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  • Investor Unity Pty Ltd



    Level 36, Governor Phillip Tower.
    1 Farrer Place, Sydney, NSW 2000

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CFDs Explained - What is a CFD?

You, as a CFD Trader

Trading CFDs can be an extremely rewarding experience, both personally and financially yet, as any experienced trader will tell you, it’s the small things that make big differences.

Such as that one extra tool that allowed you to find that great trade, the efficient execution by the broker which got you in & out at the right price, or the right risk-management tools that helped you avoid taking too big of a hit to your trading account on a trade that went the wrong way.

These are just a few of the many factors that come into play on each and every trade.

So when you start thinking about placing several trades per week or per day (or even per hour, for some people)- it’s easy to imagine how getting set up, in the right way, will have considerable impact on your success & profitability as a trader.

Yet, for anyone who’s still new to the business, the difficulty lies in trying to understand:

  • The market terminologies (which also varies between brokers)
  • Costs and risks
  • The various trading platforms and tools
  • Company stability and regulation
  • Service & support
  • Getting a good education

And so on and so on….

Quite simply- it’s hard to even know which questions to ask, let alone being able to gauge the accuracy of the answers, you simply don’t know what you don’t yet know.

The following Key Focus Areas are explained in order to dispel some myths about trading the CFD markets and help you decide what’s important to you, in order to give you your best chance of having a long and successful trading career.

What kind of trader are you and what kind will you become?

Before thinking about the markets and brokers, you should take some time to think about how you actually want to trade.

Trading is very much a personal venture and therefore trading-styles can vary greatly. Ranging from the day-trader who spends several hours in front of his multiple monitors each day, looking for opportunities and trying to catch the most from every move, to the more passive trader who places a few trades every few weeks and simply reads his reports & checks his charts every now and then.

Of course, there is also everyone in-between. But, regardless of your intended trading style, you should take some time to think about the following key criteria:

  • How much time are you able to devote to the markets?
  • How much time are you willing to devote to the markets?
  • How technically proficient are you (do you get used to new software fairly easily)?
  • What will you base your trading decisions upon? Charting, news & research, both?

Trading according to your lifestyle and other commitments

One of the major benefits of trading is the flexibility of time that it affords. For this reason, just because you have a job, a spouse, children, hobbies or anything else that takes up your time doesn’t mean you can’t trade successfully. However it does mean that you have to pick a style of trading that you can manage as trading does take a clear & concentrated mind.

Fortunately, almost all of today’s CFD brokers offer access to international markets; this provides the trader with 24 hour trading opportunities. Overseas markets should not be shied away from simply because they seem unfamiliar, as many well-known CFD instruments can be traded.

In addition to the hours of trade, international markets can also provide further benefits – such as lower commissions and higher liquidity – making it cheaper and/or easier to get in and out of trades.

Costs and profits

CFDs can be a very cos-effective market to trade. When compared with other markets, the costs of getting in and out of, and of holding trades, can be very low. Although, trading costs can differ quite significantly, depending on what you trade and which broker you trade through.

In the case of Share-CFDs, the usual commission rate is 0.1% of the total value of the trade (with a $10 minimum commission). There are no minimum trade-sizes. All CFD instruments other than shares have no commission, as the cost of trade is built into what’s known as the bid/ask spread.

For example:

At the time of writing this the ASX200 CFD was priced (through one of our partnering-brokers) at
$4520/$4521.

So, if you’d bought this contract, you would buy in at $4521 and, if you sold straight away, you’d sell at $4520.

Your loss therefore, would be just the $1 cost of spread.

‘Short-selling,’ the potential to benefit from a falling market

Since there is no physical exchange of assets involved in a CFD trade- you can effectively sell something that you don’t own, with the view that you could buy it back later – at a lower price – and thereby make a profit.

Essentially- it’s the old “buy low, sell high” in reverse: Sell high, buy low.

This sounds a little more complex than it actually is, however, it’s no more so than buying (going long). You would simply press the SELL button rather than the BUY button. So, if you thought a stock was overpriced and due for a fall, you could simply sell it at it’s current market price and then, hopefully, buy it back later at a lower price. And, just the same as if you “went long” (bought), your profit or loss would simply be the difference between your entry and exit values (plus costs).

As you can imagine; short-selling has become very popular and is an extremely powerful tool to carry in your belt- especially in an economic climate such as the one we’re in.

Hedging physical shares with CFDs

It is estimated that Australia has the world’s highest per-capita share ownership. Yet, very few people take steps to protect these assets. CFDs offer a method of achieving this quite efficiently and with relatively low cost and complexity.

Hedging is simply taking a position that’s opposite to another one, thereby protecting it either partially or completely by ensuring that the profits from one will offset the losses from the other. Let’s say, for example, you had a share portfolio worth $50,000. If you believed that these shares were going to fall in value, you could take a short-trade of CFDs on the companies in your portfolio.

Therefore, for a relatively small cost, you could have the peace of mind that if your shares do fallyou’ll be compensated by the profits on your CFDs. Alternatively, you could simply take a short position on the ASX 200 index CFD. This would be simpler and cheaper, but would provide a less complete hedge.

Financing costs and benefits

When buying into a CFD position you are effectively borrowing from your broker and, therefore, you will pay a financing cost. This is based on the current RBA rate, when dealing in AUD based products (3.25% at the time of
writing). Additionally, a CFD broker will, on most CFDs, add their own charge. This varies, between brokers, but is usually around 2%.

To put this in practical terms, using approximate figures, a $10,000 position on an Australian share CFD would incur around $1.50, as an overnight financing charge (trades opened & closed during the day incur no such charges).

As short-selling is, in many senses, simply the opposite of going long- you would receive a financing benefit, rather than pay it (about 50c, in the same scenario as above).

Understanding leverage – making your money work harder

Using leverage could also be called gearing and simply means that; whatever the total value of your trade, you would only be required to put up a small percentage of that value as “margin” (like a deposit). The amount of available leverage varies between instruments and is based on the size and liquidity of the underlying asset.

For example; large-cap stocks like Commonwealth Bank and BHP are usually traded with a 5% margin (20:1 leverage), while smaller companies usually have a 20% margin (5:1 leverage) or even 100% margin- which is no leverage at all.

Index contracts, such as the ones based on the ASX 200 and the Dow Jones offer the highest available leverage (up to 200:1 or 0.5% margin). This is for two reasons. Firstly; indices are the largest markets (the most liquid, after currencies) and secondly- they trade almost 24 hours per day with just small breaks in the morning and late afternoons.

The fact that these markets are not closed for very long means that there are rarely large gaps between closing and opening prices. Essentially; higher the liquidity and a lower chance of large price-gaps equals lower risk. Therefore a CFD broker will, generally, offer higher leverage.

A working example of using 20:1 leverage (approximate figures):

  • Your account size is $5000.
  • You decide to buy $10,000 of Caltex Australia (CTX) CFDs.
  • With 20:1 leverage (or 5% margin requirement), $500 of your account would be placed to take this trade.
  • The other $9,500 is being provided by your broker and you would then control a $10,000 position in Caltex share CFDs and, at a 0.1% commission rate, you would be charged $10.
  • If Caltex then rose by 5% overnight, your share CFDs would be worth $10,500.
  • If you sold the position, you would be charged a $10.50 commission (10,500 x 0.1%) and
    you would be left with a net profit of $477.80 (including approximate overnight financing).

Note: In the previous example; if the price fell by 5% and you had no risk management measures in place, the loss would be $500 plus costs.

The first step to profitable trading is managing your risk

Everyone knows that there is money to be made from trading yet, what holds most people back is the fear of “losing the house” due to a couple of bad trades.

Acknowledging that there are inherent risks in trading is absolutely crucial to your success however, it’s just as important to understand what those risks actually are so that you neither overestimate nor underestimate them. Most importantly- you control your risk.

Higher available leverage does not equal higher risk, necessarily…

Many have likened leverage to driving a race-car, but just because you have a top-speed of
300kmh- doesn’t mean that you’d try to reach it on your way down to the supermarket… Therefore, just because you could take a trade at 200:1 on an Index CFD trade, does not make CFD trading more risky- as long as you can avoid the temptation to over-leverage.

The most important aspect of leverage to focus on is: The size of your account, compared to the total size of your all of your open trades.

For example; if you had an account-size of $5000 and you had a trade of $10,000 then you would be leveraging your account at 2:1. If you took a $5000 trade then you wouldn’t be leveraging your account at all- regardless of whether your actual margin requirement is $100 or $20 (or any other amount).

Don’t worry about margin too much, as many tend to, unless you’re being reckless- you’ll have more available leverage than you should need.

Above all- you can and must control your risk

All brokers will provide you with a range of risk-management tools (such as orders to automatically get you out if the trade goes against you). But, the most important thing to understand is that you control your risk.

In fact, since you can’t control any of the factors that move prices up and down- your risk is one of the only things that you can control.

So, regardless of whether you want to start with an account-size of $1000 or $100,000 – you should only ever risk an amount that you’re comfortable with. I.e.- if you only want to risk $50 on the trade then only risk $50 (most brokers will offer benefits to higher-deposit accounts).

Quite simply, as long as you do control your risk- there’s no reason to be afraid to at least make a start.

Tools of the trade

With recent advances, trading using advanced technology is now relatively simple. All CFD brokers now offer trading software with access to live-streaming-prices, live news & research, comprehensive charting capabilities as well as detailed account-reporting capabilities.

Some brokers offer their clients a choice of which trading software to use. If you will need to trade from any PC, or from a company PC which you can’t install software on then it’s a good idea to consider a web-based trading platform.

While the trading universe is full of every latest gadget under the sun; the truth is that it is more than possible to, at the very least, get off on the right foot with just the basics- while spending hardly anything (if anything at all) on trading-tools.

You don’t have to be an economics major to trade CFDs

Even those that actually do trade economic news announcements are usually basing those trades on how the market will actually react to the news, without needing an in-depth understanding of what the economic news announcement really is.

Most traders (including news-traders) simply base their trading decisions on technical analysis (charting) therefore, once you have a foundational understanding of CFDs, it’s essentially the same as trading any market.

You will become educated, one way or another, there’s no way around it…

Most brokers offer education that’s designed to help you get started in trading, especially in how to place orders and open charts and the like (please note: the level of education & support can vary greatly between brokers). Although, in order to learn effective risk management principles, develop a method of picking trades and all of the other crucial elements of your all-important trading-plan, you simply must face one of two choices; either get yourself an education… or let the market do it for you.

The latter, for reasons of time, money & personal stress is simply not an attractive option. To the inexperienced, markets inevitably prove that, although getting started can be easy; developing a strategy that fits your time-schedule, level of risk tolerance & achieves desirable results can take years. Unfortunately, most just don’t make it at all…

You don’t need to pay an arm & a leg for good education

In addition to the free education provided by brokers (some), there are several excellent books- all of which can offer an excellent, low-cost form of education. For FX education, we also recommend you register as an IU Member (which is completely free), at least as a good way to get started.

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Getting off on the right foot: Where to go from here…

  1. Decide how you plan to trade, thinking about what your trading goals are. In other words; why are you getting into this business? As a hobby? For some extra income? To replace your income? To build capital for your retirement? And, very importantly- how much time you’ll have to do so.
  2. Understand the risks involved in trading, particularly in leveraged products, and that you must trade them with proper risk management and the discipline to not get carried away. Avoid emotions completely- both greed and fear.
  3. Decide how much capital that you’d like to open your account with- remembering that brokers will offer benefits to larger account holders, and most importantly- this doesn’t need to affect how much you risk on each trade.
  4. Think about which tools you’ll need, remembering that if you’re still somewhat new, there may not be much point in spending a great deal on a tool that you won’t be using if or when your trading style changes.
  5. Remember that education is not just crucial- it’s unavoidable, think about how you’ll learn about all of the crucial elements that will make up your trading plan.
  6. Open an account with a quality broker that will suit your trading style & goals.