Understanding CFD Trading - Part 3

Submitted by George Polizogo... on 19 March, 2006 - 09:56

CFDs are a lucrative vehicle for professional market traders to leverage their short and long positions. We seek to understand.

In Part 2: Understanding CFD Trading we had a look at some more basic mechanics of CFDs – Contracts For Difference such as the margin requirements for CFDs and some basic strategies that you can use when using CFDs to trade. In Part three we continue in our venture in looking at further intricacies and specifics in trading CFDs.

When you trade CFDs your position is leveraged which means you are controlling a much bigger underlying amount of value. As a consequence you either have to pay interest to maintain the position or be paid interest as a result of your position. When you have a long position – that is, when you bought into the position, you have to pay interest that is calculated and charged daily to maintain your position. On the other hand, if you have a short position – that is if you sold to enter into your position then you are credited interest. The interest rate you pay or receive is calculated to include a margin above for long CFDs or a margin below for short CFDs in addition to the going interest rate. For example, most dealers have a 2 per cent premium above the overnight cash rate; and currently in Australia (March 2006) our official cash rate is at 5.50 per cent – this means the dealer will be charging you or crediting you 7.5% per annum or 3.5% per annum respectively. So if you held a trade overnight, you would calculate the interest you’ll pay or be credited by multiplying: [Underlying value of CFD] x [Interest Rate + Premium] * 1[day] x 365 [days in one year].

Remember that CFDs allow you to short sell to make a profit if the value of the underlying equity falls. Normally, people recognize that with many things, you can make money on prices appreciating but CFDs as an instrument totally streamlines the whole short selling process. Before CFDs came along your broker would have needed to "borrow" the shares from somewhere to enable you to short a stock or other equity.

Ok, so what happens when you still hold your Contract For Difference during an ex-Dividend date? Well, if you are long, you will receive an instant payment on the ex-dividend date into your account. (Instead of having to wait until the official payment date if you hold the actual underlying stock). On the other hand, if you are short, you will be liable to pay up the dividend and be debited the gross dividend from your trading account.

CFD has opened up multiple markets for traders to practice and enact their masterful trading skills on. Depending on your CFD dealer, you will be able to trade: FTSE 100, WALL STREET, S&P 500, NASDAQ 100, DAX 30, CAC 40, SWISS MARKET, IBEX 35, MIB 30, EURO STOXX 50, NIKKEI DOW 225, ASX and HANG SENG. You have to remember that when trading overseas, the trade will be executed in the local currency. For example in Australia and US it would be Dollars and cents in their own currency and in UK it would be Pounds and Pence. When trading overseas you will be exposed to overseas foreign currency exchange (forex) risks. That is - currency risk becomes a part of your profit and loss considerations as you will be at the mercy of the fluctuations in the forex markets.

CFDs are Contracts For Difference. That is – you and the other party are under contract to provide the difference in the transaction. Therefore, you cannot take or make a delivery of the stock. In other words, you have no right to buy the stock or liable to deliver your stock to anyone. You have no rights to acquire or any obligations relating to the underlying share, compare this with Options and Warrants.

Don’t let this scare you from trading CFDs, but these are super risky financial instruments. Many people have been burnt. Be careful and always trade with a plan. CFDs are leveraged instrument, and the power or leverage can easily work in your favour and make quick profits or against you and make massive losses almost instantaneously. Profits or losses can accumulate quickly, up to ten times faster than non leveraged positions – depending on your leverage multiplier.

Another factor to keep your eye on when trading CFDs are the financing costs for long positions – short positions don’t incur you any financing costs. The financing cost should be a part of your trading plan, as it is a factor that can make or break your profit margin.

Make sure the dealer you are trading with is accredited and holds your account funds in a compliant bank account. Some CFD providers hold their client’s funds in a trust account in your local country.

Trading CFDs is not spread betting. The main difference between CFDs and Spread Betting is that CFD spreads are market determined, while betting spreads are set by bookmakers and therefore tend to be wider.

Finally, CFDs are high risk high return instruments. They are not "set and forget" investments. They are not designed for long term positions. (due to the financing costs) They can get expensive the longer you stay in a position. They are for short term trading, and if you get the markets "right", well the rewards are definitely waiting for you.

George Polizogopoulos is a staff writer for MyShareTrading.com, an information hub for traders: forex, shares, derivatives, CFD's. MyShareTrading.com © 2006 All Rights Reserved.