Using The Benefits Of Contracts For Difference
CFDs – Making Money and Avoiding The Pitfalls
Sometimes in the industry there is a bit of misinformation, and even mistrust on using CFDs to trade and invest (I say “trade and invest” because they can be used for both, and I will show you how). I often find that the best thing to combat mistrust is to be totally transparent – in this case give as much information as possible about CFDs, and how to use them. Then you can decide for yourself.
When I started writing this article, I did not realize how much I had actually learned about CFDs, which turned out to be a lot. Therefore, this post is quite long at more than 1200 words. You lead a busy life, I know, so please feel free to copy and paste the article into a Word file or to bookmark this page so you can come back to it later.
In this article I will explore three things:
1: What CFDs actually are
2: The real benefits of using CFDs
3: Traps and pitfalls to look out for when trading CFDs
As usual, I’m not trying to sell you a particular way of doing things – if you have a better or different way of doing things then go for it – but there are some benefits to using CFDs that simply can’t be ignored.
So, What Are CFDs?
CFD is an acronym for “Contract For Difference”. As the name suggests, a CFD is a “contract” or agreement, that allows the buyer of them to profit from an up move, or the seller to profit from a down move, without actually owning the underlying share (or commodity).
In other words you just own the right to the price difference – hence the name again – “Contract, For Difference”.
CFDs can be bought or sold over many shares, commodities, and even market indices. One CFD will usually be equal to one share, except with CFDs your provider will usually only require you to put down 5% to 20% of the actual contract value in order to trade.
For example, if you buy 10 shares of BHP at $33, you would have to fork out $330 ($33 x 10). But if you bought 10 BHP CFDs at $33, and the margin requirement was 10%, you would only be required to fork out $33 ($33 x 10 / 10) leaving you money to use on more trades.
If you do decide to use leverage, you are charged interest by your provider on your long positions, and you earn interest on your short positions (if you are unfamiliar with trading “long” and “short”, click here).
Whether you end up using leverage for more trades is up to you (a good money management strategy will help you keep on top of this). More on this later.
The Real Benefit Of Using CFDS
Any glossy brochure can tell you the “benefits” to using CFDs, or what brokers or CFD providers want you to think are benefits. But what about actual things – useful to the average trader or investor? Here is a list of 10 of the most useful traits I’ve found using CFDs.
1: Trading or investing with CFDs is almost exactly the same as trading with shares. One share usually = one CFD, so they are not confusing to use.
2: If you are “long” a share CFD, you get the dividend amount paid to your account as soon as the share goes ex-dividend (as opposed to waiting for the share dividend payment date, sometimes months later).
3: You are only required to use a small amount of the actual trade value as margin (usually 5% to 20% of the overall trade), so you can have money left for other opportunities that arise.
4: And you only get charged interest on your positions if your total trades use more than the money in your account. In other words, you don’t have to use margin at all.
5: Using CFDs is therefore like using a margin loan – except you only use the extra leverage if and when you need it. Unlike many margin loans where you keep paying interest, even if it is in cash. This is why I said you can actually use them to invest on much longer timeframes if you want to (and I do).
6: Any interest you pay on your positions can be Tax Deductible (of course I am not a licensed accountant, so please see one for more details).
7: Using CFDs allows you to trade Short, and any Short Positions you have open actually earn you interest (usually at the RBA cash rate minus 2%)
8: Many CFD Providers offer “Guaranteed Stop Loss” orders, meaning that if the share price gaps through your stop loss, you are guaranteed to get your stop loss price. This means less “price slippage”.
9: Many CFD Providers offer Contingent and Timed Market Orders – so you can place an order the night before saying that “if the market hits this price, then buy this many, but only after 3pm.” This way you can trade the best times of the market (usually the last hour as opposed to the first hour, as the amateurs open the market, while the professionals close the market) without actually sitting in front of your screen.
10: You can trade things you might not normally be able to trade – things like Gold, Silver, Oil, or indices like the Australian All Ords or the Dow Jones Index. If you’re looking to stretch your horizons, this can be an easy way to do it.
11: And last but not least, brokerage using CFDs is usually MUCH cheaper than buying shares. The provider I use charges $10 to buy and sell – compare this to, say Comsec or Etrade where the minimum is $20, or a full service broker who may charge up to $90 or more! This can save you thousands over course of a year.
Traps And Pitfalls To Look Out For
So, CFDs sound pretty good, don’t they? “Sure they do”, you’re thinking, “but everything has a downside”. You are absolutely right – there are some pitfalls to be ready for when trading or investing with CFDs. Here they are:
1: Use a DMA (Direct Market Access) broker, rather than a MM (Market Maker) broker. Why? Because DMA mimics the price of the underlying share or commodity exactly, where market makers actually make a synthetic market themselves. Because of this, often the price using a market maker is vastly different to the actual share, and this can cause problems with your stop loss being hit prematurely. You have been warned.
2: Do not use more leverage than you can handle. If you’ve read the article on money management, you will know never to risk more than 1-3% of your total portfolio on any one trade, and this is no different. The main difference is that you can take more trades risking 1-3%, where with actual shares you might run out of capital first.
Hopefully this has given you a great knowledge on trading and investing with CFDs. Of course, if I have left any gaps or you have any questions, go ahead drop a line in the Questions and Comments area above and I’ll do my best to answer them. As you know, I believe trading should be fun and simple. CFDs, once you get past the jargon actually simplify things quite a bit. And that makes me happy.
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June 25, 2009
Tags: Market Basics, The Basics Posted in: Free Trading Course Lesson Backlog
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