Peter Mathers Articles

Why Trade CFDs?

If you have been trading shares for a while now and you haven't looked or considered trading CFDs, you may be missing something. Since CFDs were introduced in Australia in late 2001 the number of CFD traders has been growing by the day.

The growth and popularity of CFDs has been tremendous over the past few years and now there are more countries accommodating these financial instruments to be made available and tradeable in their jurisdictions.

What are CFDs?

A Contract For Difference (CFD) is a derivative trading instrument that allows you to trade the price movements (when you enter and exit a trade), without owning the underlying instrument, in most cases shares or equities.

Compared to share trading, CFD trading is almost the same except that when you trade a CFD you don't own the actual share. If you trade a CFD on Google or BHP Billiton, you are trading the price difference between your entry point and your exit point. You don't own the Google or BHP Billiton shares; you are only counting on their price going up or down.

The most common type of CFD is a share CFD, but there are also other CFDs for Sectors, Indices and other financial instruments such as commodities and treasuries.

What makes CFDs attractive to trade?

Easy to understand and easy to trade -

Everything you know about shares and share trading applies and can easily be used to trade CFDs because the price of CFDs moves as the actual share price moves. For example, if share ABC is worth $5.00, a share CFD on ABC is also $5.00.

Tradeable on Margin -

You only need a small percentage of your trading capital to open up larger or more positions than you can normally open. CFDs providers require from 1-10% margin depending on the share CFD. Being able to trade on margin is the biggest attraction of CFDs because it increases the opportunity to make profit using a small capital but its a two-edged sword - it magnifies both potential profits and losses.

Can be traded Long or Short -

This is one of the most attractive features of CFDs because it means you can trade long and make money on a rising market or trade short and make money when the market is falling.

Dividend Payment -

Similar to dividend paying shares, CFDs also pay dividends on long positions.

No Expiry -

Unlike other derivatives that have expiry date and that become worthless upon expiry, CFDs don't have expiry date so you can hold CFDs for as long or as short a period as you like.

Low Commission/Brokerage Cost -

Compared to the brokerage fee you pay when you trade with your regular stock broker, commission charges when trading CFDs are relatively cheap. Some CFD providers charge as low as $10 for trades of up to $10,000.

Ability to trade International Markets -

CFDs open up a whole new world of financial markets including those in the US, UK, Europe and Asia which were not accessible to Australian traders before.

Are CFDs for you and where could they fit in your Investment Portfolio?

You may already have a healthy share portfolio that you want to keep growing. While CFDs may not be the ideal vehicle for the long term buy-and-hold investing, it definitely has a place in any investors portfolio.

Cheap entry into trading -

You only need to pay a small percentage of the total value of the transaction to open a CFD trade, CFDs can be seen as a relatively cheaper way to get started in trading. Some CFD providers require a deposit amount of only about $5,000. As long as you maintain your leverage exposure to a reasonable level, CFDs can be an efficient entry into trading the markets.

For example, you want to buy 1,000 shares of XYZ company at $8.00 a share. This means you need at least $8,000 to open a trade. If you trade CFDs of XYZ company, you would only need about 5% of the total amount to open the trade.

Here's how it works:

XYZ COMPANY	ACTUAL SHARE	CFD
Price	$8.00	$8.00
Quantity bought	1,000	1,000
Broker fee/Commission	$19.95	$10.00
Total capital outlay	$8,019.95 ($8.00 x 1000 shares + broker fee)	$410 ($8.00 x 1000 CFDs x 5% of total amount + commission)

You need quite a substantial trading capital to get into this trade if you buy the actual share and it will limit your ability to open other trades if you have a small capital. Trading CFDs means you can start with a small trading capital at a cheaper price.

Portfolio Diversification -

If you're a long-term buy and hold investor you can use CFDs to take advantage of short-term profitable moves in the market without affecting your long-term investment. This means while your long-term positions are growing over time, you can trade CFDs to deliver profit from short to medium-term trades.

Portfolio Hedge -

Hedging means protecting or trying to minimise any risk that may affect your existing investment portfolio. Many people are now using CFDs as a hedge to protect their share/equity investment.

For example, say you have bought 1,000 BHP shares at $28.00 expecting that the price will go higher in the months to come because of the global demand for resources. You intend to keep your BHP shares as a long-term investment. However, after a few days of buying the shares the price went down and it is now trading at $27.75. You still believe that BHP shares will go higher in the medium to long-term period, but in the mean time the share price has been going down for the past few days. You can short sell 1,000 BHP share CFDs to hedge your share position in the short term. This is because every cent movement in the physical shares (in this case it is going down, therefore you are losing) will be matched by the same movement in the share CFD (in this case, because you have a short position you are making money if the price of the share CFD goes down). This means your losses in the physical shares are being offset by your winnings in your short CFD trade (not withstanding personal tax treatments and brokerage rates applicable).