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.

The first question that novice traders generally ask is “Why bother?” Portfolio management can be a complex subject and can take a lot of time and energy. Surely it is better to simply concentrate on trading and let the money look after itself?

In an ideal world of course that would be the case. But this is not an ideal world.

Portfolio management allows you to diversify your risk. Poor portfolio management would be to have all your account leveraged in three CFD trades, all long and all in one sector. Should all CFDs drop by only a few per cent, your trading account could be wiped out. A far better method of capital allocation would be to structure your portfolio in similar way to banks. That is to “spread your risk”. 

Some CFD traders would argue that portfolio management is not essential. Many CFD traders don’t even use portfolio management, and they can go on to have long and successful trading careers. However, it is prudent for most novice traders to practice sensible money management. The discipline of portfolio management will help protect you and your CFD trading account from disaster.

One disadvantage of portfolio management is that it is likely to require more capital. A $5,000 account will always find it hard to diversify and allocate capital in a diverse manner. The simple reason for this is because $5,000 is not enough to diversify. 

Before you start you should always consider putting slightly more money into your CFD trading account, this will enable you to diversify your portfolio. This may sound unpalatable, but when you consider who else is looking after your capital for you (fund managers), you would be far better off managing it yourself.

Timeframes
It is hard to rely on one timeframe. Many people describe themselves as “15 minute chart” traders, others as “end of day”. In truth a mix of strategies is what will generally work best. 

Some people are much longer term CFD traders, in fact they are not really traders at all but simply investors. “Buy and hold” is the maxim used by many of these people (often referred to as “buy and hope” by shorter term CFD traders). 

Two of the great longer term investors in history have been WD Gann - who spoke of there being “more money in the long pull” and of course Warren Buffett - who advises anyone not to invest in a stock if they are worried about its price declining 50%.

This timeframe argument actually becomes an issue of trading style more than anything. There are trading styles as diverse as scalping and weekly swing trading that on the same CFD will produce the difference between making 200 trades a day versus 12 trades a year.

The key thing about timeframes is that your optimal timeframe is a personal thing.  What works for one person may be totally wrong for the next.  No single timeframe is right or wrong.  Just go with what works for you.

Risk diversification
When diversifying your risk think global. Do not confine your trades purely to one market. Many of the biggest share CFDs trade large daily volumes overseas (e.g. BHP is traded in the UK as BLT - Billiton).

This is a crucial thing to be aware of. The financial markets trade almost 24 hours a day. You should use this to your advantage. 

Trade while you sleep, with orders protecting your capital and taking profits. If your analysis is correct you won’t need to worry about being awake, trades will run themselves.

Make end of day decisions on these trades, you have plenty of time to analyse the picture, so use it. Do not be lazy. Do your groundwork.

Leverage
Leverage truly is a ‘double-edged sword’. Used wisely it can be the edge that gives you a huge return on limited funds. Used incorrectly and it can obliterate your trading account in minutes. Use it wisely. No good CFD provider wants you to lose. CFD providers offer leverage because they know skillful clients can benefit from it. 

Always remember Rule number 1- You must stay in the game.  It is unrealistic to expect to be making millions after your first few weeks CFD trading it is more likely to take 6 months to 2 years before you become a profitable CFD trader. 

Remember it takes a good doctor at least 5 years to qualify and they still have patients die on them.  There is no reason why learning how to trade should be a 5 minute thing. It just will not happen.

Do not over leverage - make this your mantra. Don’t use leverage just because it is there (Your car has an air bag but you don’t want to use it on every journey, right?)

Used wisely you have a huge advantage with the leverage available to you, but be aware it is like a sharp knife, best used carefully. The more skillful you become, the more you will learn how to use it and that’s what your evolution as a CFD trader will be all about. 

Before you start using CFDs in your trading strategy you should decide whether CFDs are the right financial product for you.

If you are a novice trader you can get some helpful information on trading CFDs by reading 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.

CFD Margin requirements
An initial margin amount is required to open a CFD position, either long or short.  There are two types of margins that are applied to the total value of a CFD position. These are initial margin and variation margin.

Initial Margin
Initial Margin is the initial deposit required to open a position. Generally, for Australian equity CFDs, this ranges from between 5% to 50% of the total notional value of the trade. Hence, if you purchased 10,000 XYZ CFDs at $1.35, you would be required to have at least $1,350 in your account to cover the minimum margin requirement (10% of your total position size of $13,500). The margin requirement for index and foreign exchange CFDs can be as low as 1%.

Variation Margin
Variation Margin is the difference between the initial margin and the margin required to keep the position open as the position value changes. For example if you buy 2,000 XYZ CFDs, at $5.60 it would give you a position value of 2,000 x $5.60 = $11,200. Assuming XYZ is margined at 10% you would need at least $1,120 initial margin to open this position. If XYZ goes down to say, $5.40, you would now have a loss of $400 ($0.20 x 2,000). This loss (known as variation margin) is subtracted from the initial margin of $1,120, leaving a deposit of $720. Since you still hold 2,000 XYZ contracts at $5.40 you have a margin requirement of $1,080 (i.e. 2000 x 5.40 x 10%). There is now a paper loss of $400 and the initial margin has been reduced to $720. This is $360 less than the margin required to keep the position open, which means more margin is needed to top up the account. The shortfall in margin is known as a shortage in equity. If you cannot maintain your margin requirement you will not be able to extend your position however you will always be able to reduce or close a position.

Equity Balances
The equity (or balance) of your account will fluctuate according to the money you have deposited or withdrawn from your account, the profits or losses in your account and the size of the positions held.  During the trading day your account balance, including all open positions, are valued against the prevailing market rate. Therefore your equity balance is constantly calculated in-line or marked-to-market with market movements. Your end of day account balance is calculated using the mid-closing rates (or the last traded price). The equity balance is used to assess your available margin against current positions, and potential new positions you may wish to take. Your cash balance is used to establish if there is a requirement for additional margin deposits on your account. Once a CFD trade is opened, variation margin requirement must always be maintained for your open positions. It is your responsibility to ensure that your account is sufficiently margined at all times, especially during volatile trading periods.  You will only be allowed to trade and maintain open positions on the basis of cleared funds in your account, not on promised funds or funds in transit therefore you must allow sufficient time for funds to clear when depositing money into your account.

If a position goes into profit, the increase in the equity of your account allows for more positions to be opened. 

Shortage in Equity
A shortage in equity occurs when the account balance falls below the required initial margin. Accounts with a shortage in equity are generally only allowed to reduce open positions, until the equity balance is in excess of the required deposit. No new positions can be opened until this situation is rectified.

Margin Calls
If the market moves against you and your equity balance falls below your initial margin you generally have the option to:

i. close one or more of your open position(s), to reduce your initial margin to the required level; and/or

ii. add more money to your account to maintain the initial margin.

This is the first trigger level for margin, referred to as the 'Margin Call', which you must add additional funds to maintain your open positions.

Stop Out Level
You are at risk that your open positions will generally be closed when you have less than 40% of your required initial margin (i.e. 4% of your position size) however this may vary between CFD providers.

Margin, leverage and risk
Margin and the associated leverage can be very useful if you use it correctly. It can also be devastating to the inexperienced trader who has little understanding of the dangers of using leverage without a defined risk management strategy.  There are several ways of using the leverage available by trading CFDs, from the most conservative to the most aggressive. The way in which you use leverage will depend upon your personal circumstances.

Before trading CFDs you should read the Product Disclosure Statement (PDS) that your CFD provider issues as this will explain in detail how your CFD provider deals with margin. 

To understand more about the margin requirements of CFDs and using leverage 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.