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.

Compared to short selling traditional shares, CFDs are a revolution for traders who want to make money in a falling market. Short selling with a traditional stock broker is a complicated and costly process, starting with the brokerage. Generally it is charged at full-service rates to short sell. Traders can spend around $75 a trade to enter a short position in a traditional stock. Short selling shares also attracts a higher margin rate. Generally it requires 25% of the value of the underlying position to go short compared to around 5% with a CFD provider. Short selling with a stockbroker is also dependent on the availability of stocks to borrow. If the stock is not available to short sell the position cannot be taken. If the company decides to recall the stock at any time, then the short position is closed out. Short selling a traditional share is also bound by the downtick rule. This means a trade cannot be taken in a stock unless it is the result of an up-tick in the price activity. In a rapidly falling market going short using CFDs has a big advantage, as short selling traditional shares is prohibited.  

There is a famous saying, ‘markets go up by the stairs and down by the escalator’. This means a rise in prices is likely to take longer than the equivalent size of losses. However a market in a downtrend is often subject to sharp rallies also known as the dead cat bounce. A dead cat bounce in a bear market is usually followed by a resumption of the losses. The bear market rally or dead cat bounce can cause, or can be the result of short covering. This is known as a short squeeze and occurs when short traders close out their positions by buying.

All serious traders must be prepared to go short when the market signals the uptrend is over. Every market will enter a downtrend. No stock will rally always and forever, and every bull market is followed by a bear market. A general bear market will provide abundant shorting opportunities. In a bull market there are fewer shorting opportunities, therefore a trader must be more cautious about taking short positions. As a general rule the safest shorting opportunities in a bull market are on the worst performing stocks in the worst performing sector. Traders earn interest from holding a short position. This is a consideration if a trader wants to have a short position for the long term. For example, long term corrections on stocks like Telstra, AMP, Lend Lease provide traders with extra income on top of the profits as a result of the falling price.

Example – short position in Telstra Corporation (TLS)
On 24 June 2010 you believes TLS is in a downtrend and take a short position in TLS share CFDs. You decide to hold the position using a 50c trailing stop loss.

Opening the position

Telstra Corporation is quoted by your CFD provider at $3.13 bid.

You sell 10,000 Telstra share CFDs at $3.13. The total value of the trade is:
$3.13 x 10,000 = $31,300

The margin required to open the position is 10% of the total value of the trade and is calculated as follows:
$31,300 x 10% = $3130.00
    
Whist short you will earn interest on the trade at a rate of 3.24% per day calculated as follows:
$31,300 x 3.25% / 365 = $2.78 per day*
    
*This will vary according to the daily closing price of TLS

Closing the position

Telstra Corporation makes lows of $2.25 in August. A stop is then moved down 50c above this level at $2.75. The market does not go any lower before reaching the level of $2.20 on 24 August.

You now buy 10,000 TLS share CFDs at $2.20. Profit is calculated as:
($3.13 – $2.20) x 10,000 = $9,300

The position earns interest of $2.78 per day for two months:
$2.78 x 60days = $166.80 approx

Your total profit on the trade is:  
$9,300 + $166.80 = $9,466.80 approx*

*should the position have moved against you, you would have incurred a loss on the trade.

You can find out more about how you can use CFDs to short sell in our free CFD Guide.

Benefits of trading CFDs
CFDs are derivative products that offer distinct benefits including:

Liquidity
CFD prices are obtained directly from the underlying market. This means CFDs give you access to the liquidity in the underlying market, plus liquidity offered by the CFD provider. Most of the time there is much more liquidity in the CFD market than in the underlying or physical market due to the higher number of participants including private and institutional traders.

Trade on margin
CFDs are traded on margin, typically from 5-10% to for shares and 1% for indices. This means a more efficient use of your capital as you only need to allocate a small percentage of your funds to secure a trade. This also enables you to magnify the returns on your investment with a much smaller capital outlay.

Trade long and short
Before CFDs, going short a stock could only be done through a traditional broker that would charge hefty fees on top of the normal brokerage. With CFDs traders can now go short any position or market without any extra cost. Going short is as easy as going long with CFDs. Going short also provides another benefit that was not available before. Your CFD provider will pay you interest on a short CFD position. This is similar to earning interest on your bank account balance.

Trade on-line
With an estimated 13.4 million Australians with Internet access online share trading has also been on the increase, giving traders more control and constant access to their positions. Most CFD providers offer free software and CFD trading platforms that allow traders to place orders online even outside normal trading hours.

Low transaction cost
Trading CFDs can cost you as low as $10 each way compared to traditional stock brokerage rates of around $25-30. Although transaction costs are a small portion of your overall trading cost, they have an impact on your bottom line once the volume of your transactions increases.

Access to international markets
CFDs open up a wide range of trading instruments. Most CFD providers offer CFDs on Australian and International shares, indices, sectors, commodities, foreign exchange and treasuries. Most of these markets were not available or accessible to private traders before due to the complex nature or complicated set up of traditional brokerage accounts.

Receive benefits of dividends and stock splits
As CFDs reflect the price and movement of the underlying physical share, they also mirror any corporate actions that take place in the underlying share. This means, if you are a holder of a share CFD, you will also receive dividends and stock split benefits once they become due. However, you are not entitled to any voting rights or franking credits. On the same vein, when you are short a share CFD and the underlying stock goes ex-dividend, you have to pay the dividend amount as you would if you were short the physical share.

To find more helpful CFD trading tips you can download our free CFD Guide.