What are CFDs?
A Contract For Difference (CFD) is an agreement between two parties to pay the difference in price (of the contract) between the time it was opened and the time it was closed. A CFD is a derivative product that mirrors or reflects the price of the financial instrument it is based on which may include shares (equities), sectors, an index or a currency pair (FX pair).
A 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 when you trade a CFD you don't own the actual share. When 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.
CFDs are a leveraged product, unlike conventional trading. You trade on margin and only a small deposit is required, which gives you access to a larger portion of the market. It is important that before trading you fully understand the risks involved, as CFDs may not be suitable for everyone. So be risk aware, losses can exceed your initial deposit.
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. See below under “Types of CFDs”
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ASPECTS OF CFDs TRADING
It has been mentioned that CFD trading is very similar to share trading and in most aspects they are almost the same. However, CFDs have some distinct features that differentiate it from shares. Some of these features are what make CFDs very attractive to traders and investors alike.
In the financial market leverage means the use of borrowed money to invest in other investment products such as property, shares, artwork, property trusts or managed funds. A very common form of the use of leverage is when people borrow money (from a bank or a financial institution) to invest in a residential or investment property. This is when you end up with a mortgage for a home loan or an investment loan. Other people may also borrow money to buy shares. This is commonly known as taking a margin loan to invest in a share portfolio.
Trading CFDs is similar to taking a margin loan because when you trade a CFD you are only paying a small portion or percentage of the whole amount upfront and the rest of the amount is being loaned to you by the CFD provider.
CFDs are tradable on margin which means you only need a small percentage of your trading capital to open up larger or more positions that you can normally open. Some CFDs require only as little at 1% margin, some 3% and others 5-10% margin depending on the share CFD and the CFD provider.
For many investors and traders being able to trade on margin (using leverage) is the biggest attraction of CFDs because it increases the opportunity to make profit using a small capital. However, you must remember that the ability to trade on margin can be a two-edged sword, in that it both magnifies potential profit and losses. However, when used wisely and appropriately, trading on margin can be a big boost to profitability and capital building.
Can be traded short or long
When you buy (go long) a CFD, you are expecting its price to go up so that you can sell it later at a higher price (with a profit).
When you sell (go short) a CFD, you are expecting its price to go down so that you can buy it back at a lower price (with a profit).
Being able to trade it long or short 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.
Short selling physical shares is a much complex and more costly procedure compared to short selling CFDs.
Dividends and corporate action
For many long-term investors dividends remain one of the deciding factors whether they will invest in a particular share or not. This shows the importance people place on dividends when deciding which stock to buy.
When you trade share CFDs on dividend paying shares you will also automatically be paid the dividend when you have a long position. The dividend payment is usually reflected on your trading account on the day of its announcement. On the other hand, if you have a short CFD position during the announcement of the dividend, the amount of the dividend will be deducted from your trading account.
Other corporate actions such as bonus issues and share splitting are also automatically reflected on your CFD trading account as soon as they are implemented.
The reporting season refers to the time when publicly listed companies update the market (investors including mums and dads as well as large institutions such as fund managers) about their yearly and half yearly performance. The reporting season is usually the time when companies announce whether their profit forecasts are on target or not.
Depending on a company’s performance and projected profit, the reporting season could translate to some volatility in the market. For example, if a company issues a forecast that its earnings will be lower in the next half year the share price may fall the next day as investors may be disappointed with this result. On the other hand, if a company doubles its income and profit expectation for the coming year, the share price may jump higher as investors and traders take advantage of this good news.
As CFDs mirror the price of the underlying share, any movement in price of shares during the reporting season will also be reflected on the CFD price. This means as a trader or investor, you have to be aware of the possible impact of the reporting season on your CFD positions
Product trading times
The advent of the internet and online trading means that traders and investors now have access to international markets almost 24-hours a day and not only during market hours in Australia.
With its global network that spans four continents, CFD Providers enables traders and investors to trade the Australian, Asia, US, UK and European markets using a follow-the-sun model.
Another aspect of CFD trading involves expiry date or the length of holding time. Unlike other derivatives that have expiry date and that become worthless upon expiry, CFDs don’t have an expiry date. This means you can hold CFDs for as long or as short a period as you like.
Some short-term traders trade CFDs for a few days while medium to long-term investors and traders may trade them over a few weeks or months.
Lower brokerage costs
Compared to the brokerage fee you pay when you trade with your regular stock broker, commission charges when trading CFDs are relatively cheap. charges from $10 for trades of up to $10,000? Any trade more than $10,000 may be charged 0.01% of the total trade amount.
How do CFDs stack up against other derivatives and shares?
As a financial instrument, CFDs possess some features that make them attractive to traders and investors alike.
Trade the market with added features
CFD trading has often been described as share trading with bells and whistles. This is because everything you know about shares and share trading applies and can 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.
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. Many CFD providers offer CFDs on international shares, indices and sectors.
All financial instruments – from the simplest to the most complex – have their own individual features that make them attractive or not attractive to investors. Though there is a misconception that derivatives are all about high risks, but if considered properly and traded according to your personal risk profile, derivatives – including CFDs – may play an important part in growing your investment portfolio.
Where do they fit in your investment portfolio?
After learning more about CFDs and its features, you must be wondering where these financial instruments 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 investor's portfolio.
Whether 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. To introduce diversification in their investment portfolios, some people prefer to maintain their share/equity portfolio for capital gains and ongoing dividend income while also maintaining a CFD portfolio for short to medium-term investment or trading.
Cheap entry into trading
Because 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.
Types of CFDs
As mentioned earlier there are various types of CFDs including share CFDs, Index CFDs, Sector CFDs, FX CFDs, CFDs on commodities and CFDs on international shares.
In Australia, CFDs are available in more than 500 of the listed shares. This list is still expanding and being updated, so you may want to check with your CFD Provider for the most updated list of tradable CFDs they offer. The list is regularly updated to reflect additional CFDs.
Australian share CFDs
Here are12 Sectors in the Australian stock market and some of the major constituent companies
Consumer Discretionary: PBL Ltd, TabCorp, Billabong
Consumer Staples: Woolworths, Coles Myer, Lion Nathan
Energy: Woodside Petroleum, Santos, Caltex
Financials: Perpetual, Commonwealth Bank, Macquarie Bank
Financials excluding Property Trusts: ASX, Lend Lease, QBE Insurance
Healthcare: Cochlear, CSL Ltd, Sonic Healthcare
Industrials: Wesfarmers, Toll Holdings, United Group
Information Technology: Computershare, Iress Market Technology, Baycorp Advantage
Materials: BHP Billiton, Rio Tinto, Orica
Property Trusts: Westfield Group, Centro Properties, GPT Group
Telecommunication: Services Telstra, Telecom NZ
Utilities: Australian Pipeline Trust
International share CFDs
Aside from Australian shares, CFD Providers also offers 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.
Trading share CFDs on international shares 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.
ASX top 200 CFDS
Most providers offer a version of the SPI and/or the ASX 200 and they are perfect for practicing and developing your day trading skills, because owning one contract is equal to one dollar per point. And once you have a good understanding and feel of where the market is expected to move in a session and have your keyboard skills down pat you’ll be on your way.
ASX top 200 CFDs products are based on the Sydney Futures Exchange (SFE) Share Price Index (SPI) futures contract, known as the SPI. In turn the SPI is based off the S&P ASX 200 also known as the Cash Market. Some CFD Providers also base their ASX top 200 CFDs off the XJO.
You can trade CFDs as you trade shares because the price of a CFD mirrors the price of the actual share – as Direct Market Access (DMA) CFD providers do, while the Market Makers (MM) operate roughly around the real price. Be sure to read their PDS.
CFDs offer leveraged trading to new traders as an alternative to other derivatives such as options and warrants which can be quite complex to understand.
Consider CFD as a tool to diversify your existing investment portfolio
What does CFD stand for? What are you actually trading when you trade CFDs?
When trading CFDs you are actually trading the margin of price change or the difference in price from when you open the position until the time you close the position
What are the main advantages of trading CFDs
You can trade short and long, cheap entry into trading, lower brokerage costs, CFDs are traded on margin
Will you get a share certificate when you trade a share CFD?
No, you’re not actually buying stock in that company but you are only trying to capture the price movement between the time you open a CFD trade until the time you close it
How many CFD products are available to trade with your CFD Provider?
You will need to check with your CFD Provider, but many CFD Providers have CFDs for Shares covering many different countries. Plus, Forex, Commodities, Treasuries / Interest Rates, Bonds etc.
Are stop loss orders applicable to CFDs?
Yes, unlike shares, options or warrants you can place a stop loss order with a CFD trade
Are there time limits for holding a position with a CFD??
No, unlike options or warrants you can hold a CFD trade for as long or short a time as you choose.
What is the approximate percentage outlay of trading with a CFD compared to the outlay when a share trade?
You only need approximately 3%-5% of the price plus brokerage
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