Source: Melbourne Investor Feb/March 2007

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CFDs The New Generation Trading

Source: Melbourne Investor Feb/March 2007

Written by Paul Hill

Pacific Continental

Paul is the Derivatives Manager of Pacific Continental’s new Australian office. Paul has extensive experience in CFDs and Foreign Exchange (FX) having spent a total of twelve years working in Derivatives and financial markets.

 

CFDs The New Generation Trading

What is a CFD?
A CFD (Contracts for Difference) allows you to take a position in a company’s shares without buying or selling the shares themselves. The contract value is defined as the number of shares multiplied by the unit price.

In simple terms CFDs are traded in the same way as conventional shares. Let’s take the example of a conventional share purchase of 1,000 shares in BHP (and for this example say the price of a BHP share is $10), and at the same time consider the similar share transaction with a CFD. In both cases you have control over any potential gain or loss on a $10,000 investment. Both transactions carry the potential upside of the gains from the share price rising and the potential loss of $10,000 if the share price were to fall to zero. For the share purchase, the capital outlay is $10,000 and for the CFD purchase $1,000 (if the margin deposit of the total required was 10 per cent to hold a CFD position
open). With CFDs you also have the added benefit of being able to place a stop loss at any distance away from the price thus removing the risk to lose over a certain amount if the price were to move against you.

When you close out the position, your profit/loss comes from the difference between the opening and closing contract values, hence ‘Contract for Difference’.

As you do not buy or sell the underlying stock you are not obliged to acquire or deliver the physical shares. CFD trades can be placed on most major international markets including the ASX, LSE, NYSE and NASDAQ

History of CFDs

Since their inception in Australia in 2002, CFDs have steadily increased in popularity with the Australian investing public. A few years ago, CFDs accounted for only two per cent of all shares traded through the London Stock Exchange; however, recent estimates show figures rising to 50 per cent of the daily share volume on the London Stock  Exchange. In Australia the percentage of CFD trades is rising yearly and is now estimated to be around 10-to-15 per cent.

When it began in the UK in 1998 most CFD trades were conducted over the phone to traditional brokers. By the time CFDs arrived in Australia the basic online trading platform had been developed. The current trading platforms are sophisticated tools providing many functions that traders need, i.e. Direct Market Access, multiple accounts, charts and streaming news.

Why trade CFDs rather than physical shares?

• Margin flexibility: CFDs are traded on margin which means you can take positions in the market up to 20 times greater than you would with a cash trade and deposit only 5 per cent of the contract value.
• Long or Short: CFDs give you the ability to buy the stock if you are bullish about the market or sell the stock if you feel the market will move downwards.
• Risk Management: The ability to ‘go short’ means that you can fully, or partially hedge your cash stock positions, thus reducing your overall stock market risk.
• No Expiry Date: The contract has no settlement date and becomes effective from the order date.

Dividends

Despite the fact that you do not take physical delivery of the stock, dividends are still applicable. On long (buy) positions you will receive 100 per cent of the dividend, but on short (sell) positions however you will pay out 100 per cent of the dividend if you are holding the position open when the stock goes ex-dividend. The simple way to avoid this is to make a note not to hold short positions on the day stock goes ex-dividend.

Direct Market Access

Direct Market Access is best used by an experienced trader as it allows clients to place orders directly onto the order book with each exchange, as well as allowing clients to trade inside the bid/offer spread.

CFDs are fast becoming one of the preferred ways of trading shares and with the increased range of providers and state of the art trading platforms available it is also one of the easiest to get involved in.