthy and service oriented providers who can help you with your trading.

The number of CFD providers is still growing and while this increases the competition in terms of you being able to choose only the best CFD providers it means you have to do your homework. Research and compare all the pros and cons of each CFD provider and choose the one that meets all your requirements.

Know your Provider Expect changes as new companies come into the picture and existing companies expand their offerings.

Choosing your CFD Provider: Your Checklist

Q: How long has the provider been operating as a CFD provider?
A: You would like a reliable, dependable CFD provider that has a good track record in the industry.

Q: What is the provider's core business?
A: You want to be dealing with people who have expertise in their products and services. Some CFD providers operate as part of a larger fund, investment banking or FX provider. Depending on what you want from your provider, you have to consider if they have the CFD expertise that you need on a wider product offering.

Q: What are the charges?
A: Like dealing with stock brokers to trade physical shares, you will also incur expenses when you trade CFDs. These may include commission (broker fee), the initial margin required and financing charges. Commission may vary from one provider to another and you should consult your CFD provider to check if they offer other commission rates if you're a frequent trader.

Q: How much do I need to open an account?
A: The amount of money you need to open an account may vary from one provider to another. Some require $5,000, others $10,000. There are also providers that offer a credit account that may require more financial and credit checking and proof of your financial stability.

Q: How soon can I open an account and start trading?
A: Opening an account may vary from a few hours to a few days or a week. But with all the credit and financial checks and validating, be prepared for a few days before you can trade.

Q: Does the provider offer discount for volume trades?
A: Some CFD providers may be able to offer discount for big volume or high value trades. It pays to ask your CFD provider what discount arrangements they can offer.

Q: What are the margin requirements?
A: Since the ability to trade on margin is one of the biggest attractions for you to trade CFDs, you should consider the best margin requirements that will bring you the optimum trading exposure. Current margin requirements usually range from 1-10% depending on the share CFD you trade.

Q: How much is the financing charge?
A: When you trade CFDs (on a margin) you are technically borrowing money from your CFD provider, therefore you will be charged what is called 'financing charge' for the total amount of your CFD holding. Most CFD providers use the current cash rate plus a possible 2% or 3% as financing charge, which is computed for as long as you're holding an open CFD position.

Q: What CFDs can I trade?
A: Another advantage of trading CFDs is that it gives you access to other markets outside Australia. Most CFD providers offer Australian and international CFDs, but there are a few that offer CFDs on Australian shares only. Make sure that your provider has a wide range of markets and instruments to trade that will give you access to bigger and more liquid markets with better trading opportunities.

Q: How small is the 'spread' that they offer?
A: Make sure your provider offers the tightest spread for your chosen trade. Spreads will vary depending on the product offered.

Q: Does the provider offer risk management tools, ie stop-loss orders?
A: As will be discussed in more details in a later part of this book, stop-loss orders are useful tools to manage your CFD trade. A stop-loss order is one effective way to minimise potential losses and to protect your profit. Make sure that your chosen CFD provider allows you to place stop-loss orders and change them as your trade progresses with little or no additional charge.

Q: Where does the provider keep client money?
A: Under existing laws governing financial services companies in Australia, CFD providers are required to keep client money in a segregated account.

Q: What happens to your money not allocated to open trades?
A: Some CFD providers pay interest on a certain amount of money on your account as long as they're not allocated to cover any open position. Some CFD providers pay interest if you have $10,000 of free equity in your account.

Types of CFDs

Australian Share, Indices and Sector CFDs
In Australia, most of the CFD providers offer CFDs on the top 500 listed shares. The list is continuously expanding due to demand for other share CFDs and the entry of new providers who may offer specific groups of CFDs not offered by existing providers. Consult your CFD provider for a complete list of tradeable CFDs they offer.

The Australian stock market consists of 12 industry groups called sectors. This grouping is based on an international standard to make it easier to classify companies into their respective industries. Check with your CFD provider if they offer Sector CFDs to make sure that you can trade them if you don't want to do stock specific trading.

International Shares and Indices Many CFD providers offer CFDs on international shares including US, European, UK and Asian shares. This means you can trade share CFDs on Google, Amazon, Wal-Mart, Honda, Toyota, Vodafone, BMW, Porsche and other big brands that are not available in the Australian market.

An index is a collection of stocks and the corresponding composite value of its components. In Australia, the All Ordinaries (All Ords) is the index which consists of all the publicly listed companies in the Australian Stock Exchange. The closing value of the All Ords changes everyday depending on the price movements of all the shares. Other major indices in the international financial markets include the Dow Jones Industrial Average (USA), Nasdaq (USA), FTSE 100 (UK) CAC 40 (France), DAX (Germany), Nikkei 225 (Japan), Hang Seng (Hong Kong).

Check with your CFD provider if they offer CFDs on international indices because there maybe some good trading opportunities within these indices particularly in times of big uptrends or downtrends.

Trading share CFDs on international shares, sectors and indices offers many advantages including:

  • access to bigger and more liquid markets that offer more trading opportunities than what is available locally
  • low brokerage fee because you don't have to pay the extra administrative charges that you pay to trade physical shares in overseas companies
  • Australia's time zone makes it user friendly if you want to capture some trading action in the UK, US or Asian markets.

First Published: 18 September 2008 - Copyright © Peter Mathers

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