Articles of Interest

A CFD or Contract for Difference is a type of derivative contract taken out between two different parties, the buyer and seller. The seller has an obligation to pay the difference between current price of a specific share or other instrument over which the CFD is based and the price at the time of selling the contract to the buyer. Should the difference be negative (a loss), it works the other way round where the buyer pays the negative difference to the seller.

CFD trading began in London in the 1990s. It was only in 2001 that investors realized that Contracts for Difference had advantages over traditional share trading, the main advantage being the avoidance of stamp duty.

CFDs have a number of advantages in that no CFD contract expires and the owner of a CFD is required to only maintain minimum margin meaning a low capital outlay is required, this is very different to traditional share trading where the full value of the position is required upfront. It is essential that CFD traders calculate their risk tolerance and study market trends on regular basis to avoid margin calls which can occur should the CFD position move against them. CFD traders can also go short and use stop loss orders enabling allowing them to minimize losses.

There are many types of financial instruments available allowing investors to outlay a relatively small amount of money in trade. Depending on the level of knowledge an investor has they will choose the relevant financial product to suit their needs. If we compare all types of financial instruments Contract for Difference trading is most similar to futures trading with the added benefit of liquidity and leverage.

Below are four of the main benefits of CFDs:

1. Financing Rates
CFDs incur a financing rate when you hold a position overnight. The financing for long positions is typically the Reserve Bank rate or cash rate plus a premium. So if the Reserve Bank rate (RBA) is 4.25% then you pay 6.25% per year calculated daily as the CFD provider will typically add a 2% haircut on top of the RBA rate. The financing rate for CFDs is typically much less that that charged by margin lenders.

2. Leverage
Leverage is one of the main reasons CFDs have become so popular. Leverage works like this, imagine you had $5,000 in a share trading account you could only trade up to $5,000 and a 5% move on $5,000 would only be $250. If you took that same $5,000 and used it to trade CFDs you could open a $20,000 position, that same 5% move now equates to $1,000. Using the CFD you can have potentially made another $750 with no additional outlay.

3. Liquidity
One of the most important aspects of CFDs is liquidity. Unlike other derivative products such as options, CFDs directly mirror the liquidity in the underlying market. When trading with a CFD provider using a Direct Market Access (DMA) model you can see the exact volume available in each stock at each price level in the market depth, you are also able to participate.

4. Low Commissions
The most significant advantage of CFDs are their low commission rates, some of the CFD products such as index CFDs are even commission free. Typically CFD brokers charge a minimum of $10 or 0.1% for share CFDs.

You can learn more about CFDs and their benefits in our free CFD Guide.