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Introduction to CFDs

CFDs for beginners

This is the first in a two part explanation on the basics of CFDs and how they can be traded. To ensure your understanding of terms used in this page, please refer to the Glossary.

Risk Management

Risk Management

Risk management will play a major role in any successful trading plan. If you use a trading method that allowed you to be successful the majority of the time you would assume that you would be profitable right? What would happen if your average losses were 60% bigger than your average wins?

Despite the fact that more of your trades are profitable, the fact that your losses are larger would result in your account going backwards especially when you factor in transaction costs. This illustrates that the key to trading success lies not in achieving a greater number of profitable trades but in intelligent position sizing, management of your trading capital and risk management. Careful consideration given to these factors can ensure you are not over exposed to the market and that any losses incurred are kept relatively small.

As a side note, you should recognise as early as possible that losing trades are an inevitable part of trading. As a trader we always aspire to increase the number of profitable trades and minimise the number of losing trades but the truth unfortunately is that there are too many factors influencing share prices at any given point to predict the outcome of a trade with any real certainty. Rather than focusing on a futile aspiration of trying to maximise profitable trades it is advisable to instead focus on perfecting the things that you have a very high degree of control over. This, in simple terms, means controlling your risk.

Risk management plays such a crucial role in trading success because it allows you to protect your capital. It is essential that you know your stop-loss levels prior to entering a trade. It is best to know your exit price in advance for a number of reasons. Firstly, it is a critical element in the position sizing methodology discussed previously. Secondly predetermining your exit level allows you to make a decision when you have no capital at risk. You may have found in the past that it can be very difficult to make a trading decision whilst you have a position open. This is because decisions can be influenced by your emotions. Instead of this, if you predetermine your exit level and ensure you exit at your predetermined price you should find the whole trading experience much less stressful.

In order for this model to work we need to know three things; our entry price, our exit price and our available capital.

What is a CFD?

What is a CFD?

A CFD is an agreement between two parties to exchange the price difference of a financial instrument. The profit and loss of a trade is determined by the difference in the entry and exit price of the underlying instrument from when the contract is opened and closed.

CFDs are a leveraged product, which allow the buyer or seller to gain full market exposure while only outlaying part of the full notional value of the instrument.

CFDs therefore offer the potential to make a higher return from a smaller initial outlay compared to investing directly in the underlying security.

Leverage usually involves more risks than a direct investment in the underlying instrument. It is important you understand that leverage has the potential to work against as well as for you as using leverage magnifies your trading profits and losses.

A full list of CFDs offered by FP Markets is available here.

Advantages of Trading CFDs

Advantages of Trading CFDs

CFDs have been used by professional investors for over twenty years and emerged first in the over-the counter (OTC) or equity SWAP market. Equity swaps were used by institutions to cost effectively hedge their equity exposure.

CFDs have become one of the most popular derivative products in the Australian and European financial markets.

The popularity of CFDs has been driven by:

  • Leverage: CFDs enable you to obtain full exposure to a share for a fraction of the price of buying the underlying instrument. CFDs require only a small initial margin as a trading deposit.
  • The ability to go ‘short’: CFDs allow you to sell shares you don’t own. This enables you to profit from falling share prices.
  • Low transaction costs: CFD providers pass on volume discounts allowing you to benefit through lower transaction costs.
  • Hedging: CFDs allow you to employ more advanced strategies such as hedging to protect your existing share portfolio.
  • Simplicity: CFDs mirror the price of the underlying instrument, unlike other forms of derivatives (i.e. futures).
  • Dividends and Corporate actions: CFDs allow you to benefit from dividends or bonus issues which may occur in the underlying instrument on which the CFD is based.

CFDs provide all the benefits of share trading combined with added advantage of being able to utilise your unrealised profit, and only outlay part of the full notional value of your position.

Key Features - Margin

Features of a CFD – Margin

To gain a thorough understanding of the mechanics of CFDs it is important for you to become familiar with the key features of the product.

Margin

CFDs are traded on margin and there are two different forms of margin that may be payable when trading CFDs – Initial and Variation Margin.

Initial margin

An Initial Margin is a deposit used as collateral to open a CFD position. The margin is held to ensure you can meet your obligations. A margin rate is expressed as a percentage and is calculated based on the liquidity and volatility of the underlying security. Margin rates typically range between 3% – 100%. The margin requirement of a CFD position is calculated using the “mark to market” concept. This means that the current value of your position is assessed during each trading day. The margin required is adjusted to reflect the current market value of the position as the price of the underlying security fluctuates. Additional margin amounts will be payable should you fail to maintain the required margin on your position.

Calculating your initial margin

Quantity x Price = Full Notional Value
1000 x $10 = $10,000
Full Notional Value x Margin Percentage = Margin Required
$10,000 x 5% = $500
Your Initial Margin is $500.

Variation margin

In addition to the Initial Margin required to open to hold a CFD position, you may also be required to pay an additional margin incurred by an adverse price movement in the market, this is known as Variation Margin. The Variation Margin is based on the intraday marked to market revaluation of a CFD position.

For example, if you have a long position and the price falls then you are required to pay a Variation Margin. The Variation Margin is a percentage of the total position size and the amount required will cover the adverse movement in the value of your position.

On the other hand, if you have a short position and the price falls, you would receive a Variation Margin equal to the positive movement in the value of the position.

Failure to pay a Variation Margin call can lead to the position being compulsorily closed out. You as the position holder are obliged to pay for any shortfall in funds if Variation and Initial Margins are insufficient to cover the shortfall.

Payment of margins

Margins are calculated on an intraday basis to ensure an adequate level of margin cover is maintained. This means that you may be obliged to pay more if the market moves against you. If the market moves in your favour, your margin requirement may be reduced.

Margin payments are usually required within 24 hours of being advised; in some circumstances margin call payments may be required on shorter notice. If you do not pay in time, your CFD provider can take action to close out your positions without further reference to you.

Key Features - Financing

FINANCING

Financing is the daily cost incurred for holding an open position overnight. The financing rate is applied to the full value of your position and paid or received daily on long and short positions. If you hold a long ‘buy’ position you will be required to pay a financing charge, if you hold a short ‘sell’ position you will receive financing income.

Financing rates are calculated by your CFD provider by adding or subtracting a margin percentage from the RBAIOCR (Reserve Bank of Australia Interbank Overnight Cash Rate) and dividing the resulting amount by 365, representing the number of days in a year. The resulting percentage is then multiplied by the full notional value of the position to give you a daily financing rate.

Calculating The Financing Rate

RBAIOCR + Margin (long position) / number of days in year = Daily rate
(4.5% + 2%) / 365 = 0.0178%

Full Notional Value x Daily Rate = Daily Financing Payable
$10,000 x 0.0178% = $1.78

Your nightly financing rate is $1.78.

In the case of a short position you would receive the financing rate. In the calculation above you would simply subtract the margin from the RBAIOCR rate.

Key Features – Commission

Key Features – Commission

CFD commission is calculated based on the full notional value of the position with a minimum charge. Commission rates will vary between CFD providers.

CALCULATING YOUR COMMISSION

Full Notional Value x Commission rate = Commission charged
$10,000 x 0.10% = $10

Your commission charge would be $10.

Key Features – Leverage

Leverage

Leverage or gearing is like borrowing, it allows you to increase your potential return on a trade as you are able to increase your exposure whilst only contributing a fraction of the total value of the position.

Products such as shares are not leveraged and have a leverage ratio of 1:1. CFDs can have leverage ratio of up to 33:1 meaning that every $1 invested has the effect of multiplying the profit or loss by 33.

Leverage example

You deposit $10,000 in your CFD account and hold five CFD positions that are each worth $10,000 (your total exposure is equal to $50,000), you have leveraged your initial capital by five times (or 5:1) leverage.

In the above example your maximum loss could be $40,000 in addition to your $10,000 initial deposit, however this would only occur should all of your five CFD positions fall to a zero value, this is highly unlikely but it illustrates the potential downside of using aggressive leverage.

To further illustrate the potential dangers of leveraging too aggressively we will look at another example which is something of a worst case scenario. If you decided to open the largest position possible using your available capital, assuming you are trading a share CFD with a 5% margin rate you could potentially open a $200,000 position. In this case it would take only a negative price movement of 5% in the underlying share price to completely eliminate all of your trading capital. A movement of 5% is well within the realms of possibility and could happen on a single trading day.

This example highlights that the higher your leverage ratio the more susceptible you are to adverse price movements. This example also highlights that employing a high  leverage ratio means that all or the majority of your capital is tied up in maintaining your margin.

A small negative price movement will require the payment of additional margin, and you will need to deposit additional funds to cover the additional margin requirement. This is known as a ‘margin call’ and happens when you have no free equity in your trading account.

The leverage ratio you use should depend on your experience. If your initial trading capital of $10,000 grew to $20,000 then the same 3:1 leverage ratio would allow you to gain exposure to the value of $60,000 rather than the original limit of $30,000. Successful trading and capital growth will allow you to increase your market exposure while employing conservative leverage levels. Experienced traders who watch the market closely can use higher levels of leverage.

If you have additional trading reserves readily available, higher leverage ratios could be employed. You may have $30,000 allocated for trading in a separate account but hold only $10,000 in your trading account. You could consider leveraging the total $40,000 capital at 3:1 allowing you to gain market exposure of $120,000. If you employ this strategy it is important to monitor your CFD account closely to ensure you do not fall into margin call due to lack of free equity in your CFD account.

Key Features – Margin Call

Margin Call

Trading CFDs requires you to monitor three important values to assess the balance of your account, the deposit required to maintain your positions and the trading resources to take new positions. These values are referred to as Gross Liquidation Value (GLV), Initial Margin (IM) and Free Equity (FE). Your GLV and FE will decrease if your CFD position(s) move against you. A margin call occurs when your GLV falls below your Initial Margin or the amount you have in the account. Should this occur you must either close one or more of your open positions to reduce your initial margin requirement or deposit additional funds to fund your account.

Relatively inexperienced CFD traders should use a leverage ratio of 3:1. This level will allow you to gain additional market exposure whilst limiting the effects of any adverse market movements. The table on the opposite page illustrates how your maximum exposure amount changes as your equity fluctuates. The Gross Liquidation Value (GLV) is the total value of your account, irrespective of margin requirements. GLV is sometimes referred to as your Total Equity. This is the amount of capital in your account if you were to have no positions.

Gross Liquidation Value (GLV) Leverage factor chosen Maximum exposure
$3,000 3 $9,000
$4,000 3 $12,000
$5,000 3 $15,000
$5,500 3 $16,500
$6,000 3 $18,000
$8,000 3 $24,000

 

The table below illustrates the impact of a 30% adverse price movement to the share price of each CFD position on your account. The unrealised loss on the positions is $4,500 which has reduced the value of the account value of the account to $500 GLV.

 

MARGIN CALL EXAMPLE

In this example we assumed you started with $5,000 capital in your account and you have three open CFD positions which have different margin requirements.

Currently the total margin requirement is $1,000 therefore the trader has $4,000 of Free Equity available to purchase CFDs. If we look at the total exposure in the market it is actually $15,000.

 

CFD Share CFD price Number of CFD held Margin required Margin used Exposure
ABC $25.00 200 5% $250 $5,000
XYZ $10.00 500 5% $250 $5,000
SST $5.00 1000 10% $500 $5,000
Total $1,000 $15,000

 

GLV $5,000
Initial Margin $1,000
GLV $4,000

 

The table below illustrates the impact of a 30% adverse price movement to the share price of each CFD position on your account. The unrealised loss on the positions is $4,500 which has reduced the value of the account value of the account to $500 GLV.

 

CFD Share CFD price Number of CFD held Margin required Margin used Exposure
ABC $17.50 200 5% $175 $3,500
XYZ $7.00 500 5% $175 $3,500
SST $3.50 1000 10% $350 $3,500
Total $700 $10,500

 

GLV $500
Initial Margin $700
GLV $(200)

 

As shown in the previous table the account has fallen in to a Margin call since the Initial Margin is $200 greater than the GLV or funds in the account. As soon as this occurs you would receive a request to top up your account immediately, or be at risk of part or full closure of your positions.

CFD Trading Examples - Going Long

Going long and making a profit

‘Going long’ is simply buying a CFD position to profit from a share price increase.

The difference between the entry price and the exit price is the profit or loss that is made on the trade. The example below compares the Return on Investment (ROI) on identical CFD and share trades. This comparison illustrates the similarities between CFDs and shares while highlighting the fact that CFDs have the ability to greatly increase ROI.

Amy and Steve purchase 500 BHP Billiton shares, the shares are currently trading at $35 a traditional share position would require an outlay of $17,500. BHP CFDs have a margin rate of 5%, the margin required to open the position is $875. Steve opens a $17,500 share position and Amy opens a $17,500 CFD position. Both traders are charged 0.10% commission.

The table below illustrates the outcome for both Amy and Steve if the underlying price of BHP rose to $36.00 the following day.

 

CFDs Shares
Dayhone Amy Steve
Opehing Purchase Price $35 $35
BuyhQuantity 500 500
Comhission Paid 0.10% $17.50 0.10% $17.50
GSTh $0 $1.75
Tothl Exposure $17,500 $17,500
CFDhMargin – 5% 5% $875
Inihial Outlay $892.50 $17,519.25
CFD Trading Examples - Going Short

Going short and making a profit

‘Going short’ is simply opening a short ‘sell’ CFD position to profit from a share price decline.

Amy believes Qantas Airlines (QAN) will release lower than expected profit figures and she expects the share price to drop in response. Amy places a sell order for 10,000 QAN shares at the current market price of $2.50. The margin rate on QAN is 5% so $1,250 is required as margin to open the position. The trade is placed and Amy holds a short QAN CFD position.

When opening a short position you have received a cash payment for the full value of your short position and receive interest on this amount at the RBA rate minus 2% pa. The overnight interest rate is calculated by dividing the per annum applicable interest rate payable by 365 (days per year).

The table below demonstrates the outcome of the trade assuming that the price of QAN falls by 10 cents to $2.40 the following day.

Please note we have not compared this trade to an identical equity trade due to the limitations with short selling physical shares.

 

Opening Short Qantas Position
Price $2.50
CFDs sold for $25,000 exposure 10,000
Total Exposure $25,000
Commission (0.10%) $25
Margin Requirement $1,250
Initial Outlay $1,275
Closing Short Qantas Position
Price $2.40
CFDs bought to close position 10,000
Position sized closed $24,000
Commission $24
Total outlay $1,324
Financing Received at 2.5% pa based on RBA rate of 4.5% [($2.45 x 10,000) x (RBA – 2%)]/ 365 $1.68*
Gross Profit $1,000
Net Profit (Gross minus trading cost + financial received) $952.68
Return on outlay excluding cost of trade 71.95%
CFD Trading Examples - Scalping

Scalping

Scalping is a trading style that is particularly suited to CFDs due to the greater flexibility and lower transaction costs of CFDs. Scalping involves placing multiple trades throughout the trading session with a very short term focus. The aim of scalping is to frequently take profits from small price movements. Trades are often exited shortly after becoming profitable.
The time frame for scalping trades is intraday and ideally within a few minutes. This style removes the risk of holding positions overnight. With the holding time for scalping trades being so short this style reduces the likelihood of significant or large losses from adverse market movements.

Scalping is a trading style that allows easy entry and exit and allows profits to be made in all market conditions. Opportunities for short term trades occur in all market periods and during varying levels of activity.

The potential effectiveness of scalping lies in the fact that it is easier to catch small price movements of a stock such as $0.10 than to catch larger less frequent movements of greater than $0.50.

There are different approaches that traders take when scalping depending on the characteristics of the market and the stock itself. Large liquid stocks allow scalps to be made.

Traders use the leverage of a CFD to buy or sell large numbers of shares without having to outlay the full amount to profit from very small movements. An example of this would be to purchase 10,000 shares and to sell for a 3-5 cent profit. Assume you purchase 10,000 share CFDs at $5.00 and then sold at $5.03. The small movement of $0.03 provides a $300 profit (minus commission costs). Similar trades would be entered a number of times throughout the day with small profits continually being taken.

Scalping trades can be made on both long and short trades. If employing this trading style it is important to maintain your discipline and adhere to your exit rules and ensure trades are held for a short term. The risk reward ratio for scalpers should be adjusted to be closer to 1:1 as position sizes and exposure is larger and slight price movements are compounded by frequent trades into larger profits.

CFD Trading Examples - Pairs Trading

Pairs Trading

CFDs allow traders to gain access to a strategy that involves matching two stocks against each other; one through a long and the other a short position. Often opportunities to pair two stocks together occur when a divergence in price of similar shares in the same sector arises.

When a pair’s trade is opened a hedge is created so profits are made on the movement in price of the long position verses the short position. The offsetting nature of this removes the impact of overall market or sector movements. If the overall market was to move in a particular direction the trader should not be impacted since a gain or loss would be offset.
The strategy is simple to construct and is relatively low risk as it is market neutral.

As two stocks are played against each other, risk is limited. Profitability is based on stock selection and not overall market movements.

The strategy is most successful when two highly correlated shares are matched. Finding suitable stocks can involve either fundamental or technical factors to measure correlation and divergence. Historical data can be used to indicate a mean price or comparable ratios such as Price to Earnings. From this information a trader can attempt to profit from being long in the share that is below the mean or underpriced and short the share that is above the mean or overpriced. Profits can be made on both positions if the shares revert to the mean or converge.

Pair’s trades are simple and also inexpensive. The offsetting positions reduce overnight financial costs as the short position generates revenue that can be used to cover the cost of the long. To reduce costs and mitigate risk the position size for each trade should be hedged and matched equally. Although this is a low risk strategy it is possible for stock specific factors to cause the divergence to widen resulting in losses on both positions. Traders should maintain stop-losses on both positions in case the stocks drift apart rather than come together.

An example of shares that may be suitable for pairs trading is selecting two highly correlated stocks such as National Australia Bank and Commonwealth Bank. Traditionally both stocks should move together as their businesses are similar.

Factors That Affect CFD Prices

Factors that Affect CFD Prices

Share and Share CFD prices are affected by a number of variables. Key factors that may play an important role in determining share values are:

  • Earnings and other fundamentals
  • Dividends
  • Economic announcements
  • General shifts in market/sector strength

Earnings and Other Fundamental Numbers

It is largely company performance that drives share prices. If you buy a share, then you buy a slice of the company, a slice of its successes and failures. A company that performs well attracts more interest in its shares. Interest translates to demand, and demand translates into higher prices. The converse is true for a company that performs disappointingly.

To determine company performance, traders and analysts examine several fundamental figures (i.e. numbers derived from a company’s balance sheet and income statement). A company’s earnings – the amount it makes after paying its expenses – is typically the most important of these. Yet there are other fundamental numbers such as the return on equity (ROE) and the price-to-book ratio that present traders with an indication of the overall health of a company. There will be more about company fundamentals in coming weeks.

Dividends

Companies can do two things with profits: they can keep and reinvest them or they can pay shareholders a dividend. Dividends are per-share payments so if a company with 1,000,000 shares issued pays a $5,000,000 dividend, each share receives $5.

Traders value dividends highly because they represent regular cash returns on investments. Since dividends are prized, a company can boost share value by boosting its dividend (though investors will want to see that the company can afford this generosity). Companies increasing dividends generally enjoy stock-price increases, whilst the converse is equally true. Despite this, fewer companies pay dividends nowadays and instead retain earnings to reinvest in the company. In such cases, an investor who needs regular income is forced to sell at least some shares or invest, instead, in companies that do generate dividends.

Dividends on Share Positions

Shareholders of companies that pay a dividend will receive the dividend in their preferred method ie reinvested or a direct credit to their nominated account. To be entitled to a dividend a shareholder must have purchased shares before the ex dividend date.

Dividends on CFD Positions

When dividends are paid on underlying shares, holders of long CFD positions qualify for dividends. Holders of short CFD positions have to pay an amount equal to the full (gross) dividend paid on underlying shares.

Cash dividends are booked on ex-date to reflect market price movements on the ex-date. Dividends on CFD positions are cash adjustments paid or debited by First Prudential Markets and not by the underlying company. Dividends paid on CFDs are not eligible for franking credits associated with dividends paid on physical shares, so may differ from the dividends payable on underlying shares.

Economic Announcements

Economic announcements, usually released by governments and other large groups, include interest rates, gross domestic product (GDP), unemployment figures etc. They often affect the economy as a whole, not just an individual company. Such news may well be important to you as a trader, but you should not miss it because it is scheduled months in advance. Traders know a year in advance when the U.S. Federal Open Market Committee (FOMC) will meet to discuss interest rate changes. Likewise in the UK and Australia, the government’s budgets and mini-budgets are scheduled well ahead of the actual events. This gives you plenty of time to research the likely content of announcements and position your portfolio accordingly.

Investment analysts, economists and other market participants constantly analyse these announcements, trying to second-guess their content. Analysts seldom agree, but the body of opinion produces what is called the “consensus estimate” and is broadly reliable.

Familiarity with the consensus estimate lets traders to take advantage of price movements once the economic announcement is released because the consensus estimate will already be “priced in” to the value of the market. Investors will have placed trades before the announcement to take advantage of where they believe shares will move. If the economic announcement matches the consensus estimate, then prices will barely move because most institutional investors have already placed their trades. It is only really when the consensus estimate has been inaccurate because the market is wrong-footed that prices have to adjust to accommodate the new economic realities. At such a time, when market participants are scrambling to factor in the new information, you will have opportunities to capitalise on price movement.

General Shifts in Market/Sector Strength

Companies prefer their stock price to reflect their individual corporate performance, yet other general market forces can lift or lower share values regardless of that performance.
There’s an old adage that every trader ought to know: “A rising tide floats all boats.” Simply put, it means that in a bullish market most stocks go up because the market and the economy in general are going up. On the other hand, it means that in a bearish market, most shares go down because the market and the economy in general are going down.
This truism may apply to the market in general but not necessarily to certain sectors of it. For instance, healthcare stocks may be booming but retail shares may be slumping. Bullish and bearish forces within individual sectors can have the same impact on the stocks within those sectors as bullish and bearish forces can have on the overall market. Nothing is set in stone.

We will tell you more about the analysis of market and sector trends in a later section. Right now simply knowing that these forces exist will put you well ahead of most retail traders.