What is Contract for difference trading?
Wondering what the CFD meaning is, or need tips on how to trade CFDs in Australia?… if so, we can explain!
A Contract for difference (CFD) is essentially an agreement or contract between you and your CFD broker. The contract is to trade the change in price of a financial asset (such as shares, indices, currencies, commodities, etc) from the time you open the CFD contract to the time you close it.
The CFD definition is essentially a tradeable financial instrument who’s price mirrors that of the asset underlying it. It therefore allows for profit or loss to be realised when the underlying asset’s price moves in relation to the open position, without the trader owning the underlying asset. Source: Investopedia – Instead Of Stocks, Trade CFDs … An Introduction To CFD Trading
Introduction To Leverage
CFDs are derivatives because their value is based (or derived from) an underlying asset (such as a share, commodity or market index). Leverage is an aspect that is critical to understand prior to opening any CFD online account. With any leveraged derivative, including CFDs, traders are only required to deposit, via the initial margin, a relatively small percentage of the underlying assets market value to open a position. However, CFD traders receive the same profits, and are exposed to the same losses as if 100% of the price was paid.
When using leverage, small movements in the market can have a large impact on the success of your trades. Profits and losses are magnified, and therefore the risks are also greater. When trading CFDs with leverage it is therefore imperative to understand the risks involved and learn to handle it correctly!
Trade CFDs Online
CFDs provide an alternative, flexible way to trade the price movements of thousands of global markets including stocks, foreign exchange, indices, commodities, binary options and more, without owning the underlying financial instrument. You can even trade CFDs on cryptocurrency now with many providers. Trading CFDs online therefore reduces the capital, and margin requirements, often needed to trade such markets.
With CFD’s, you do not buy or sell the underlying asset (eg physical shares such as ASX CBA or BHP). Instead you buy or sell a number of units (eg 1 BHP share CFD unit may be equivalent to 1 physical BHP share) to take advantage of market opportunities. Because you don’t need to buy the underlying asset, you can benefit from share price movements with a fraction of the capital. Remember, these are leveraged products, so you trade with a margin where you only deposit a fraction of the full cost of the asset.
Unlike other derivative products like options and warrants, CFDs do not have a time limit. You can keep an open position with a CFD for as long as you want to take maximum advantage of the market movements. In the CFD market you are not forced to close a position because of an expiry date.
- CFDs provide additional flexibility in a trading strategy. Traders have the ability to open short positions, in addition to trading long positions as with traditional stock investors. Hence, gains can potentially be made in both rising, and falling markets
- Efficient use of your capital – CFDs give you ‘leverage’ so you can trade without needing to put down the full value of a position. This in turn leaves capital remaining for other investments rather than being tied up in the one transaction
- Can trade a contract for difference to hedge an existing physical portfolio
- No fixed time period
- No time decay factor
- Access a wide range of global markets from one online account
- Contracts for Difference are a complex, highly leveraged financial product. They require a certain level of experience, so may not be suitable for everyone.
Remember leverage can be a double-edged sword as both profit and loss are magnified, therefore risk management is essential!
- Liquidity / Gapping Risk – Liquidity risk is a constant reality of trading on any financial market. Market prices can at times move extremely quickly. This can result in one or more price points being skipped as price moves. This gapping in prices is a key risk when trading CFDs. The high leverage ratios therefore means any gains or losses due to the price gap are magnified. For example, the price of a CFD could fall from $3.71 to $3.60 without trading at any of the price levels in between. If you had placed a stop-loss, short sell order or any market order to sell the CFD at $3.69, your trade may only be executed at the next available sell price, $3.60 (or less) in this case, or possibly not executed at all (if not using a market order type). This ‘gapping’ is most prevalent in times of low liquidity and at the start of trading sessions. This is exacerbated on derivative financial instruments that have a long period closed between trading sessions, such as share CFDs.
- CFD trading carries a high level of risk to your capital and can result in losses that exceed your initial deposit.
Please ensure that you understand all the risks involved. It is imperative to assess, understand and implement a defined money & risk management plan into your overall CFD trading plan.
CFD Trading Strategy
At the core of trading financial markets is the analysis, whether fundamental and/or technical analysis, a trader performs. In particular a trading strategy will generally look for opportunities (higher probability) a market or financial instrument may move in a certain direction. While fully teaching how to trade CFDs is beyond the scope of this page, we have a specific online trading courses page for those interested in further education on how to trade the markets.
In addition, below is a simple hedging strategy particularly useful for equity traders. The principles can also apply to forex trading, commodities, & future contracts to hedge market exposure without liquidating all open positions.
Using A Hedge In The CFD Market
Hedging using the CFD market is particularly useful strategy for periods of market uncertainty or downturns.
For example, your shareholding (physical shares purchased in the stock market) may have appreciated in value over the years. However, you’re concerned the stock market may be about to turn, lowering share prices & wiping out some of your gains. By taking the opposite position and short selling stock or index CFDs, traders can manage potential downside risk. This is achieved by ‘locking in’ existing profit or loss without needing to sell any shares and crystallising a potentially taxable capital gain.
If market prices fall as anticipated, the CFDs will gain, countering the loss in value of the shares. If however, the markets do not fall, then the value of the shareholdings will continue to increase and the CFDs will loose value. Assuming the trader or investor took a short position of similar value to their shareholdings, there will be no net profit or loss. Essentially one trade offsets (hedges) the other. This strategy is a protection mechanism, rather than to profit from falling markets.
These trading strategies help investors control how, and when, to realise the capital gain in a share position/s.
Best CFD Trading Platforms
A trading platform is the system or software a CFD broker uses to allow you to make trades.
When opening an account with a CFD provider, you are generally given online access to their online trading platform. Depending on the type of CFD account, you may also have access to more sophisticated platforms such as IRESS Trader & MetaTrader (MT4 or MT5) trading platforms.
Many CFD provider’s have a demo account where you can ‘test drive’ their online trading platform. These demo accounts are also useful for testing your CFD trading strategies, before opening a live account. On all our CFD provider comparison & reviews we provide links to the brokers CFD trading demo accounts. We highly recommend opening a demo account for each broker you’re considering an account with.
Regulation of Contract for difference Providers in Australia
When considering online CFD trading in Australia, verify the broker is regulated in Australia. Confirm they have a current Australian Financial Services (AFS) licence number, also referred to as AFSL, issued by the Australian Securities and Investments Commission (ASIC).
All financial service providers, including CFD providers, are obliged by law to provide a Product Disclosure Statement (PDS) before you open an account. The PDS not only discloses risks, but complete disclosure of all relevant information required to promote understanding and comparison of the product. This may include but not limited to key product features, applicable fees, risks and benefits, plus complaints handling processes.
If you are considering acquiring any financial product, including a Contract for difference, you should obtain and read the relevant Product Disclosure Statement and any other offer document/s prior to making any financial decision.
If you are unsure of the risks, or have any doubt whether you have sufficient financial resources or experience to trade these leveraged products, you should seek professional advice first.
ASIC Disclosure Benchmarks For OTC CFDs
ASIC has also developed 7 disclosure benchmarks for ‘over-the-counter’ (OTC) CFDs to help traders assess the risks. These include:
- Client qualification
- Opening collateral
- Counterparty risk – Financial resources
- Counterparty risk – Hedging (how the Contract for difference provider manages their market risk)
- Client money
- Margin calls
- Suspended or halted underlying assets
As listed above, the PDS should explain the key features and risks of trading CFDs. In addition, since 31 March 2012 for OTC CFDs, include information about the above disclosure ‘benchmarks’, which can help you assess the risks of the providers products and services. Check to ensure the provider meets ASIC’s 7 disclosure benchmarks.
If they do not meet a benchmark, confirm the explanation of why not!
Choosing A Reputable CFD Broker Best Suited To Your Needs
Successful CFD online trading depends on much more than just choosing the right trading strategies. Finding the best CFD trading platform and reputable, Australian regulated CFD trading provider who actually meets your needs isn’t easy!
You’re also relying on the Contract for difference broker to:
- process all your trades quickly and efficiently during the trading day/session;
- provide all payments to you that are generated while your trades are still open (e.g. notional ‘dividend’ payments);
- credit the proceeds of any profitable trades instantly to your trading account; and
- process your trading account withdrawals in a timely manner when requested.
Use CFD Online Review Sites
There are an overwhelming number of online CFD brokers to choose from. Many of which will have different offerings, platforms, regulation, pricing and the list goes on.
This is where we (Online Brokers Australia) really shine!
We only list the very best, hand-picked and reputable online brokers in each category. If they don’t meet our initial stringent requirements test, or don’t have a key point of difference CFD traders are looking for… we simply won’t list them!
View our compare CFD brokers page to easy review key features of the listed Contract for difference providers. All CFD trading accounts listed show spreads and fees for common financial instruments, plus links to detailed CFD provider reviews.
What Is The ‘Bid-Ask Spread’ When Trading?
The bid-ask spread, often simply referred to as the spread, is the difference between the buy price (also called bid) and the sell price (also called ask). Another way of thinking about it is simply the difference between the highest price that a buyer is willing to pay for the contract and the lowest price that a seller is willing to accept to sell the same financial instrument.
Traders will find the bid-ask prices displayed in their CFD online trading platform, and on the deal ticket when opening a trade. In addition to any commissions, it’s important to realise that the bid-ask spread is also a cost. While it may not seem like a “fee”, it definitely is a cost to traders. I highlight this as many new traders only consider the costs of commission. However, the spread is a more “subtle” cost and can easily add up, especially for active traders!
Understanding CFDs – ASIC Australia Resources
ASIC’s Andrew Templer explains below the concepts of a ‘long position’; ‘short position’ (short selling); leverage meaning; initial margin; and margin calls:
Video courtesy of ASIC MoneySmart
Thinking of trading contracts for difference (CFDs)? – ASIC CFD trading Australia guide
CFD TRADING RISK NOTICE:
Contracts for Difference (CFDs) are a complex, leveraged financial products. They require a certain level of trading experience, so may not be suitable for everyone. CFD trading carries a high level of risk to your capital. Losses can exceed your initial deposit. Please ensure that you understand all the risks involved.
If you’re considering acquiring any financial product you should obtain and read the relevant Product Disclosure Statement prior to making any financial decision. If you are unsure of the risks, or have any doubt whether you have sufficient financial resources or experience to trade CFDs, you should seek professional advice before trading CFDs online.