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Essential information for CFD trading

What is a CFD?

Contracts for Difference (CFDs) are an agreement between an 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 the CFD trade is closed.

Even though CFDs have some disadvantages over direct share investment, the proliferation of CFD providers and the leverage they offer means that CFDs are an important trading tool within the Australian financial sector.

On The Positive side

A CFD will mirror the performance of a share 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 "shares" 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.

What you should be aware of;

There are some disadvantages to trading CFDs, over trading shares directly on the ASX, many of which are based around the fact that they are an OTC (over the counter) derivative. That means that the CFD provider, not the Australian Securities Exchange (ASX), is the counterparty to your contract and it is their terms and conditions 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, our suggestions recommend trigger price points where an automatic stop loss is activated by the CFD Provider (broker) at a % move in the underlying share price against the suggestion. You would adjust this according to your individual leverage scenario. This should ensure that you do not receive 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.
A CFD does not offer franking credits, this is an important consideration when the underlying stock goes ex-dividend. Although the ASXCFD product promises to offer some benefit from franking credits it is not a straightforward swap.
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.

The Australian Securities Exchange says investors should also be aware of all the costs involved. "The costs include, not only commission, but also an interest rate, so they operate in much the same way as a margin loan. Some providers will also make a margin out of the spread." However, the caution that the ASX has expressed with regard to CFD trading has not discouraged them from developing their own exchange traded CFD product that appears to be a more complicated product than the CFDs offered by 'normal' CFD providers in Australia.

Why Contracts for Difference?

Leverage.
If you do not have the money needed to trade shares directly on the ASX, trading CFDs can offer you the exposure rquired to make a profit from small percentage moves on the underlying share price. 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. Certain CFD providers offer, at a cost, a guaranteed stop Loss (GSL) that can effectively increase leverage levels by (further) 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.

N.B. The above points do not apply to ASX CFD product as the CFDs are traded on an exchange you require somebody else to buy the CFD you are offering to sell, and that may not happen!

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.

This is best illustrated by an example:

You are the proud owner of 20,000 shares in BHP, priced at $40.00. You are still bullish and expect the shares will continue to climb in the long term but you anticipate the price to drop a little in the short term.
Because of Capital Gains Tax reasons (in regard to the time you have held the shares) you don't want to sell the shares. Additionally, you consider them a good long-term investment, You want to lock in the gains you've already made, but not sell the shares and therefore create a capital gain.
CFDs are a great tool to do this; you can hedge your portfolio by opening a short CFD position (by selling to open) equivalent to the 20,000 BHP shares in your portfolio, you will be 'market neutral'.
If the share price of BHP falls $1.00, you will make a compensating gain from your short position on the CFDs. If the share price of BHP rises $1.00, you will make a compensating loss from your short position on the CFDs.

Whichever way the price goes, your financial position remains neutral.

As with all hedging there is a cost. In this instance it is 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.

The content of this website does not constitute a recommendation or financial product advice and should not be relied on as such. None of the information takes into account your personal objectives, financial situation or needs and you must determine whether the information is appropriate in terms of your particular circumstances.
We neither take into account carrying costs/ interest payments to you (on short positions) nor commissions as they may vary according to your personal arrangements with your broker.
Investors should not invest in CFDs unless they are experienced in equity derivatives and understand and are comfortable with the risks of investing in CFDs. Investors should read the product Disclosure Statement for their individual CFD provider, particularly any section concerning the risks involved, and obtain their own financial advice as to whether CFDs are an appropriate investment for them. Share Select™ has an agreement with certain financial service providers such as Macquarie Bank Limited, that assists subscribers to open a Macquarie Prime account account. In performing these functions Share Select™/CFD Select™ are not representing Macquarie Bank Limited but may be paid a fee for doing so. Details can be found in our Financial Services Guide.