The Basics of CFD Trading

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This section is about trading using what’s called a ‘Contract for Difference’ – or CFD.

A Contract for Difference represents the difference between the price when you buy and sell a CFD of a share, index or commodity.

Put simply, a CFD is a contract between a buyer and seller.

The buyer and seller agree to exchange the difference between the price of a share at the opening and closing of a trade.

The CFD is a popular financial tool because it allows investors to buy or sell a contracted number of shares in a given stock at a certain price for any period of time.

There is no physical delivery of a CFD contract.

Nor do you have any of the additional benefits of owning a share, such as attending an Annual General Meeting.

You do, however, take part in dividends and any corporate actions such as bonus shares.

All CFD trading is settled in cash.

Money either flows into or out of your account depending upon the success of your trading.

But before we get into the trading aspect…firsts things first…

What is an underlying asset?

The underlying asset is the price of a CFD stemmed from a physical asset in the market.

This is either a share on the ASX, foreign exchange market, commodity or index.

The price of the CFD will ‘mirror’ the price of the underlying market.

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It’s important to note that CFD traders do not trade or own the underlying asset.

CFD trades simply involve betting on the future price of a particular asset.

Most CFD providers offer a wide range of underlying markets.

All CFD providers have a Product Disclosure Statement (PDS).

Some are more detailed than others.

While the document may appear long, it contains vital information inside.

A reputable CFD provider will have detailed information on costs, markets and trading examples, while also highlighting the risk of CFDs.

Make sure you take the time to read it before you open an account.

This brings me to an important facet of CFD trading that if used correctly can help you make more money with less of your own capital… But should be used with great caution.

How leverage can help you maximise potential profit…

Leveraging means that you use a percentage of your money, with the CFD provider ‘lending’ you the remaining amount.

In other words, when you open a trade, you place a deposit upfront.

Generally, this is a percentage of the total value of the trade.

And the CFD provider will lend the remaining value of the trade.

This is called a ‘leveraged’ position.

For instance, if you put in 5% of your own money to open a trade of the market value, the CFD provider makes up the remaining 95%.

The value in this is that, even though you have only submitted 5%, you are entitled to the same gains or losses as if you had paid 100%.

Different providers will ask for different percentages.

In addition, there are ways to reduce the amount of leverage you use.

However, even though the CFD provider lends you the remaining amount of money to meet the full trade size, you are always responsible for the full value of the CFD trade.

So, what does a cfd trade look like?

Let’s say the current level of the ASX is 5,100 points.

If you believe the market is going to move upwards — that is, trade higher — you would take out a ‘long’ position.

In other words, you’re entering a CFD trade and think the ASX 200 will move higher than its current level of 5,100 points.

Because CFDs are leveraged, you don’t need to outlay a large sum of cash to open a position.

Instead, you place a deposit. 

This is what CFD providers call your ‘margin’.

Most indices are highly leveraged.

It’s quite common to see an index leveraged at 99:1.

If this is the case, that means your deposit — or margin — is only 1% of the value of the trade to open it.

For example, if you wanted an exposure (the total value of your trade) to be $50,000, you would buy 10 Aussie index contracts.

Which means 10 contracts times 5,100 gives you an exposure to the market of $51,000.

With 99:1 leverage, you would pay a margin of just $510, which is 1% of the total value of the trade.

If the index rose from 5,100 points to 5,400 points over the next three weeks, you would have made a significant profit of $3,000 ($300 per CFD x 10 contracts).

This is a very large increase over your $510 investment.

Not a bad return by anyone’s standards!

BUT if you get it wrong, your losses are magnified too.

Say the index falls 300 points, to 4,800.

This means you’ve lost $3,000. Which is your initial investment…and much more.

Get the idea?

This brings me to a vital point…

Understanding the risks of cfd trading.

A golden rule of trading is this:

Never trade with money which you cannot afford to comfortably lose.

You’ve heard it a thousand times — but BELIEVE IT.

The best guard against this is a realistic view of life — not a belief that there is a magical or mystical force at work.

This is science linked with randomness otherwise known as ‘luck’.

CFDs are incredibly risky.

It’s VITAL you understand this.

Your risk is NOT limited to your stake.

Your losses could be considerably more.

Let’s go back to the Australian index CFD trade to show you what I mean.

What you have to remember is that, with any CFD trade you may have, you are always responsible for the total value of the trade.

Don’t let any tiny deposit fool you.

If you take out a $50,000 trade size, you need to be able to back that up if the market moves in the opposite direction of your trade.

Look, that’s an extreme example.

In fact, there’s a good chance the CFD provider would have cut the trade.

But they will hold you accountable for any money owing.

Again, this is why we don’t recommend using 99:1 leverage.

Keep it small.

Before opening any position, ask yourself if you can afford to lose the amount you’re exposed to.

If you can’t, stop right there.

Unlike options, where you generally need to take out 100 contracts at a time, the minimum CFD contract is one.

This gives you the ability to get a feel for trading.

You can start by buying or selling one contract at a time.

In time, when you become more comfortable with leverage, you can buy more contracts.

Make sure you understand the risks you are taking on before you get into investing via CFDs.

AND don’t place trades you don’t understand.

That brings me to the next step…

How do you place a cfd trade?

To place a trade, just call your CFD provider or log on to their trading platform and enter the trade.

An example of a trade goes like this:

Say you want to buy 10 Australian index CFD contracts.

This is called ‘BUYING’ or ‘GOING LONG.’

If you call the CFD provider, you’ll say something like this:

‘This is John Smith member number, 14000014. Can I buy 10 Australian Index contracts.’

The ‘14000014’ is your unique member number allocated to you when you join.

The operator will give you a number like, ‘5100’.

This is the quote number they have just given you for the Australian index contracts.

You agree. And that’s it.

Your trade has been placed.

You will receive a confirmation of your trade.

Remember, most dealers will take the time to help walk
you through a trade.

When you call them, tell them you’re new to this.

Everyone has to start somewhere.

In addition, most CFD providers have extensive online tutorials to show you how to get started with your first trade.

From there you can look at more detailed tutorials.

One or two CFD providers even have a client services team that will talk you through how to place your first trade over the phone.

Take advantage of this information.

It’s there to help you.

And finally, you don’t even have to call a dealer.

Most brokers have online trading platforms that you can use.

And now to the final question about CFD trading…

How much can you trade?

This depends strictly on how much you have deposited into your account.

Of course, it is important to remember that if a bet goes against you, you MUST be able to pay the full value of the trade.

Most of the time, losses will simply be deducted from the Cash in your trading account.

Always make sure you have the money to cover your losses.

Never risk money you cannot afford to lose.

The trades you are allowed to place depend upon your means (income and savings) and the cash that you have available in your account.

Do You Need Any Cash to Start?

Yes.

Here’s why: When you open an account, you will need to make a cash deposit that will be used as security against any trades that you make.

It is important to remember that, when trading CFDs, you can lose more than the balance in your account.

If the market moves sharply against you, the CFD provider will email or call you to ask for additional funds to cover your losses.

You must be prepared to pay the ‘margin call’, as it’s known, or close out your trade and take the losses.

What are the advantages of using cfds to trade?

There are several advantages in using a CFD broker compared to a traditional stockbroker:

You can make small trades — much smaller than the usual minimums allowed in trading shares and futures directly.

You can deal 24 hours a day. Even at 3:00 am!

Most stockbrokers don’t take kindly to being woken at this time of the morning, though!

You can deal immediately.

They quote a price and, if you take it, the deal is done on the spot.

You do not have to wait for the deal to be executed in the underlying market.

Finally, with the exception of share CFDs, there is almost no commission to pay!

They make their money on the ‘spread’ of their quotation.

You should also be aware of something called a ‘Financing Charge’, which is applicable when trading CFDs on shares, sectors and indices (but not on commodities).

Put simply, because you are borrowing funds from your CFD provider in order to trade the performance of an actual share, you need to pay interest to the CFD provider.

Just like when you borrow to buy a house or car.

This is called financing and is usually referenced to a benchmark interest rate.

Finance charges vary depending on the CFD provider.

However, it can be about 2% or 3% above the relevant benchmark interest rate for that country.

Check with your CFD provider to see their charges.

All of this information will be in a CFD provider’s product disclosure statement (PDS).

If it’s not, get another provider.

This information should be clear and disclosed upfront.

Always make sure to read the CFD provider’s PDS.

It contains all the legal information you need to know about CFDs.

Hopefully, I’ve answered all your CFD questions and alleviated any fears you have about them.

Now I’m going to give you a list of CFD providers available to Australian investors. But before I do, please understand that we have no affiliation with any of these brokerages, nor do we receive a commission from them.

You can go ahead and pause the video now to take down these details.

Cheers,

Callum Newman Signature

Callum Newman,
Editor, Profit Watch

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