If you have been trading shares for a while now and you haven't looked at 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 allowing these financial instruments to be traded 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 (buy) and exit (sell) a trade, without owning the underlying instrument, in most cases shares or equities.
Compared to share trading, CFD trading has one key difference – when you trade a CFD you don't own the actual share. If you trade a CFD on Pepsi or BHP Billiton, you are trading on the price difference between your entry point (buy) and your exit point (sell). You don’t own the Pepsi or BHP Billiton shares; you are only counting on their price going up or, under another strategy, going 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. You can also use margin trading to magnify the value of your investment.
Everything you know about shares and share trading applies to CFD trading and can easily be used to trade CFDs because the price of CFDs moves as the actual share price moves. For example, if one share in a company, let’s call it ExampleCo, costs $8.00 a share, a CFD on ExampleCo is also $8.00.
Here's how a CFD trade works. Let’s say you want to buy 1,000 shares in ExampleCo at $8.00 a share. This means you would need at least $8,000 to buy the actual shares ("open the trade"). If, instead, you trade CFDs of ExampleCo, you would only need about 5%-10% of the total amount to open the trade.
Here's how it works:
| ExampleCo | 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 1,000 shares + broker fee) | $410 ($8.00 x 1,000 CFDs x 5% of total amount + commission) |
As you can see, you would need quite 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 only have a small amount of trading capital. Trading CFDs means you can start with a smaller amount of trading capital and enter at a lower price.
Types of CFDs
Australian Share, Index and Sector CFDsIn 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 the tradable 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.
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. Check with your CFD provider to see if they offer Index CFDs if you want to trade this type of CFD.
What makes CFDs attractive to trade?Easy to understand and easy to trade – As mentioned, everything you know about shares and share trading applies to CFD trading and can easily be used to trade CFDs because the price of CFDs moves as the actual share price moves.
Tradable on margin – you only need a small percentage of your trading capital to open up larger or more positions than you could open if trading shares directly. 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 it is a two-edged sword – it magnifies both potential profits and potential losses.
Can be traded long or short – that is, you can – using different strategies and methods – make money if the price of the underlying share goes rises or falls. 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 dates and that become worthless upon expiry, CFDs don’t have expiry dates 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 long term buy-and-hold investing, CFD trading can have a place in many investors' portfolios.
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 a comparatively 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.
Let's say you want to buy 1,000 shares in ExampleCo at $8.00 a share. This means you would need at least $8,000 to buy the actual shares ("open the trade"). If, instead, you trade CFDs of ExampleCo, you would only need about 5%-10% of the total amount to open the trade.
Here's how it works:
| ExampleCo | 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 1,000 shares + broker fee) | $410 ($8.00 x 1,000 CFDs x 5% of total amount + commission) |
As you can see, you would need quite 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 only have a small amount of trading capital. Trading CFDs means you can start with a smaller amount of trading capital and enter at a lower 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-term 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 goes down and the shares are trading at $27.75. You still believe that BHP shares will go higher in the medium-term to long-term, but in the mean time the share price continues to go down as the days pass.
What could you do to protect your position or even take advantage of the situation? 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 the brokerage rates that may apply).
Written by Peter Mathers (Trading Analyst AFSL 317817) owner of
www.tradinglounge.com.au which offers general trading advice.
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