What are CFDs?
CFD’s are a type of Derivative. Derivatives are so-called as they are ‘derived’ from the underlying value of an asset (such as shares or commodities). Other kinds of Derivatives you may have heard of include Warrants or Options.
Whilst the price of a given CFD contract is directly linked to the price of the underlying asset, when you purchase the contract you do not actually take ownership of any actual shares. Essentially you are betting on the price movement of the underlying share.
Types of CFDs
There are three major categories of CFD’s –
Share CFD – these are linked to an underlying share listed on one of the world’s major exchanges such as the NYSE, FTSE, DAX, CAX or ASX. This is similar to traditional share trading where you are betting on price changes of a particular stock. Most providers give the option of individual shares or Indexes. An example of an Index contract would be – Healthcare Index, Telecoms Index, Energy Index. An Index is basically a basket of key stocks which make up a particular Industry group – often defined by an international ratings agency such as Standard & Poors (S&P)
Forex (Foreign Exchange) – You can also trade currency CFDs. Currency CFDs are always traded in pairs. For example if you go long EUR/USD (don’t worry, I will explain Long & Short soon), this means that you are Long Euro and Short US Dollar.
Commodities – Trading on price movements of major commodities including – Oil, Gold, Copper, Wheat etc.
Why CFDs?
There are several major attractions of trading CFD’s over other instruments –
Leverage
This is a double-edged sword (which is why you will see me include Leverage as one of negatives also!).
CFD’s offer massive leverage compared to traditional share trading and even dwarf the leverage available under margin lending. Depending on the underlying asset, the leverage can be anywhere from 2 times to 100 times! For example, to buy $100,000 of Index share CFD’s, you will probably need a deposit of only $1000
So, using the above case, after a 10% movement in the price of your Share CFD, you have turned your $1000 into $10,000 – a 1000% return!
However, if the market turns against you (for example, moves 10% in the opposite direction), you have now turned your $1000 into a debt of $9000!
Cost & Ease of Entry/Exit
CFDs are cheaper than traditional brokers for executing a trade. Depending on the type of CFD and the provider you will pay around $10 to enter or exit. Certain types of CFDs don’t have a fee to enter – the CFD provider makes their money on the buy/sell spread. This is the difference between the price you could buy the CFD and the price you could sell the CFD. A portion of this gap would be profit for the CFD provider.
Ability to go Short or Long
The simplest way to explain Short and Long is –
If you are Long, you own that amount of the asset (or CFD)
If you are Short, you owe that amount of the asset (or CFD) or you require that asset sometime in the future but do not have it now.
The Wheat market is a great way to explain Short & Long. After harvest, a farmer has 1000 tonnes of wheat for sale. He is Long 1000 tonnes. At the same time, a Flour Milling company needs 1000 tonnes of wheat for their production. They are Short 1000 tonnes of wheat.
So what does this mean for CFD trading? You can make money when the market is going up or down. For example – at the start of the Global Financial Crisis (GFC), if you were bearish (negative about the direction of the market – or put simply, you thought the market would drop), you could go short in various CFD’s to profit from the drop in the market.
Dividends
Dividends are credited to your account immediately if you are Long a stock which goes ex-dividend while you are holding the CFD. When you are Short that stock, you are debited that amount.
Why Not CFD’s?
Leverage
The amount of leverage available when trading CFDs is so large that in the hands of an inexperienced player, you can blow yourself up pretty quickly if you are not careful. It is like putting a novice driver behind the wheel of a Ferrari and letting them drive on a winding mountaintop road at 200 kilometres an hour. I speak from experience. When I first tried CFD trading (and I would consider myself to be an experienced share trader), after making a few thousand dollars pretty quickly, a small correction in the market cost me $9000 in the space of a few minutes (and this was with stop-losses in place – it could have been MUCH worse). Because of the amount of leverage involved, even small moves in the market can be brutal.
Time
CFD trading is not a “set & forget” trading style. You must constantly monitor open positions and depending on which markets you are simultaneously trading, can be a 24 hour a day proposition. If you are type of person who cannot ‘let go’ of their trading when not in front of their computer, CFDs are not for you.
Technical v Fundamental Analysis
Technical analysis is essentially using various mathematical theories to give clues as to where the potential price direction may be. There are far too many to mention here but some of the most popular include– Relative Strenth Index (RSI), Moving Averages (EMA or SMA), Pivot Points, Bollinger Bands etc
Rather than go through all of them, they have been covered better elsewhere. Particularly on Investopedia - http://www.investopedia.com/dictionary/default.asp
My personal take on Technical Analysis is that in some cases, in the right hands it can be helpful – particularly to confirm or repudiate an existing idea you have about a particular trade. There is also an element of it being a ‘self-fulfilling prophesy’. By this I mean, that because so many traders are following the same or similar technical indicators, together they can move the market in a lot of cases. For example – say a particular stock has never been able to break through the $1.00/share mark – if it suddenly breaks through this level, it is a very strong signal for technical traders and they will no doubt all jump on the stock and push it even higher.
I have found the major flaw of pure technical analysis to be that you are at the mercy of broader fundamentals. For example, on the chart you see that WTI Crude (Oil) is looking expensive based on your technical analysis. You therefore decide to short it. Shortly thereafter, a rebel group in
Let me save you some time & money. Essentially, most people new to technical analysis go through the following process –
1. Try various technical analysis techniques
2. Find one or more indicators that seems to be more successful than others
3. Base trading around these indicators
4. Grow to rely to heavily on these indicators
5. Random “Black Swan” (see below*) event occurs
6. Lose a
* A Black Swan event is an impossible to forecast world or market event which renders technical analysis useless. The term was coined by Nassim Nicholas Taleb in his book “The Black Swan”. I strongly recommend anyone to read this book before embarking on any major trading activity.
Fundamental Analysis is what is used in traditional investment and stock picking. Essentially you are making a decision based on the general information you have (or ‘fundamentals’) of a company. For example, if a company announces that they are raising their forecast earnings and you decide they are attractive because of this, this would be “fundamental analysis”. Again, this method is also at the mercy of random events. You can buy a promising company on the basis of solid fundamentals and then a single, unforeseen event can wipe out the company.
Which CFD Provider?
There are a multitude of different CFD providers, each with their respective positives and negatives. I don’t want this guide to be an advertisement for any particular provider so will leave that advice to other sites.
The two dominant ones (especially in the
The two key factors which should drive your decision are –
Cost of Entry – Low fees
Small Spread – The larger the spread, the more the market has to move before you break even or make a profit
Advice, Tips & Strategy
- Have a rigid trading plan & strategy which you stick to with discipline. Without this, you are simply gambling. You may as well just go to the race track & blow your money. Your plan should include –
- Position sizing – how much are you willing to risk on each trade? This amount needs to be enough that you can make money but not too much that you can get wiped out if a couple of trades go against you
- Stop Losses – A stop loss is basically a pre-determined level at which you will exit the trade to protect your capital. For example, you buy a stock at $1.00 and you decide that if it drops to 90c you will sell. In this case you have realized a 10c loss but have protected yourself from further losses. Stop losses are EXTREMELY hard for novice traders to follow because the natural reaction is “Well I thought it was good value at $1.00, at 90c it is even better value so I should buy more” or “It will go up again so now I will just hold it as an investment stock”. There is a saying in trading “cut your losses and let your profits run”. The best way to explain this is – say you decide that you will have a 5% stop loss (so if your trade moves 5% against you, you will automatically exit). If you have 100 trades over a certain period and say, based on pure chance you had 50 profitable, 50 losing – if you cut the losing trades quickly and let the winning ones run (ie – don’t sell out immediately) – you will be ahead in the long run based on typical probability (however, the previously mentioned “Black Swan” can render even this theory useless!)
- Leverage – don’t use so much leverage that a small movement in the market will trigger the dreaded Margin Call. A Margin Call is when the provider contacts you because your equity has dropped below a threshold of safety – usually the result of a sudden move in the market against you. You will then either have to exit out of positions or put more money into your account. My advice here is simple, don’t use Leverage to the extent that a sudden change will make you a forced seller of your CFDs. Leave plenty of room for drops – trust me, you will sleep better at night.
- Have a robust system for deciding when you take your profits and exit the trade – don’t be greedy – set a reasonable level and exit with discipline. Too many times I have broken my own rules and waited too long to exit a trade because I got greedy – invariably it then crashes back to earth – taking all my profits with it!
- Psychology, Psychology, Psychology – this is the single most important factor. If you are the type of person who gets upset when their stock portfolio drops or they make a small loss on a share trade, CFD’s are NOT for you. It takes a certain degree of dispassion and level-headedness to succeed in CFD trading. CFD trading uses “Mark to Market” system – this means that your performance is monitored in real time – so every dollar you win or lose is right in front of your eyes. With traditional shares you are shielded from this to an extent.
- Pairs trading – if you are interested in CFD trading but don’t like the idea of sudden market moves either making you rich or poor, pairs trading is a good idea. In fact, I would recommend pairs trading to anyone starting out in CFDs because it gives you a relatively less volatile environment to fine tune your strategy. Essentially pairs trading in share CFDs is picking two stocks which tend to follow each other in movements over the long term. You then go Long the one you think is undervalued compared to the other and go Short the other one.
Here are some possible pairs trading combinations –
BHP Billiton/Rio Tinto
Royal Dutch Shell/BP
Johnson & Johnson/GlaxoSmithKline
The benefit of this strategy is that, generally, if there is a broad market correction or jump, you will be protected. However the down side is that it is a much slower way to make money.
- Don’t trade just for the sake of trading – if there are no trades which meet your criteria, be patient and wait until there are
- When you wake up in the morning, if you are nervous about what the market will do today, you are doing something wrong. For example, when I first started out in CFDs I remember being completely leveraged to global markets recovering. I would panic each morning hoping that overseas markets did not drop overnight. This is a sign that you do not have a robust trading plan in place which can absorb daily market fluctuations.
- Have realistic expectations – making a living from trading is shrouded in myth and false expectations. The common image is of someone waking up at 10am, putting a couple of trades on then spending the rest of the day on their yacht. The reality is more like a haggard, unshaven ghostly figure with no friends who can’t get candlesticks out of their head. Trading can be an extremely psychologically unhealthy pursuit. If you have any underlying issues such as – Anxiety Disorder, Obsessive Compulsive Disorder or Schizophrenia, please do not harbour ambitions to become a trader – it is not the right career for you. Sometimes I think the perfect trader is a sociopath, completely detached from all emotion.
- One of the most frustrating things you will probably find is that, in general your losses make you feel worse than your wins make you feel good. For example, you may find that a $1000 loss puts you in a bad mood all day however a $1000 win doesn’t necessarily give you the equal and opposite reaction. Humans have a weird inbuilt negative bias which served our ancestors well as it helped them survive, but doesn’t help the modern-day CFD trader!
- Tax implications – this will depend on the country you are in however here is some basic information –
The ATO has the following guide –
http://www.ato.gov.au/businesses/content.asp?doc=/content/21749.htm&page=7#H7
The ATO has provided a ruling that says – gains or losses from CFD trading are to be on the revenue account, not a Capital Gains Tax (CGT) event. This means that if you make losses from your CFD trading they will be an ‘allowable deduction’. If you make a profit, it will be included in your taxable income. This is pretty easy to do yourself in ETAX.
Here is the ATO ruling –
http://law.ato.gov.au/atolaw/view.htm?docid=TXR/TR200515/NAT/ATO/00001
Please note I am not an accountant and this is just general information – please seek advice from your accountant or financial advisor.
Conclusion
I hope you have found this Introduction helpful and informative. It is by no means an exhaustive coverage of all aspects of CFD trading but hopefully it gives you a taste of what to expect. My intention is for this guide to neither recommend or advise against CFD trading – it is a completely individual decision. You could either make your yearly salary in 1 day or send yourself bankrupt. It all comes down to your trading plan…..and a little luck (or lack of!).
