Contracts for difference (CFDs) have received so much hype in the last couple of years that it warrants asking the question… “Why trade CFDs?”
Compared to traditional share trading, CFDs have some fantastic benefits that every share trader should look into seriously.
The major reasons for wanting to trade CFDs are
Let’s have a look at each of the reasons here.
The major reason for share traders looking to make the move to CFDs is to get their money working much harder for them through leverage.
With normal share trading, if you have a $10,000 account then you can only access up to $10,000 worth of shares which can be a limiting factor when you are trying to diversify your portfolio. With $10,000 cash in your share trading account you might choose to trade 2 stocks with $5,000 in each one. Ie $5,000 worth of BHP and $5,000 worth or Woolworths for a total of $10,000 in positions.
With the leverage that CFDs give you access to, that same $10,000 can be used to gain exposure to far more than that amount. For instance you may wish to trade up to $30,000 worth of total positions.
Instead of just buying 2 CFDs at $5,000, you can now buy perhaps 6 positions at $5,000 each. This enables you to benefit from a $30,000 portfolio despite only having $10,000 in your CFD trading account.
$10,000 cash trading up to $30,000 in positions = 3 * leverage.
You control the leverage in your account
Most people are not aware that the use of leverage in your CFD trading account is one of the most misunderstand yet vital components of long term CFD trading success.
Here are some guidelines when using your CFD leverage.
Level of Experience
|$20,000 – $30,000
|$70,000 – $100,000
|Leverage too high. Highly skilled intraday trader with very tight stops
If you are starting out then it is important to use as little leverage as possible. Your number one goal at any stage of trading is Capital preservation.
What the professionals don’t know
The simple fact is professional traders don’t know which way the market is going at any given time. They have tools that stack the odds in their favor but even that fails around 40-60% of the time. Therefore the one saving grace is correct use of leverage, stop losses and money management rules.
Keeping your CFD trading costs low
Another great benefit of trading CFDs is the low cost of trading. The one common element of all traders is the fixed costs of commissions or brokerage. Given that this is a fixed cost it is vital to select a CFD broker with a competitive commission or brokerage rate.
Most CFD brokers in Australia have commissions starting at $10 minimum or 0.1%. This means if you did a CFD trade with a total position size of $7,000 then the brokerage would be a minimum of $10.
If on another occasion you opened a CFD trade with a total position of $12,000 then your brokerage would be $12,000 * 0.1% or $12.
If that position then rose to $13,000 and you closed it the commission would be $13 to get out. This gives a ‘round-trip’ of $25.
Many of Australia’s leading Share brokerage firms like Commonwealth bank or Etrade have commissions ranging from $19.95 – $29.95 plus GST.
Opportunity to profit from falling markets – Short Selling
One of the greatest benefits of CFDs is the ability to profit when the market is falling. For many this is a brand new concept which can take time to get your head around. Once you understand how simple short selling is you will find no better way to take advantage of down trending markets than CFDs.
On the 1st of November 2007 the ASX top 200 index hit just over 6800 points. From that peak the ASX Top 200 index fell to a low of around 5040 on the 17th of March 2008. That represents a loss of more than 25%. Considering your super fund was largely invested in the ASX Top 200 stocks, do you think it might be worth finding out about short selling?
$100 Billion wiped off the market in 1 day
On the 22nd of January 2008 the Australian market fell a record 400 points or just over 7% and wiped a massive $100 Billion from the markets. That was in 1 day.
Short selling allows CFD traders to take advantage of downward trending markets and protect their current share investments through effective hedging strategies.
ShortSelling in a nutshell
Short selling is basically selling a CFD for a higher price (say $10) with the hope of buying it back at a cheaper price (say $9). Remember, with contracts for difference our profit or loss is simply the difference between where we got in and where we got out.
Therefore in this example we shorted the CFD at $10 and bought it back at $9, thereby making a $1 profit per CFD. If we had 1,000 CFDs short then we would have made $1 * 1,000 or $1,000 (not including trading costs).
For a complete run down of short selling CFDs read Short Selling CFDs
Hedging using CFDs
Protecting your current portfolio is a key reason to look to get started with trading CFDs. CFDs give traders the added bonus of being able to perfectly hedge an existing share portfolio during volatile or uncertain times.
Traditionally investors who may be looking to hedge an existing share portfolio would use another derivative product called options. Options would allow you to hedge your current shares but only in lots of 1,000.
So let’s say for example you had 4350 BHP shares, then your hedge using options could only be done with 4 option contracts (equates to 4,000 shares) or 5 options contracts (5,000 shares). So using options in this case would never allow a perfect hedge.
With the introduction of CFDs also came the ability for long term investors to hedge existing portfolio’s with the exact quantity of CFDs. So if you did in fact have 4,350 shares in BHP that you wanted to hedge then you simply short sell exactly that quantity.
How does hedging work?
The goal of hedging is generally to protect your investments during periods of market uncertainty or when you are confident the market and more particularly your stocks, are going to trend down. Therefore you would want to protect your portfolio via hedging.
You may have 4,350 BHP shares which you purchased at $45 and your research indicates that BHP is heading for troubled times over the next 3-12 months.
Using CFDs you could lock in the price of $45 by short selling 4,350 BHP CFDs using your current CFD broker. So let’s see what happens if BHP did in fact drop to say $40 over the next couple of months.
|Starting price of BHP
|End price of BHP
|$5 * 4,350 = $21,750 Loss
|$5 * 4,350 = $21,750 Profit
|Break Even – Perfectly hedged.
In this example you didn’t have to sell your physical BHP shares thereby having a potential capital gain or loss, but instead you were able to perfectly hedge your position using CFDs and cover them perfectly.
Not only did you cover your BHP share loss but every day your hold a position short, your CFD broker will pay you overnight interest or financing. Yet another benefit of hedging an existing share portfolio using CFDs.
Accessing Dividends with CFDs
Trading CFDs gives you access to dividends just as you would in the share market. With CFDs, so long as you hold the CFD prior to the ex-dividend date, then you are entitled to the exact dividend that the share is giving.
So if you are on CBA (commonwealth bank) shares and you have 1,000 CFDs the day before it goes ex-dividend then you will be paid the exact same dividend as with the shares. So if CBA pays a $1.05 dividend then that is exactly what you will receive with your CFDs as well. In this case you would receive 1,000 * $1.05 = $1,050.
Differences with dividends and CFDs
Normally with holding the shares on the stock market you receive the dividend plus franking credits, so long as you held the stock for at least 45 days prior to the ex-divided date. With CFDs there are no franking credits. Franking credits simply mean that the company has already taken the tax out so a 100% fully franked dividend allows you to claim 100% of that income without being taxed again at the end of the financial year.
This means that the income your receive as dividends from your CFD trading has full taxation implications. Best to speak to a qualified accountant about your particular tax situation as laws are constantly changing.
No time expiry with CFDs
Another benefit of trading CFDs is the fact that you can hold a position for as little or as long as you like. Most traders & investors start with shares and then move to a derivative product like options. Unfortunately options have what is called an expiry date and along with that comes time expiry.
Time expiry is where the price of the option deteriorates as approaches expiry. In many cases it is possible to get the direction correct with a bought option position but because of time expiry you can lose.
Those people who simply trade the options have time expiry constantly working against them as each contract expires at a specific time in the future.
CFDs have no expiry date which allows traders to hold a position for as little or as long as you like without the worry of taking delivery of the physical stock.
So if you wanted to hold your positions for minutes, days, weeks, months or even years then you can with CFDs. This is the very reason many options traders prefer using CFDs over their current investment choice.