Peter Mathers Articles

How to Trade CFDs

Today, most, if not all, CFD providers give you a direct link to them through an internet based and electronic trading platform. Like electronic banking and other internet based transactions, the more familiar you become with the electronic trading platform, the better your trading experience.

After opening your CFD trading account with a provider, the first thing you need to know is how to use the trading platform of your CFD provider. Again, this will vary from one provider to another and it pays to learn the features and capabilities of the trading platform to make your trading routine as efficient and smooth as possible. Though there will be differences in the look and feel of each trading platform, your CFD trading software must have all the features and capabilities that will allow you to:

• open and close trades
• put in additional orders or trades
• amend or cancel existing orders and stops
• manage your trade from entry to exit
• preferably have quality charts for analysis
• see your daily account statement

Types of Trades

Going 'Long'

Going 'long' means you open a CFD position by buying it with the expectation that the price will go up and then selling it at a higher price, that's when you make the money.

An example of a 'long' CFD trade
STEP 1: TO OPEN A TRADE, YOU BUY:
300 BHP share CFDs at $28.00 with a (eg) 3% margin and (eg) $10 commission

(300 share CFDs x $28 = $8400) x 3% = $252 + $10 = $262 (margin required)

This means you will be required to have at least $262 in your trading account to open this BHP share CFD trade.

STEP 2: TO CLOSE A TRADE, YOU SELL:
After you bought BHP share CFDs commodity prices jumped in the international market overnight. The following day the price of BHP shares is also expected to go higher and you want to close your BHP share CFD position.

You sell 300 BHP share CFDs at $28.50 (for a 50 cents movement in each share CFD) - $10 commission = closing price

(300 share CFDs x $28.50 = $8550) - $10 = $8540

STEP 3: CHECKING YOUR PROFIT AND LOSS:
Your profit and loss calculation will look like this:

(sell price - buy price) x number of share CFDs - commissions = profit

($28.50 - $28.00 = .50) x 300 share CFDs - $20 = $130 profit or 51.6% return for an initial outlay of $252

NOTE: This calculation does not include the financing charge which is calculated on a daily basis for as long as you hold your CFD position open. Financing charges vary from one CFD provider to another.

GOING 'SHORT'

Going 'short' means you open a CFD position by selling it with the expectation that the price will go down and then buying it at a lower price, giving you the profit even if the CFD price goes down.

Example of a 'short' CFD trade
STEP 1: TO OPEN A TRADE, YOU SELL:
300 BHP share CFDs at $28.00 with a 3% margin and $10 commission

(300 share CFDs x $28.00 = $8400) x 3% + $10 = $262

This means you will be required to have at least $262 in your trading account to open this BHP share CFD trade.

STEP 2: TO CLOSE THE TRADE, YOU BUY:
After you bought BHP share CFDs commodity prices dropped in the international market overnight. The following day the price of BHP shares is also expected to go lower and you want to close your BHP share CFD position.

You buy 300 BHP share CFDs at $27.50 (for a 50 cents movement in each share CFD) - $10 commission

(300 share CFDs x $27.50 = $8250) -$10 = $8240

STEP 3: CHECKING YOUR PROFIT AND LOSS:
Your profit and loss calculation will look like this:

(sell price - buy price) x number of share CFDs - commission = profit

($28.00 - $27.50 =.50 ) x 300- $20 = $130 profit

or 51.6% return for an initial outlay of $252 (margin required)

NOTE: When you have a short CFD position, you will be paid the interest on the total amount of your trade for as long as you hold the position open. This computation does not include the overnight interest you will earn. Interest payment may vary from one CFD to another. Short selling is a great opportunity for traders and money can sometimes be made faster 'shorting' due to the speed prices can retrace.

Types of Orders

Market Order -

As the name implies this is an order you place to buy or sell a CFD at the current market price. If you are a buyer, you are willing to pay the price on the Offer, and if you are a seller you are willing to accept the price on the Bid.

Limit Order -

Is an order where you specify the price where you want to buy or sell. A limit order is useful when trying to capture or protect your profit in a certain trade.
For example BHP is now trading at $29.00 and you are long BHP at $28.00. You want to close this position when the price goes to $29.50. You can place a limit order that says: 'Sell BHP at $29.50 on limit.'

Stop Loss Order -

Is an order that tells your CFD provider at what point you want to get out of a trade when the position turns against you. Many CFD providers will allow you to place stop loss orders automatically on the electronic trading platform. You should make sure that your provider offers stop loss orders, which is one of the most basic trade management tools. This will be discussed in more detail in Chapter 4.

Stop Entry Order -

Not all CFD providers may offer this order and this may only apply to sector and index CFDs. This order allows you to open a trade when a certain level is hit.
For example, if the S&P/ASX 200 (Index) is trading at 5000 and you think that with all the volatility in the market it will be falling at about 4990, then you would like to go short when this level is hit. You can place a stop entry order that looks like this: (This will automatically open a trade for you at this level). 'Sell S&P/ASX 200 at 4990 on stop.'

Good 'til Cancelled (GTC) -

this is an order or instruction that you attach to a buy or sell, limit or stop order that will keep the initial order open until you decide to cancel it. This is useful and will save you time instead of reminding your CFD provider to place the order over and over again or placing the order yourself everyday.

Good for the day -

similar to GTC, this is an instruction that you attach to another order that says you only want to keep this order for the day. This means that at the end of the trading day if your initial order was not executed, then it will be automatically cancelled and you may have to place another order for it the next day.

Components of a CFD Trade

Commission -

This is similar to the broker fee you pay to trade physical shares with your stock broker or a discount brokerage company. One advantage of trading CFDs is that commission or broker fees are relatively lower compared to what you pay your stockbrokers. Some CFD providers charge as low as $10 commission for trades of up to $10,000. On the other hand, stockbrokers usually charge at least $30 for each trade and much more for the few that can short sell.

Margin -

A CFD is a derivative product and is traded on margin, which means you only need to put up a fraction of the total position to open a trade. The margin is the amount you need to have in your trading account, which may vary from 3% - 10% depending on the CFD you trade. Index and Sector CFDs and margin FX trades only require 1% margin.

Financing Cost and Benefit -

As a margin traded product CFDs attract financing charges, which is similar to paying interest on a margin loan from a bank to buy shares. Technically, when you open a CFD trade on a margin, your CFD provider is lending you the money for the rest of the amount. Financing cost varies from one CFD provider to another, so it is wise to check what you will be charged.

One thing to note with financing cost is that you have to pay it if you have long CFD positions, but you will be paid an interest if you have short CFD trades. This is because technically, you are lending money to the CFD provider when you open a short trade and therefore you are to be paid interest.

Finance Cost Computation -

For example, the official cash rate is 6% (interest rates are set by each country's central bank) and a CFD provider will charge an administrative premium of say 2-4%. Therefore you will be charged a minimum of 8% on the total value of your CFD trade on a daily basis for as long as you hold the trade.

BHP 'long' position financing cost

($8,400 x 8%) 360* = $1.86 per day

This amount will be reflected in your daily account statement from your CFD provider

NOTE: 360/year is the industry standard for calculating financing costs.