CFD Advantages

Trading CFD’s has advantages. A CFD is a derivative which are highly leveraged. The advantages of trading Contracts For Difference are:

• No Stamp Duty on CFDs (for UK Traders)
• No or little Commission – some CFD dealers don’t charge commissions while others would charge a small amount.
• Go Short! As a CFD trader you can choose to benefit from market downturns (as well as the usual long trades)
• Leveraged, Margin Trading – You don’t have to fully fund the value of your trade since CFD dealers offer leveraged, margin trading which allows you to put in 5 to 10 percent of your equity in the trade.
• Control Your Risk using Stop Losses, Guaranteed Stop Losses and Limit Orders.
• Access to Many Global Markets with a Single CFD Trading account.

CFD Stop Loss

More often than not, CFD brokers and dealers automatically provide a free stop-loss order service to their trading clients. This is to encourage people to limit their losses on this very risky leveraged trading instrument. A stop loss on your CFD is exactly that, a tool for the trader to limit their trading losses. It is up to the trader to self regulate their usage of this tool and any trader is encouraged to utilise the tool in their trading systems.

For example you have opened a long position on XYZ stock at $10, but you only want to limit your trading liabilities to 50 points so you can set a stop loss on your CFD trade at $9.50. So if your trade goes sour, the stop loss order immediately executes a sell to exit your long position.

However, these is a disadvantage and also risk to using a stop loss. For instance, if the market is having a stormy day at sea, that is, an over-volatile market where the underlying stock under the CFD is spiking up and down, you may find that you are stopped out too easily if you have put your stop loss order too close to the action. The risk when using a stop loss is when the market gaps and the stock just doesn’t trade at your stop loss limit. If you think about it – it’s a VERY BIG risk. However an advantage to the stop loss order on your CFD is that if gives you the discipline to follow a system as it automatically takes you out a trade which at some point in time you expected to make you a profit because it was trending to some sort of pattern. That is only an advantage if you resist the urge to continuously move the CFD stop loss. (!)

Common Features of Contracts for Difference (CFD)

Depending where you are trading Contracts for Difference (CFD) in the world, there are a few common features of these leveraged trading instruments.

Contracts for Difference (CFDs) are Traded on Margin

One main feature that traders choose to utilise when trading CFDs is their leverage. Instead of paying full value for the trading transaction, the trader only pays a percentage (a fraction) of the total position when opening the position - this is called the Initial Margin. This margin allows for leverage trading plays, which allows for increased exposure to the underlying share price movements unlike if you buy the underlying securities themselves.

Because Contracts For Difference are traded on margin and the prices of the underlying securities fluctuate during market hours, the dealers have something called Mark to Market. The margin is actively marked to the market price – which means the percentage is actively being calculated as the share price moves. You must keep a margin on all open positions over the required level including any market profits or losses (paper profits and losses) as long as the position is open. If the trading position moves against you and reduces your cash balance and you end up in the red below the required margin level you will receive a “Margin Call” and will need to fund the account to maintain the position otherwise your CFDs would be automatically liquidated.

A CFD can be Traded in Rising or Falling Markets

Trading in CFD allows the trader to easily take a long or short position on the market or any security that is provided by any CFD dealer. That means the trader can trade both rising and falling markets. You can profit when the share price goes up and you are long, and you can also profit when you have a short position and the underlying shares fall. When you buy the CFD with the expectation that the underlying shares will rise, you are taking a long position. When you sell or short sell the CFD with the expectation that the underlysing security will fall you are taking the short position.

No Stamp Duty, Tax Implications on CFD

Don’t take my word as gospel but depending where you are with trading CFDs, you aren’t physically buying the underlying shares or stocks so you don’t have to pay stamp duty. Other tax implications for trading CFD can be that you can register your trading activities as a business.

Commissions

Instead of a brokerage, CFD’s have commissions, which is basically the same thing. The CFD commission is calculated on the total position value and not just the margin paid.

CFD Overnight Financing

CFD’s have overnight financing. A consequence of the leverage is that you are basically borrowing money - and someone needs to be paid the interest. So when you hold a position open overnight you’ll get a finance charge for that benefit. Long CFD positions attract an interest charge of 1 to 2 percent above your national bank’s lending rate and short positions pay interest but 1 or 2 percent below your national bank’s official lending rate. This interest on the position is calculated daily with the application of the interest rate on the daily closing value of the position. (Daily closing value is the number of shares you hold and the closing price of the underlying shares).

Flexibility in Trading Market Sentiment

Trading Contracts For Difference offers the trader flexibility in trading market sentiment. There are CFD’s that allow you to trade specific shares, or market indices if you have an overall market sentiment or even sectors and specific international currencies.

CFD and Risk Management

CFD providers commonly provide risk management facilities because of the high risk nature of leveraged trading and the double edged sword effect. Many of these CFD dealers provide Stop Loss, Limit Orders and If Orders so market traders can actively manage their risk in trading CFD’s.

How CFD’s Work

Let’s use a case study to illustrate how CFD’s (Contract’s For Difference) work. So lets take Australian listed Woodside Petroleum (WPL) and assume the price is at $50. After our technical or fundamental analysis we have decided whether we want to sell (going short) or buy (going long) the stock (or the CFD). Say we go long (buy the stock) and decide to risk $1 on each point of fluctuation in Woodside’s share price. (A point is worth a cent in this context) This means for every cent that the WPL shares move, the trader either gains or loses $1. Now the way you decide this $1 risk per point depends on the leverage (CFD dealers usually have a 3%, 5%, 10% or 20% options available on the amount of leverage) and the size of your contract with your CFD dealer. So if the WPL shares have gained 10 cents and want to take profits your profit would be 10 x 1 = $10 or if the share lost 10 cents then you lose $10.

So to take this example of how CFD’s work to the next level, still assuming the $50 underlying share price for WPL. Say we have $10,000 (ten thousand dollars) to invest in the trading game. Say if your CFD broker has a 5% margin required (the leverage amount) for WPL. 5% of $50 is $2.50 so you need to deposit at least $2.50 per share with your dealer to trade WPL CFDs. The reason why I say at least is because the shares may fluctuate since these CFDs are mark to market which means, at all times you trade CFDs you must maintain this 5% margin level or else the broker make liquidate your position. So with the $2.50 per share margin requirement you can buy 4,000 ($10,000/$2.50) shares or $200,000 worth of exposure to WPL. That’s the power of leverage. And remember – it’s a double edged sword.

Risky CFD’s

If you’re looking into trading CFD and have been doing your due diligence before playing with fire, you would definitely have heard from someone that CFD’s are risky. Super risky. And they aren’t too far from the truth. They are. So you need to be super careful when you do start trading CFD’s. So why are CFD’s so risky?

• They are leveraged trading instruments, and because of it is geared, means it’s a double edged sword. Both profits and losses are magnified as a result of the gearing.
• No rights as you do not hold the underlying security, so you have no voting rights.
• Interest and fees: If you plan to hold a position in the long term its going to cost you big time in fees and or interest.

Ways to control your level of risk with CFD’s

• Trade CFD’s with a trading plan, complete with a stop loss mechanism.
• If you are planning to hold the security in the long term, consider buying the actual security to avoid paying fees and interest
• Before you even touch CFD’s, especially if you have not traded before, I recommend you to paper trade and get a demo account if possible. Do this for a few months. Be patient. Trading success is a long term thing. Greed and impatience can be dangerous while trading.
• When you do get the nerve and the courage to finally trade, start small. Start with the smallest amount your dealer would allow.
• I also recommend you keep a spreadsheet detailing your profits and losses, and with the spreadsheet, keep a journal about your trade before, during and after the actual trade.

What is a CFD?

CFD is the abbreviation of Contract for Difference. And that’s exactly what it is, a contract for the difference of the value of the underlying equity or security. Very simply put there are two parties, you the trader and the broker, provider or dealer. You (the trader) initiate the CFD deal with your dealer by buying long or selling short a certain security. The security can be anything such as stocks listed on the US Dow Jones or the Australian Stock Exchange or any currency traded in the foreign exchange (forex) markets. The dealer will charge you some sort of commission (for forex deals, they make money on the spread). The CFD is the agreement between the two parties that at the end of the contract (either brought about with you closing an open trade by buying or selling out of your position or by your broker liquidating your securities because of the lack of margin – called a margin call) both parties will settle the difference in the contract value between the opening and closing prices of the contract. (If you hold more contracts than one - which is usually the case, you then multiply the difference by the number of contracts you hold to find out your profit or loss). Continue reading What is a CFD?…

CFD Trading FAQ

So here you are reading the CFD Trading Frequently Asked Question (FAQ) page. I’m sure if you’re a CFD n00b (net speak for newbie) you’ll find this page very helpful.

n00b: What CFD mean? Is CFD an abbreviation for something? What does CFD stand for?
CFD Trader: Well, CFD is an abbreviation for Contracts For Difference. And what does it mean? In simple terms, every time you press a button to start a CFD trade you are effectively entering a new contract, and the agreement in that contract means that either party to that contract either you the trader or the CFD dealer is liable to pay for any difference in the value of the underlying equity under which the contract was initiated. Is that simple enough?

Continue reading CFD Trading FAQ…