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Trading with Contracts for Difference (CFD)

Date Added: November 21, 2007 09:46:29 AM



Known as equity swaps in the institutional market, they originated in the UK in the 1980s. Contracts for Difference (CFDs) are an agreement between the investor and the CFD provider to settle the difference in cash between the price at which the CFD trade position is opened and the price it's closed.

On The Positive side

A CFD will mirror the performance of a stock without owning them, and the profit/loss is determined by the difference between the buy and the sell price. Because contracts for difference trade on margin, investors only need a small proportion of the total value of a position to trade. A CFD will also mirror any corporate actions that take place. The owner of a share CFD will receive cash dividends and participate in stock splits. Traders use CFDs as they allow them to leverage into "stocks" for little upfront cost. Moreover, in a falling market, you can sell the CFD you don't own and buy back when it has slipped in price value enough for you to pocket the difference and make a profit.

On The Downside

There are some significant disadvantages to trading CFDs, many of which are based around the fact that they are an OTC (over the counter) derivative. That means that the CFD provider, not a Securities Exchange, is the counterparty to your contract and it is their terms and conditions, designed to benefit them, that you agree to.

The downside to CFDs include;

  • The deposit is not a down payment for the balance of the CFD trade, but rather a margin held by the provider as protection against any possible losses. This means that an investor may receive a margin call demanding more money if they have bought into the stock thinking it was heading up and the share price falls.
  • Given this, we suggest the use of a stop loss that is activated by the CFD Provider (broker) at a % move in the underlying share price against the trade. You would adjust this according to your individual leverage scenario. This should quash any margin call demands.
  • You are liable to pay interest on the total transaction amount, regardless of the amount of margin that you have contributed.
  • As an OTC (over the counter) derivative you are not offered the same protection as when you purchase shares. For example, some CFD providers are not obliged to use the stop losses you specify, they may also 'bundle' together orders from other traders and give you an average price.

Why Contracts for Difference

Leverage.

The leverage level offered by the CFD provider magnifies the underlying movement of the stock. Most providers set differing leverage levels and you can find the best level that suits you trading style. By using a Guaranteed stop Loss (GSL) it is possible to effectively increase leverage levels by capping the margin requirement held against you. Control of Risk. If you have ever traded, you know how important it is to use stop losses for capital preservation, especially when using a leveraged product.

  • CFDs allow you to cut your losses quickly and leave your profits to run. This ability to quickly exit at the prevailing market price allows for greater risk control.
  • CFDs reflect the price of the underlying equity, therefore, you will always know what the market price is of your shares and know what you can sell out for, provided you choose a CFD Provider who uses "at market" prices. Some CFD providers (market makers) may only give spreads, which have the potential to force you in at higher prices and out and lower prices.
  • Placing automated Stop Loss orders can exit you out of suggestions that go against you while you are busy in your day-to-day activities.

Other things you may want to consider about CFDs

Hedging

Another application of CFDs, as an alternative to using Exchange Traded Options (ETO's), is to use CFDs to hedge positions in your equity portfolio. As with all hedging there is a cost. i.e. the commission you pay to open the CFD position, however, you will receive a net interest payment from the CFD provider as you are shorting the stock. Additionally, there is the indirect cost of depositing a margin payment with your provider to cover the CFD.

Further information can be found at Share Select http://www.shareselect.com.au who offer advice on Stock investment and trading, including derivatives such as CFDs