Introduction to CFD’s

Description

A CFD is an agreement to exchange the difference between the entry and exit price of the contract. There is no restriction on the entry or exit price, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first. CFDs mirror the movement and pricing of the underlying share. A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Unlike trading a share, to buy $10 000 of a share using a CFD, you do not need $10 000, only the margin requirement, which could be as low as 3 percent or $300. This gives traders access to leverage, enabling them to amplify their returns (and losses) compared with movements in the underlying share.

Mechanics

Buying shares on margin is similar to borrowing money through a margin loan to buy shares, or buying a house using a mortgage. To own a house, you are not required to have the full purchase price, only a deposit. This deposit is required by the bank to ensure that if they have to sell your house they do not lose money. CFDs offer a similar opportunity to a trader. Most people buy shares for cash, but if you use CFDs, you can place down a deposit, known as a margin. This margin requirement is used to protect the CFD issuer if it has to sell a trader out of a position.

The margin requirement varies from share to share and provider to provider between 3 percent and 80 percent of the face value of the share. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.

To trade long, place an order to buy the CFD. Each provider will use a slightly different method to place orders but if you have bought a share before, it will be very easy to adapt to buying CFDs. To trade short, then place an order to sell the CFD. The mechanics of placing the order will depend on the CFD provider that you are using.

Advantages

CFDs are a revolution in trading. During the technology boom back in 1999, as traders we were discussing the opportunity that the Internet created. The ideal scenario was to have a laptop computer, allowing the trader to be anywhere in the world and trade shares anywhere in the world. CFDs finally make this dream a reality. Before the Internet, information on overseas shares was hard to find and trading them was even more difficult. In addition to this, retail clients were not readily able to short sell shares. Shares had to be borrowed in large quantities and specific rules applied to short sell them. That has all changed with the introduction of CFDs. The world’s markets offer an unlimited opportunity and using CFDs traders can now choose exactly what they would like to trade, when they would like to trade and how much they would like to trade. CFDs offer freedom of choice and a lifestyle that many people dream of: the ability to make money 24 hours a day from anywhere in the world, with minimal restrictions on your daily life.

CFDs versus Shares

The key differences between trading a CFD long and trading a share long are due to the leverage that is employed. The initial outlay is much lower when trading CFDs than when trading shares, even though the face value is the same. Brokerage rates vary depending on the amount of trading that is done. GST is not charged on CFD brokerage, yet is charged on share brokerage. The CFD trade attracts finance charges while it is held, while this does not apply to the share trade. The net effect is a return of 20 times the amount using CFDs over shares due to the leverage that is employed.