What is CFD trading?

What is CFD trading

A Contract For Difference, or CFD, is an agreement between a broker and a trader to pay the difference in price of a contract between the time it is opened and the time at which it is closed. It is a derivative instrument, which means that the price of a CFD is based on an underlying asset. These assets may include shares, commodities, indices or currencies.

CFDs are an over-the-counter product. This means that they are not traded on an Exchange, and that when you trade with a CFD provider, they are the counterparty to the transaction. However, it also means that you do not have to pay any miscellaneous taxes or clearing fees (unlike with physical shares). CFDs give investors the freedom to use a single trading account to trade shares like Yahoo! or CapitaLand, indices, currencies or commodities like Gold across international markets.  Investors can therefore take positions in rising and falling markets without buying or selling physical assets.

Is CFD trading for you?

CFDs offer all of the benefits of trading shares, indices or currencies without having to own the underlying asset.  Due to the fact CFDs trade on margin, investors only need a small proportion of the total value of a position to trade.
This provides traders with greater leverage opportunities as they enable investors to buy or sell an instrument at a percentage of the price of the underlying share.  This offers exposure to wide and diverse markets at a small percentage of the cost of owning the actual share.

Why trade CFDs?

Over the last fifteen years traders and investors have become increasingly sophisticated and knowledgeable about managing their own finances.  According to Gavin Ward, Director of Asia at CMC Markets Singapore, “CFD trading has increased in popularity as self-directed investors have realised the benefits over more traditional forms of investing.”

Potential to profit whether the market goes up or down

CFDs can be traded whether the price of a financial instrument is likely to go up in value (strengthen) or go down (weaken).  Traders can go long by buying an asset with the expectation that it will rise, just as you would when buying normal shares.  Or short where an asset that you do not own can be sold in the expectation that the price will fall and you can buy the asset back at a cheaper price –which is almost impossible in the ordinary share market.  Therefore CFDs can still be traded whether the market is going up or down. In fact, shorting is often used to hedge physical share positions in volatile market conditions.

A CFD example of a short trade:

The trader believes Company A is overvalued and is going to fall and places a trade to SELL 2,000 Share CFDs at $5.55.  The total value of the contract would be $11,100.  Even though they are selling short, they would only need to make an initial 10% deposit (initial margin) $1,110.
A week later their prediction was correct and Company A falls to $5.45 – $5.46 and they decide to close their position.

The profit on the trade is calculated as follows:

Opening Level:          $5.55
Closing Level:           $5.46
Difference:                $0.09
Profit on trade:          $180 (2,000 x $0.09)

To calculate the overall profit you must take into account any financing charges on the deal, unless you financed the trading position yourself and didn’t use any leverage.

The smaller the margin, the greater your leverage

You are only required to deposit a small percentage of the overall value of the trade and the smaller the margin, the greater your leverage.   Using leverage provides the potential to magnify your profits because it is possible to pay just a small proportion of an instrument’s value yet the profit or loss is the same as owning 100% of the physical instrument. 

However, it is important to remember that any losses are also magnified.  Hence it is vital that risk-management tools like stop loss or take profit orders are utilised to help control your risk.
Minimum CFD margins typically fall between 2% and 20%, providing significant levels of leverage. Some CFD trading platforms allow you to increase or reduce your leverage to provide whatever level of exposure you feel most comfortable with.

For example: To 'buy' the equivalent of 1,000 CapitaLand Share CFDs you would only need to deposit 10% of the total transaction amount you might have to pay if you were buying physical shares from a stockbroker. If each physical share costs $3.00, then you would only need to place an initial deposit of $300 (10% of $3,000 = $300) compared to the full value of $3,000 plus commission and taxes, which is what it would take to complete the equivalent transaction with a broker.
 
Cross-market opportunities

With CFDs, there are thousands of products you can invest in across all the major shares and indices in Australia, the US, UK, Europe and Asia.  Below is a selection of different asset classes and products you can choose from when trading CFDs:

•    Foreign Exchange (Forex) covering different currency pairs from developed and emerging markets
•    Cash Commodities including agricultural, precious metals, industrial metals and energy
•    Global Indices covering most regions including the FTSE100 and the Dow Jones Industrial (DJI)
•    Shares from across the globe – you don’t have to stick with just Singaporean shares

Your capital can go further

Trading with leverage can be an efficient way to use capital – it means you can have 100% market exposure for a fraction of what you’d pay to own physical shares. Of course, this also means it is possible to experience losses that are greater than your initial investment.

Want to learn more?
http://www.cmcmarkets.com.sg/education