If you’re an experienced trader or perhaps even just curious about the industry, chances are you would have heard of CFDs. It’s likely you’ve heard about cases of CFD traders losing hundreds of thousands of dollars and if you haven’t, a quick Google search will deliver endless examples of this.
While these cases are extreme, it’s true that CFDs are risky, complex products and are ideally suited to more experienced traders. This guide offers a complete overview of CFDs, including how they're traded, some trading strategies and what risks are involved.
If you already understand CFDs and want to compare trading accounts, you can do this below.
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Disclaimer: Trading in financial instruments carries various risks, and you can lose more than your capital. This article may contain general advice. You should always seek professional advice when deciding if a product is right for you.
What is a CFD?
A CFD stands for contract for difference. A CFD is an agreement based on an underlying asset or financial instrument such as a share, commodity or currency pair. In the contract, you can decide if you believe the underlying asset will increase or decrease in value between the time the contract was initially opened and when it is closed.
It’s important to understand clearly from the outset that at no point do you own the underlying asset itself, nor are you trading the underlying asset either. You own the CFD, or contract, which is provided to you by the CFD provider.
When you open a trade you can choose to either go long or go short. Going long means you expect the underlying asset (such as the share) to increase in value, and going short means you expect it to decrease. If you are correct in your assumption, you’ll be paid the difference in value.
However if you’re incorrect, you’ll owe the difference. You can also lose a lot more than your initial capital because of leverage. We’ll go into more detail about leverage later in this guide.
How are CFDs different to buying shares?
Investing in shares means you’re actually buying the underlying asset. That is, you are buying a share in a company. As a shareholder, you benefit from the capital growth of the shares’ value over time. When you sell your shares, you’re selling the actual asset and your holding in that company.
However, when buying a shares CFD you do not own the shares, you own the contract provided by the CFD provider. You’re simply speculating on whether you think the share will increase or decrease in value without ever owning or trading it. Think of it more like a bet on the share price.
So why trade CFDs?
CFDs allow you to speculate on thousands of financial products and global markets which you may otherwise be unable to access.
You can go long or short, hence you can benefit in both rising and falling markets.
You can usually access free demo accounts, plus charts and trading tools through your broker.
Unlike other types of derivatives, CFD contracts don’t have a fixed expiry date, meaning you can close out your position (in other words, end the contract to realise a profit or loss), when you decide.
What can you trade with CFDs?
Some of the most common markets you can access with CFDs are shares, indices, commodities like oil or gold, metals like copper and forex in the form of currency pairs.
However, you’re not limited to these. CFDs allow you speculate on many more markets like bitcoin and other cryptocurrencies, government bonds and even big events such as national elections. If you want to trade CFDs, you need to fully understand how the CFD itself works as well as the underlying asset. If you have no experience trading shares, for example, it may not be a good idea to buy a shares CFD.
What is margin and leverage?
Traders are only required to put in a small percentage of the trade’s value to open the CFD trade. This is known as the margin requirement, and can be as little as 5% of the full trade value or even less. You could think of this margin as the deposit.
For example, let’s pretend you want to trade Woolworths shares via CFDs, which are hypothetically valued at $10 per CFD. You decide to buy 100 of these CFDs, so the value of the trade is $10,000. With a margin of 5%, you are only required to pay $500 to open the trade.
Even though you only put forward 5% of the value of the trade, you’re entitled to benefit from 100% of the potential gains, as though you had put forward 100% to start with. This is what makes CFD trading attractive to so many people. Still, it’s important to remember that because you’re trading with leverage, the same applies if your trade was to lose. You’d be expected to pay the CFD provider for the entire loss, which could far exceed your initial 5% margin requirement. Plus, you could also be charged a commission on the trade by the CFD provider.
What is a stop-loss?
A stop-loss is a feature that helps to minimise a trader's risk when trading CFDs. Traders can set the stop-loss for a particular price, so when the CFD falls below that price the trade is closed. This helps minimise your losses by closing the trade at a certain point before it continues to decrease in value.
Risks to be aware of with CFD trading
CFDs are extremely risky, complex products and are ideally only suited to very experienced financial traders. Here are some of the potential risks that you should know about before deciding if CFD trading is right for you.
CFDs are complex.
CFDs are very intricate and confusing products. Even if you have a general understanding of what a CFD is, this doesn’t mean you’re ready to start trading CFDs.
You can lose more than your initial capital.
If you gamble on the pokies, the most money you can lose is the amount you put into the pokie machine. This is not the case with CFDs. If you lose a CFD trade you can lose much more money than you started with, meaning you actually owe the CFD provider money, sometimes hundreds of thousands of dollars.
You don’t own the underlying asset.
When trading CFDs all you own is the contract between you and the CFD provider. Therefore you can’t benefit from the capital growth of the underlying asset over the long term.
CFDs depend on how the market performs.
Even though you don’t own the underlying asset, CFDs are still affected by market conditions. This can increase risks even more in a volatile market.
How to decide if CFD trading is right for you
Due to the complexity and high level of risk involved, CFDs will not be suitable for the vast majority of traders. CFD trading could be right for you if you:
Are an experienced trader
Have a strong understanding of not only CFDs but many financial products and markets
Possess a high tolerance to risk, and are not at all risk-averse
Can afford to lose quite a bit of money (it’s not guaranteed that you will, but you need to be comfortable you can afford to lose if you did)
Have some level of legal expertise to understand the complexity of CFDs
Are not interested in owning the underlying assets
Understand the measures available to minimise your risk and are experienced using these tools, for example stop-loss orders
Have conducted plenty of research – trading CFDs is not a decision that should be taken lightly
When you trade CFDs, you never own the actual underlying asset; instead, you bet on its price movements. In short, what you actually purchase is a contract. When you invest in shares, however, you buy and sell the shares themselves.
Some of the underlying assets that you can trade CFDs on include Australian and international shares, indices, commodities, foreign exchange and treasuries.
CFD trading is not recommended for casual investors. Because of the specialised knowledge required and high level of risk involved, this type of trading is best left to expert investors.
Wrong. Because you are trading with leverage, it’s possible to end up losing significantly more than your initial investment amount.
The best way to find a good trading platform is to do plenty of research. As well as right here at finder.com.au, you can find plenty of useful information on blogs, forums and the websites of individual providers. Examine the features and benefits each trading platform offers and open a demo account if possible to try before you buy.
While you can certainly learn useful information at a training seminar run by a reputable financial or training organisation, attending a course is by no means all you need to fully prepare you to trade CFDs.
No, CFD trading is risky and far from a steady investment option. If you’re looking for safe and secure returns on your money, consider other investment opportunities.
ASX exchange-traded CFDs are CFDs that are listed on the Australian Stock Exchange (ASX). With terms and conditions set by the ASX, these are slightly less risky to trade than other CFDs and can be traded through brokers that have been authorised by the ASX. Note that these are no longer offered by the ASX, as of 2 June 2014.
When you buy shares in a company you are usually entitled to dividends, and although trading CFDs means you never actually purchase shares, you can still take advantage of some of the benefits of ownership. When you buy a CFD, your trading account will be credited with a certain amount of money that reflects the dividend amount an ordinary shareholder would receive. When you sell a CFD, your account will be debited a similar amount which will be paid to the counterparty.
No, there is no real minimum limit when you trade CFDs.
The exact process for buying and selling CFDs will vary depending on the trading platform you choose. Contact your trading platform operator for detailed information and instructions.
Yes there is, but this differs between trading platforms. A commonly quoted minimum limit is $5,000.
CFD and share trading glossary
Ask or Ask price. This is the price at which you can buy CFDs
ASIC. The Australian Securities and Investment Commission
Bid or bid price. This is the price at which you can sell CFDs
CFD (Contract for difference). This is a contract entered into by two parties who agree to exchange money according to the change in value of an underlying asset.
Contract currency. This is the currency in which a particular asset is traded.
Dealing. Dealing is when you open or close a CFD position.
Derivative. A financial instrument whose price is derived from an underlying asset.
Going long. When you open a buy position.
Going short. When you open a sell position.
Hedging. Taking an opposite position to reduce the risk associated with an initial position.
Initial margin. This is the minimum deposit required when you wish to open a CFD position.
Leverage. Leverage allows you to trade a larger value asset than the worth of your initial investment. This is sometimes also referred to as gearing.
Open interest. This is the interest rate that applies to all CFD positions that are held open overnight.
Stop-loss. A stop-loss order can be placed when a CFD position is opened and is triggered when the price reaches a specified level. These orders are used to close out positions that have resulted in a loss and aim to prevent further loss.
Belinda Punshon is Finder's corporate communications executive, and previously worked as a writer on home loans and property. She has a Masters in Advertising, Public Relations and Journalism from the University of New South Wales and a Bachelors in Business from the University of Technology Sydney.
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