What is a CFD?
A CFD (contract for difference) is a form of leveraged trading that can allow you to speculate on the movement (up or down) of the price of securities such as shares, currencies, commodities, bonds and stock indexes.
How do they work?
As CFDs are derivatives you don’t buy or sell the underlying asset such as a share or currency. The leverage component of a CFD means that you only need a small percentage of the total value of the trade to open a position. This is commonly referred to as ‘opening a position’ which can be ‘short’ or ‘long’, depending on if you are speculating if the value of the underlying asset will increase or decrease over time. Because CFDs are leveraged, it means both gains and losses are magnified greatly depending on the full value of the position taken.
How much does it cost to trade CFDs?
Commissions (applicable for CFDs on Shares): A separate commission charge is required when you trade share CFDs.
Holding Costs: Positions in your account may be subject to a holding cost at the end of each trading day. This can be positive or negative.
Spread: The spread is the difference between the buy price and sell price. You enter a CFD market using the buy price quoted and exit using the sell price.
Examples
As CFDs are complex financial instruments it’s perhaps easiest to understand them by looking at some examples.
An example of a profitable CFD trade
You believe that a share price of a company will rise and as such you buy a CFD long position. The share price of Company XYZ is trading at 9 / 10 (9 cents is the sell price and 10 cents the buy price). This means that the spread is 1 cent.
As you believe the price will rise, you buy 10,000 CFDs (or ‘units’) at 10 cents. Let’s leave the commission price of the trade fixed in this example for simplicity, at $5. The margin rate of Company XYZ is 3%, meaning that you have to deposit 3% of the total value of the trade as margin. This would be: (10,000 units x 10 cents x 3% = $30).
In this case we will say that the price of the underlying share rises to 15 / 16. Don’t forget a commission gets charged on exit too, again lets leave this at $5 for simplicity.
As the price of the share has moved 5 cents in your favour, (10 cents to 15 cents), to calculate your profit, you multiply the number of units you bought by the increase in price of the share. This would be (10,000 x 5 cents = $500). Then subtract the commission fees ($5 + $5) giving a total profit of $490.
If things didn’t go your way (a losing trade)
Instead of increasing to 15 cents as in the previous example, the underlying share price drops to 5 / 6. At this position you decide to close out to limit any further losses you believe may occur. When you close out, again a commission is charged; again let’s leave it to $5.
The price has dropped from 10 cents to 5 cents, meaning the price has moved 5 cents against you. Multiply this by the number of units (10,000 x 5 cents = $500) and include the commission fees ($5 + $5 = $10) to give a total loss of $510.
As you can see from this example CFD’s have the potential to either make significant leveraged gains, but also significant losses depending on the direction of your position and the market. An important consideration is that you can lose more money than you place on deposit. In this example the deposit was $30 but the losing scenario greatly exceeded this deposit amount.
Short-selling using CFDs
Not only can you use CFDs to potentially profit in a rising market, you can also use CFDs for short positions. This means that you sell a product, and if the price falls, you can buy the product back at a lower price. The difference (less fees) is profit. Of course there is still risk involved, if the price rises, a loss can be made, again possibly exceeding your initla deposit.
Hedging using CFDs
If you have an existing portfolio of assets (say shares) CFDs are a possible way to hedge. You may wish to retain your shares but are concerned they may have a short term loss in value due to say, a market downturn. To offset a loss in your share portfolio, you may short sell the same shares you have in your portfolio using CFDs as a short term hedge.
Advantages and Disadvantages of Trading using CFDs
Advantages
CFDs offer substantial leverage when compared to traditional trading. Margins for CFDs can be as low as 2% in some cases, meaning you only have to put up 2% of the value of the underlying asset to trade on the full value. Leverage, however, does mean that losses can be magnified just as easily as gains.
Global Reach
CFDs on most online market platforms allow reach across borders to many of the world’s major markets, with access available around the clock.
Shorting has less complex regulation
Some markets have rules that don’t allow shorting, or regulate that instruments must be borrowed before shorting can be performed. As CFDs mean that the underlying asset is not owned, they are not subject to the underlying costs and in some cases regulations
Minimum capital requirements
The CFD market is not bound by any minimum capital amounts to day trade. Typically accounts online can be opened with as little as $1k to $5k on deposit.
Diversity of trading opportunities
As mentioned in the opening paragraph, CFDs can be traded on stocks, indexes, treasury, commodity and currencies. These can form an alternative to exchanges.
Disadvantages of CFDs
Spread cost
Traditional markets have downsides such as fees, regulations and capital requirements, which are not present in CFDs. What is present however is the spread cost which is the difference between the entry (buy) and exit (sell) price. This can trim profits and makes it harder to profit from small moves in the market.
Less industry regulation
CFD markets are not as highly regulated as traditional exchanges. To some extent broker reputation and longevity is important, as is investor sophistication.
In Conclusion
More than most other financial products and deriviatives, CFDs magnify both the gains and losses depending on whether you think a products price will go up or down, and what it does in reality. Low regulation can make for a smoother trading experience though the spread cost can make trading more granular.
How do I trade CFDs?
If you have considered the risks of trading CFDs, and want to take advantage of the versatility and leverage as part of your portfolio, in simple terms, the steps you need to take are as follows.
Choose a broker / platform
Many online platforms are available to trade CFDs, both here in Australia and internationally. This blog includes an in-depth review of a number of these here.
Create and add money to an account
One of the big advantages of choosing an online platform and broker is that most have demo accounts where you can practice trading with virtual funds. This is a risk free environment which allows practice without using real money. When you’ve got your head around how it all works, you can consider funding the account once you are verified.
Which market
You need to choose a market to trade on. This may include markets such as Forex, Australian Shares, International Shares, Treasury, Commodities and so on. This blog has a short guide to trading on each and which platforms are best suited to each which can be found under the below links. There is considerable choice available and you will find that many trading platforms offer significant research to help you find a trade or market that you are comfortable with.
Are you buying or selling
Depending on whether you think the price will go up or down, you will either buy or sell your CFDs. If you think the market will rise, you will be buying CFDs, and conversely if you think it will fall, you will be selling CFDs.
How much to trade?
Select how many CFDs you want to trade. As an example 1 CFD in equity trades is the equivalent of 1 physical share. Be cautious with your trade size and make sure you have sufficient funds to be able to place the trade. Most platforms will calculate your initial margin using a calculator.
Stop Loss
A stop loss is an order to close your position if the market moves too far against you. This is a key risk management technique that can be automatically triggered if the market reaches a certain level.
Monitor, and when required, close your trade
Most platforms allow you to monitor the performance of your trade in real time. The also allow you to close out your position at the click of a button. This can be done on a desktop, tablet or phone app with most providers. Many markets are available 24 hours a day and this is something you should consider when selecting your product.
