Here you can learn about the three types of Contract For Difference (CFDs) available in Australia when you trade stocks.
CFDs are contracts between a buyer and seller that demands the seller to pay to the buyer the difference between the current value of a share and its value when the contract is settled. If the difference is negative, then instead the buyer pays the seller. Many investors like to use CFDs because of their simplicity and they tend to be easier to understand compared to other derivatives.
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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.If you decide to open an account with a CFD provider, you should decide what type of CFD you want. In Australia there are three types;
- Direct Market Access (DMA)
- Market maker
- Exchange-traded
Market makers and DMAs are the most common CFDs both in Australia and around the world, whereas exchange-traded CFDs are provided by the Australian Securities Exchange (ASX).
What is a DMA CFD?
DMA is the term used for electronic facilities, often provided by independent firms, that permit particular investors or financial firms to access liquidity to trade securities they want to buy or sell.
Typically, these authorised firms or investors are usually brokers, dealers and banks that act as market makers. Generally they're a broker or dealer holding a certain number of shares of a particular security (at its own risk) in order to facilitate trading in that security.
By using DMA, the investor can manage its account and trade directly without the intermediation of brokers, dealers, investment or buy side firms. This means that the trader can access the infrastructure of the sell side firms with lower costs and commission.
What are the pros and cons of using DMA as a CFD?
DMA has opened the door to the individual trader who wants to participate in CFDs themselves rather than handing the order and trade to brokers for trading. The individual trader now has the opportunity to bypass the middle man and send the trade directly to the execution desk to finalise and uphold the integrity of the trade.
The benefits you can get from DMA are:
- You can set your own trading goals and change them when you feel it is appropriate without wasting your time contacting a trading specialist.
- You can take more or less risk depending on your past performance or on your trading skills and experience.
- The electronic environment allows fast transactions and fewer price differences or discrepancies than you could experience if you placed an order with a broker or dealer.
- Everything you do is based on your own decisions: you can use more or less liquidity and buy/sell only when it suits you.
- It is a great resource for skilled and experienced traders; if you are a newbie, it's better to contact a trading specialist or financial advisor.
The cons are:
- If you are an inexperienced investor you could risk losing profits or even lose money as you might not be able to read trends in time.
- If there's insufficient trading in the underlying market, you won't be able to open and close CFD positions.
- There is a smaller offer range than with the market maker.
What is a Market maker CFD?
This is a trading company that creates its own market and determines the price range for the underlying asset on which the CFDs may be traded. It creates both the buy and sell price for a financial instrument or a commodity. So if you buy a CFD over a particular asset you are a price taker (not a price maker as in DMA).
The prices, however, do not differ from the market price of the underlying asset.This means you have to deal through a broker or a dealer and do not have access directly to the market as with DMA.
What are the pros and cons of a Market maker?
The pros are:
- The assets gain more exposure as they reach a wider range of markets because of a higher degree of liquidity in the market.
- If you are a newbie, you could get some advice from your broker or dealer on how to invest in these types of CFD.
- Higher liquidity means that you can trade even if there's insufficient trading in the underlying market.
The cons are:
- Higher brokerage and commission fees.
- The risks are more or less the same as those of volatile markets.
- You must accept the price of the trader (even when it sets a higher price than the market: the so-called extra margin or spread).
- The broker has the right to re-quote the prices after submitting an order.
What is an Exchange-traded CFD?
This model allows you to trade CFDs that are listed on the ASX and these CFDs can only be traded through brokers or dealers authorised to trade them. The ASX has also created standardised terms and conditions in order to reduce the risks, as this market is separate. As in the DMA environment, people who trade determine the prices and so are called price makers. The CFD price follows the market price of the underlying asset (even if they are two separate markets).
All the trades are processed, registered and cleared by ASX24, part of the ASX Group. This means that buyers and sellers do not deal directly, but through the ASX24. This reduces the so-called 'counterparty risks'.
A counterparty risk is the risk that the counterpart fails to fulfil its obligations. An example might be that you buy a CFD from XYZ company and then you sell it at a higher price. If your counterpart cannot pay the difference between the exit price and the entry price, you do not make any profit. As you don't deal directly with a broker or seller, the ASX guarantees the obligation.
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What are the pros and cons of Exchange-traded CFDs?
The pros are:
- The counterparty risk is reduced consistently.
- If you are a newbie, you can use the consulting services of your broker or dealer.
The cons are:
- Higher brokerage and commission fees.
- If you are an experienced trader you cannot trade directly. You need to open an account within the brokerage platform.
As you can see, there are a range of possible trading strategies using these different types of CFDs that can you help you achieve your investment goals. Remember to consider your buying power and how the markets are performing before choosing which CFD to use.
