 |
 |
  
|
CFD's are a type of derivative - their value is DERIVED from another asset. CFD stands for Contract For Difference and similar to an option or warrant, it is a contract between two parties.
CFD's are a type of 'Over The Counter' (OTC) option. They are never exchange traded. However, unlike most OTC options, where both parties negotiate the terms of the option every time they trade, the terms of a CFD are standard. The reason a CFD is not classed as an exchange traded option is that the CFD trader can only deal with one other party - the CFD market maker. A CFD trader cannot buy a CFD from anyone other than a CFD market maker or sell to anyone other than that same CFD market maker. No novation exists in CFD's.
Another similarity CFD's have with traditional options is that they are used to gain leverage on the movement of the underlying share. Let's say a market maker like Marketech offers a CFD in stock XYZ. If XYZ is trading on the Stock Exchange with buyers at $1.01 and sellers at $1.02, Marketech may make a two-way price to you buying CFD's at $1.009 and selling at $1.021. You may then wish to buy CFD's at $1.021 or sell at $1.009.
Marketech does not charge a brokerage fee. It makes money by offering a slightly wider spread to what is offered in the underlying market. In this case, a third decimal place has to be created in the price and 0.1% is added to either side
Lets say you buy 10000 CFD's at $1.021. Two days later, the market marker is buying CFD's at $1.199 and selling at $1.211. You now sell the 10000 CFD's to Marketech at the bid price and your trade is complete. You made $0.178*10000 = $178 on the trade. There was no brokerage paid so this amount is deposited into your account.
As well as the low cost of trading, a great attraction of CFD's is the leverage available. If you purchased the XYZ shares through a stockbroker, you would have had to outlay over $10,000 for the purchase of the stock. With the Marketech CFD, you would only have to outlay 10% of that amount ie. Around $1,000. You are then able to free up the remaining $9,000 dollars you would have spent for other investment opportunities. The cost of doing this is that Marketech has lent you the remaining cash to purchase the position. This is where leverage enters the equation. Remember in this hypothetical trade you made $178. So with an outlay of only around $1000, this represents a profit of = 17.8%. Compare this to buying the actual stock and making a profit of $160 (which would realistically be less because of higher brokerage costs) / $1,000 = 1.78%.
In the way they operate, CFD's are not too much unlike futures contracts. However, there are two main differences. Firstly with CFD contracts, there is no promise to deliver or receive the underlying asset at any point in the future and therefore no expiry date. Secondly, futures contracts are usually traded on an exchange whereas in the previous example, CFD's are traded exclusively with Marketech.
CFD's are one of the fastest growing financial instruments in the world today. So what is the attraction to trading CFD's? There are many answers, notably:
Leverage of CFD's has already been discussed but CFD's can provide superior leverage to many other financial instruments. For example, a margin lending account may lend 70% of the money for a position on a stock. CFD market makers may lend up to 95% of the capital to acquire the position (and more for indices).
It could be said that this leverage creates a dangerous position for the trader but it does allow for more capital to be freed up, allowing the trader to use the excess capital to diversify the portfolio.
But the downside of leverage should be repeated here, as a great downfall of many beginner traders is not recognising that leverage can act as a double-edged sword: As well as having the ability to make large profits from trading CFD's, there is the possibility that you could make large losses.
Nevertheless, a disciplined trader can use leverage to their advantage and greatly increase their exposure to the market.
A big advantage to trading CFD's is the cost of trading. Marketech does not charge brokerage (unless the value of the trade is below 10,000 in which case a $10 ticket fee is charged). Marketech earns income from offering a slightly wider spread than the underlying market. This is the case for all international shares for which Marketech offers CFD's on over 2,000 international stocks. This can be an enormous saving in both time and money for anyone who has ever bought or sold international stocks may testify.
The brokerage for short-selling a CFD is also exactly the same as buying a CFD. This also differs from conventional short-selling which can often cost a little more in brokerage due to the extra paperwork/compliance the broker must complete before and after short-selling the share.
Returning to the XYZ example - If you purchased the XYZ shares through a stockbroker, you would have had to outlay over $10,000 for the purchase of the stock. With the Marketech CFD, you would only have to outlay 10% of that amount ie. Around $1,000. You are then able to free up the remaining $9,000 for other investment opportunities. The cost of doing this is that Marketech has lent you the funds required to purchase the full position. Marketech charges overnight bank rates + 1% which, at the date of this recording, was around 6.25%. This compares very favourably with margin lending rates.
This is a cost if you choose to buy CFD's. If you sell CFD's, you can actually earn interest.
Another advantage of trading CFD's is that it allows traders to trade 1,000's of stocks from around the world. Whether it's BHP in Australia, Cadbury Schweppes in the UK, Heineken in the Netherlands, L'Oreal in France, McDonalds in the U.S., Ericsson in Sweden, Nokia in Finland, Volkswagen in Germany, Ryanair in Ireland, Telecom Italia in Italy, Banco Popular in Spain, or Nestle in Switzerland, all these CFD's are available for to trade from one account. What's more, all these stocks are still available at the same low brokerage rate.
Naturally the times that these markets are open will mean that the trader must trade various hours of the day if they are to trade live. The Marketech Trader platform allows the trader to enter bids and offers, as well as place profit and stop targets even when the market isn't open. This allows Australian traders to put in place trading strategies on global markets knowing that their strategy is being put in place even as they sleep.
The 24 hour markets can sometimes be an advantage to traders. Most Australians work during the day and are unable to trade the Australian markets because they are too busy. The European markets can present a good opportunity to trade because they are open mostly during 'home' hours.
In the original XYZ share example, it was shown how money could be made by buying the CFD. What if we wanted to sell the BHP first with the aim that we could buy back the stock at a lower price in the future. This is known in trading as 'short selling'. With 'normal' stockbrokers this isn't always possible and there are additional costs for 'borrowing' the stock. With CFD's you are able to short sell as easily as you buy stock.
Options very rarely allow the holder to participate in corporate actions such as dividends and rights issues. Only the holders of the physical underlying share are able to access the benefits of these corporate actions. However, CFD's often allow this by crediting the CFD holders the amount of the dividend or by creating a new CFD for the rights.
Note that not all of the dividend is given. In most circumstances, the holder of the physical underlying share that pays a dividend will be entitled to tax (franking) credits when they are paid the dividend. No such tax credits are granted with the CFD 'dividend'.
Hedging is a technique by which a trader may hold a position in the underlying stock which they wish to keep for any particular reason but want to protect themselves from a negative move in the stock. By taking a position in another financial product, the trader can offset any losses if they are bearish about their underlying position. Derivatives are often used for hedging purposes. Many problems can arise in hedging and the cost of hedging can sometimes outweigh the risk and cost of not having hedged at all.
It is often difficult to transact at the market price when hedging shares with futures (due to a wide spread). Add to this the cost of hedging. Hedging with options can often be cumbersome because of the non-linear payoff profile options can give. Also, both futures and options have expiry dates. This means that the hedge must be 'rolled-over' at the expiry date. Finally, the option and futures prices can be affected by many factors other than a movement in the underlying stock, for example - interest rates.
CFD's offer a near perfect hedge tool. Their price almost exactly mirrors that of the underlying share with no fluctuations from external factors such as interest rates. With no delivery date, there is no requirement for roll-overs of the hedge.
New traders often begin by doing paper trades. There are clearly many advantages to doing this, as any mistakes made will only result in 'paper losses'. However, there are also a number of disadvantages. Firstly, when looking at a chart, people will often claim that their entry or exit price for their paper-trading was simply the closing price for the day, or worse still, the best price (lowest or highest price) for the day. When trading in real time, this is often not the case and it could dramatically change the profit and loss. Secondly, the biggest difficulty in trading comes with controlling the emotions of fear and greed and these true feelings don't occur until the trader has a real position in the market.
CFD's have no minimum size so one (!) CFD contract may be purchased. This gives the trader a real execution (so they don't optimise the entry/exit levels in their paper trading) and gives them a real feeling of trading. With the cost of trading being low compared to purchasing the underlying, the brokerage should not 'eat into' the trading capital too badly. The amount traded should be lifted to an amount that gives the trader the feelings of fear and greed (this will be different for everyone based on their own financial circumstances) yet doesn't break the bank.
CFD's are fast becoming the financial product of choice among traders. Their liquidity, low cost of execution, low financing costs, ease of trading and access to different markets makes them the ideal trading tool.
The Marketech Trading is a world class CFD trading platform offering CFD's on stocks from all over the world. If you have any questions regarding CFD's or the Marketech Trader platform, please contact Marketech on 1800 00 59 55 - we will welcome your call.