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What is a CFD?

Posted By Robert On Tuesday, January 14th, 2014 With 0 Comments

A contract for difference is an investment instrument used by active investors to capitalise on their market view. A contract for difference (CFD) is in effect an agreement between two parties to exchange the difference between the entry and exit price of the contract. This transaction, also commonly referred to as a SWAP transaction, concludes with the parties settling the difference between the purchase price and the sale price. As such, a CFD is an agreement between you (the investor) and the broker (the CFD provider) to exchange the price difference of an asset between when you open the CFD and when you close it.

Simply put a CFD is a product that offers traders the ability to take either a leveraged “long” or “short” position without having to take delivery of the underlying instrument. The trader provides a cash deposit (known as initial margin) as collateral. Margin requirements in Australia start from 5% on the ASX top 20 and typically 10% for the ASX top 100.  Other parts of the world are similar with blue chip shares being offered at very low margins to trade.

A contract for difference (CFD) is an agreement between two parties to exchange the price difference of a financial instrument. The profit & loss of a trade is determined by the difference in the entry and exit price of the underlying instrument from when the contract is opened and closed.

A CFD trader has the rights to any profits or losses the CFD position incurs. CFDs are a leveraged product, which allow the buyer or seller to gain full market exposure while outlaying only part of the full notional value of the position.

CFDs therefore offer the potential to incease your return on investment (ROI) by making a higher rate return from a smaller initial outlay when compared to investing directly in the underlying instrument.

Unlike traditional share dealing, with CFDs you can take a view on both rising and falling markets and trade using leverage. There is no physical ownership of the underlying asset with a CFD meaning you do not receive voting rights or dividends. Although share CFDs are traded on the price of the underlying shares, they convey no right or obligation to acquire or deliver the physical shares. CFDs provide an alternative approach to trading the share market. Potentially they offer better returns as well as the opportunity to profit* from short to medium term price rises (or falls), or to hedge against adverse movements in the market place.

Features of CFDs

Leverage

CFDs are traded on leverage, meaning you pay only a small fraction of the total trade value to open your position rather than paying for it in full, this is known as margin trading.

When opening a position you decide the fraction of the price (the margin) you are prepared to invest by adjusting your account leverage. You can choose to pay a margin as low as 1/50th of the total value of the position; however you may be restricted by the maximum leverage level applicable to each provider’s underlying.

Selecting a lower leverage means a higher margin creating a more conservative investment, whereas higher leverage creates a lower margin and a more aggressive investment.

Margin trading is comparable to executing a physical trade financed by a loan. As such, you receive or pay financing costs on open trades.

Leverage can amplify your return; however, your losses are amplified in exactly the same way if the market moves against you and can lead to losses exceeding your initial margin.

Leverage carries additional risk than a direct investment in the underlying instrument. It is important you understand that leverage has the potential to work against as well as for you as using leverage magnifies your trading profits and losses. All CFD traders must be aware that losses can exceed your initial investment.

Go Long or Short

With CFDs you can; go long (buying the market) or; go short (selling the market). Remember whether trading long or short you are trading with leverage. This can amplify your return; however, your losses are amplified in exactly the same way if the market moves against you and can lead to losses exceeding your initial margin.

If you believe that a particular market is going to rise, you can go long. For example if you go long EUR/USD, you buy EUR and sell USD. If you are correct, you can later sell your EUR at a higher price, making a profit. If you are wrong, you incur a loss by selling EUR at a lower price than you bought at.

If, on the other hand, you think a particular market is going to fall, you can go short. For example if you go short EUR/USD you sell EUR and buy USD. If you are correct, you can later buy back EUR at a lower price, making a profit. If you are wrong, you will incur a loss as the EUR price has risen and you must buy back EUR at a higher price.

No Stamp Duty

A CFD is a derivative product, you don’t own the underlying and therefore it is exempt from stamp duty. Tax laws can change and are subject to your circumstances, we recommend you seek independent advice.

Spread

The spread is the difference between the bid (sell price) and the ask (buy price). Whilst the buy price is always higher than the sell price, it is important to understand that the spread will vary between markets and can change depending on market conditions.

The wider the spread, the more the market will need to move in your favour before your trade will be profitable.

CFD Margin

A CFD is a margined product that allows customers to trade larger market volumes proportional to the size of the initial deposit. Margins are calculated as a percentage of the overall value of the trade, typically 10% of the contract value of the underlying shares purchased (or sold).

Participate in Corporate Actions – Dividends/Stock Splits

Just as CFDs are traded on the price and movement of the physical share, they also replicate any corporate actions that take place in the underlying share. This means that the owner of a share CFD will receive cash dividends, and participate in stock splits, just as they would if they owned the physical share. Your account is adjusted to reflect a dividend if you have an open CFD position in the relevant share at the open of the market on the ex-dividend date. If you are holding a long CFD position then any dividend payment due on the underlying share will be credited to your account. If you hold a short CFD position you will be debited any dividend payments. With a CFD you are not entitled to any voting rights or imputation credits.

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