Articles of Interest

It’s not hard to find blogs and forums where people talk about the benefits of CFDs over shares but have you questioned whether the people actually writing these comparisons are traders who have experience in both financial instruments or are they just paid authors out to promote CFDs. In this quick review we will touch on the differences between both CFDs and shares and highlight the unique aspects of each product that has allowed traders and investors to harness the power of their investment portfolio from the comfort of their own lounge room.

CFDs and shares are very different not only in the way they work but also in how they are traded. One of the fundamental differences is the fact that CFDs are an over the counter or OTC product meaning your transactions are not conducted on an exchange but rather with the CFD provider that you are dealing with. Shares on the other hand are traded on an exchange meaning that you are buying and selling off other people in the market with your stock broker simply acting as a conduit providing you with a gateway to the market.

So now that you know one of the most important fundamental differences between CFDs and shares let’s get into some of the key mechanical differences in detail.

Settlement
One of the most apparent differences between both products is the way in which they are settled. When you buy shares on the stock exchange you don’t have to pay for the share for three days, conversely when you sell shares you do not receive any money for three days. The transaction day plus 3 days or T+3 is the settlement period set by the clearing house not the broker. Of course when trading CFDs there is no clearing house involved as the transaction is OTC this means the your CFD provider essentially sets the rules, as CFD providers typically do not want to wear the risk of having the settlement of a transaction fail they will ask for the money upfront, this concept of same day settlement is known as T+1. It’s worth noting that some online share brokers also apply T+1 settlement to minimise the risk of settlement failure.

There really is no real advantage of T+1 or T+3 settlement as ultimately the net effect is the same, however most active traders prefer same day settlement for the simple reason that it makes their cash flow easier to manage.

Leverage
Unquestionably the most important and apparent difference between CFDs and Shares is the concept of leverage. By the very nature of the instrument CFDs are leveraged meaning that for a relatively small outlay you can obtain a relatively large exposure to a share. Typically the margin rate on most CFDs is around 10% this means that with a margin of $1,000 you could potentially gain $10,000 exposure to the price movement of a share. If you were to buy $10,000 worth of shares you would have to outlay the full amount, rather than the $1,000 required to open your CFD position, providing a more efficient use of capital and return on your initial investment.

It is important to be aware that although leverage can work in your favour, it can also work against you, this means that your profits and your losses are amplified however you can also potentially loose more than your account balance. With share trading on the other hand you cannot lose more than the amount paid, however you profit potential is also reduced.

Short Selling
Equally CFDs and shares can be short sold although the process is often easier with CFDs for the simple reason that short sell transactions can be done online rather than over the telephone. The main reason why short selling shares directly is not a simple process is due to short sale reporting requirements which must be disclosed via tagging short trades executed on the exchange. Although CFD providers also have short sale disclosure requirements to meet they are not required to tag short trades for the simple reason that they often pre borrowed stock to cover any short sales, essentially this means that they have covered their clients short positions before the client even places the trade.

Costs of Trading
A common myth in the market is that CFDs are cheaper to trade than shares, however this is not always the case. Financing plays an important part in CFD trading however most traders often forget about this. Without conducting any mathematical calculations as a rule of thumb an AUD $100,000 position will cost you around $25 per night in financing, on this basis if you hold a position open for at least 5 days this is the equivalent on paying $125 in brokerage or 12.5 basis points. Of course if you don’t have the capital it may be worth paying this however if the margin of the CFD is high you should think twice as CFD financing is not calculated on the borrowed amount but rather on the full notional value of the position as such it may be more economical to pay for your position outright and pay a higher upfront brokerage cost.

CFDs can of course be a cost efficient trading tool but this is only when positions are held open for a relatively short period of time however, share positions on the other hand can be held open for as long as you like with only the initial transaction cost payable, this is an important difference to keep in mind.

Despite having to pay financing costs one of the benefits of CFDs is that you are not required to pay any GST on your commission, although a relatively small amount it is worth considering the impact of GST on your trading costs if you are an active trader.

Unrealised Profits
As CFDs are marked to market on a daily basis your profits or losses are also debited or credited from your account daily this is very different to trading shares where profits or losses are only realised at the time of sale. In this regard one of the benefits of CFDs is that you can utilise your unrealised profits without having to close your positions, naturally there is also a downside to this in that your losses are realised on a daily basis meaning that unlike share trading the free equity in your account may decline without you closing positions.  

Only five differences have been touched upon in this article, in later articles we will cover some additional differences between shares and CFDs. In the meantime if you would like to find out more interesting information about share and CFD trading you can download our free CFD guide.

When trading CFDs it is important to choose the right CFD provider. Generally most people look for the best commission rates, reliable trading platform, and widest product range however there are many other aspects of a CFD provider which you should consider.

Firstly, you should create a checklist of the items to investigate prior to choosing your CFD provider:

1. What markets are CFDs offered on?
Some CFD providers only offer CFDs over ASX listed stocks others offer CFDs over stocks listed on many global exchanges. You need to work out what CFDs you intend to trade in your trading strategy and choose a provider that is able to offer the CFDs you plan to trade.

2. Can my CFD provider offer more than just CFDs?
Some Banks, Brokers and even CFD providers can offer CFDs but many simply ‘white label’ the offering of specialist CFD provider to offer CFDs as an additional product next to shares, futures and options. If you trade multiple products you should consider choosing a CFD provided that can service all of your needs at once, however, if you are only likely to trade CFDs, a specialized provider would better suit your needs.

3. What margins and fees do I pay?
All CFD providers have different margin requirements and fees. Generally CFD providers will charge you fees for the following:

• Holding a Position Overnight (financing)
• Exchange Data
• Transaction Fees (commission)
• Trading Platform
• Negative Account Balances

Many people look at commission charges alone without considering the financing cost that CFD providers charge when holding positions overnight. You should look at all charges holistically and take into account that most CFD providers will not pay you as much interest on your free cash as you would get from a bank. 

4. What platform should I use?
Before choosing a provider you should trial a demonstration of the trading platform that they use. There are many types of trading platforms some are very simple and easy to use, whilst others are difficult and complicated. Each any every trader has their own preference and trading style some prefer platforms with advanced charting packages whilst others prefer simple and easy to use platforms. It is important to be aware that some CFD providers charge for their trading platform, in many cases these CFD providers have outsourced their technology and need to pay a third party. It is also very important to ensure that the platform that you use can offer the order types that your trading strategy requires, some platforms do not offer trailing stop-loss orders and others do not offer if-done orders. You should ensure that the platform you chose is suitable for your trading style and can offer you all of the features that you require. 

5. What range of CFDs should my provider offer?
Aside from shares CFDs are offered over a variety of different instruments including foreign exchange contracts, commodities and indices. Some CFD providers do not offer CFDs on all of these instruments. You should determine whether these instruments form part of your overall trading strategy before choosing a CFD provider as this may be a determining factor.

6. What is a spread?
The spread is the difference between the bid and the ask price, typically spreads are only applied to index and foreign exchange CFDs. Crossing the spread is much the same as a paying commission, this is how CFD providers makes money from their clients trading activity. Spreads can vary from provider to provider, much like commission there is not one standard spread all providers charge.

7. What margins should I pay?
Each CFD provider offers CFDs on different margin rates, these can be as low as 1 percent or up to 100 percent. The margin you pay will vary depending on the liquidity of the underlying instrument over which the CFD is based. You should be aware that margin can work in your benefit or against you. Should you choose a CFD provider that offers low margin rates you should carefully evaluate as to whether you wish to use the full amount of leverage offered to you by you by the CFD provider. Low margins should not be the determining factor in choosing a CFD provider but rather you should consider the product range offered by the provider.

8. How long has the provider been operating for?
You should ensure that your provider is well established and can offer you the customer service that as a new trader you will require. You should call up a few providers and experience their service first hand or even visit their office to see their operations.

In Conclusion
As a new CFD trader it is important to shop around and choose a provider that will best suit your trading style, remember not all providers are created equal. Ask the right questions and chose a provider that can allow you to focus on what is really important, that is your trading! 

To learn more about CFDs you can download our free CFD Guide.

The leverage CFDs offer makes day trading attractive, however, before commencing a day trading strategy you should asses the benefits and downside to using CFDs.

Below are some of the benefits of using CFDs in your day trading strategy:

Low Commission
The commission rates on share CFDs are much less than on traditional shares, this means that you can trade more actively for smaller price movements making CFDs extremely cost effective for day traders.

No financing charges
If you do not hold your CFD position open overnight you will not incur any financing charges

Risk minimisation
You are not exposing yourself to the risk of a stock or share CFD gapping up or down overnight as a result of global market movements.

Free cash flow
As you are only holding your positions for a short time frame you are not locking up you cash, this means that when you see a trading opportunity you will have sufficient funds in your account to place the trade.

Although there are many advantages of using CFDs in your day trading strategy there are also some downsides, these are listed below:

Time
As all of your trading will occur during market hours over short time frames you need to monitor your trading screen on a regular basis, this process can be time consuming.

Decision making
As time is of the essence in day trading it is important to have a very good idea about your trading system as you will have to make quick decisions about your trades.

Capital outlay
Day traders focus on profiting from smaller price movements, therefore in order to make large amount of money, it is necessary to start off with a bigger float or use more leverage.

If you have the time, a good intraday strategy and can afford to start trading with a larger float, then day trading may be the right trading style for you. Before rushing out, opening a CFD account and becoming a day trader you should consider the following tips: 

• Trading CFDs is very much like running your own business, however, as CFDs are leveraged, there is a chance of losing more than your actual deposit, using stop loss orders and having a good money management plan will minimize this risk.

• Before starting to trading, ensure that you understand and stick to your trading strategy. You should start by practicing your trading system in a demo account.

• All traders will have both winning and losing trades. Trading a profitable trading system is the most important factor in making profits overall. It is likely that when you start out trading you will have some loosing trades. However, despite the fact that the number of losing trades is often more than the number of winning trades, the size of the winners are generally considerably larger than the losers. In order to make consistent long term profits, you need to properly back test and understand your trading system.

• Measure the performance of your trading system, you need to look at its profits as a percentage of your initial cash float, the maximum historical drawdown as a percentage of your initial cash float, the steadiness of returns, and the profit-loss ratio combined with the win-loss ratio.

• Choose your CFD provider carefully. Each CFD provider offers a different number of CFDs some of which are short sellable and others not. The trading platform each provider uses determines the type of orders that you can use in your trading strategy. You will need to consider all of these issues as they may have an impact when back testing your trading system.

To find more helpful information about day trading CFDs you can download our free CFD Guide.