cmc markets trading smart series: understanding cfd's
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Understanding CFDsTHE CMC MARKETS TRADING SMART SERIES
CMC Markets | Understanding CFDs 2
CFDs, or contracts for difference, have taken their place among other derivatives such as options in the toolkit of traders around the country. Their flexibility has led to a dramatic growth in popularity. In fact, Investment Trends research showed that there were an estimated 22,000 active CFD traders in Singapore in September 2010. However, you shouldn’t forget that CFDs are a leveraged product which carries significant risks and, despite their attractions, they must be treated with care. This guide aims to provide some of the basic information you need before you consider trading them.
Proudly No. 1 for CFD education Results from Investment Trends September 2010 Singapore CFD Report, based on ratings given by 8,900 investors
CMC Markets | Understanding CFDs 3
What are CFDs?A contract for difference, or CFD, is an agreement between two
parties 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 when you trade CFDs you are trading
an instrument whose price is based on an underlying asset that you
may already be familiar with. These assets may include companies
(or equities), commodities, indices or currencies. Importantly, CFDs
are an OTC, or over-the-counter, product. This means that they
are not traded on an exchange, and that when you trade with CMC
Markets, we are the counterparty to the transaction.
When you trade CFDs, you don’t actually own the underlying asset.
Instead, you are trading a contract whose value is determined in line
with the value of the underlying asset. The underlying asset could
be shares like Google or BHP Billiton, or it could be a commodity like
gold. Our Product Library lists all tradeable CFDs. This can be found
on the CMC trading platform and at cmcmarkets.com.sg/markets.
Aspects of CFD tradingCFD trading has distinct features that distinguish it from share
trading, even though it may appeal to traders and investors alike.
LeverageIn the financial market, leverage means the use of borrowed money
to invest in products such as property, shares, artwork, property
trusts or managed funds. A common example of using leverage is
borrowing money from a bank or financial institution to invest in a
residential or investment property. This loan is usually secured by
a mortgage over the property. People may also borrow money to
trade or invest in shares. Margin loans where the shares are used
as security for the loan are commonly used for this purpose.
With CFDs you can also elect to open positions without having the
full value of the CFD position in your account. The amount required
to open a position is known as margin. Some CFDs require as little as
2% margin, some 5%, and others 10–20% or more. It depends on the
CFD.
For many investors and traders, being able to trade on margin using
leverage is one of the biggest attractions of CFDs. When trading on
margin you make the same profit or loss as if you funded the entire
value of the CFD position you are dealing in.
Using margin increases the opportunity to profit because you can
often afford to hold larger positions than if you were funding in full. It
also has the potential to increase the return on a smaller amount of
funds you use to open a position.
Nevertheless, it’s important to be aware that trading on margin is
a double-edged sword, because it magnifies both potential profit
and potential losses. You may lose more than your initial investment
when you trade CFDs.
Sound risk management is essential to success for both traders
and investors. This is particularly true where leverage is involved.
You can’t be a trader or investor without taking risk, but it is vital to
take steps to limit this risk to levels that are appropriate for your
circumstances.
The CMC trading platform includes a customisable margin facility to
assist with risk management. This puts you in control of the margin
you use on each transaction. You can dial the margin up or down to
anywhere from using no leverage at all to employing full leverage
where you need have only the minimum margin requirement to open
a new position.
The extent to which you use leverage is only one aspect of a sound
risk-management plan.
Flexibility
Two attractive features of CFDs are low transaction costs and
low margins, but they are not the whole picture. CFDs’ flexibility is
another key feature. CFDs allow you to benefit from either rising or
falling prices. In other words, with CFDs you have the ability to trade
on both the long side and the short side of the market. This means
that you can align your trading portfolio more closely to prevailing
market trends.
Short selling occurs when your opening trade is a sell order. If the
price falls and you close the position (with a buy order), your profit is
the difference between the two. This enables you to benefit directly
from a fall in the price of the underlying assets such as currencies,
commodities, indices or companies.
The availability of short selling can allow you to better capitalise
on the time you devote to market analysis. Strategies used to
successfully identify buying opportunities can usually be applied to
identifying selling opportunities as well. This applies whether you use
technical analysis or trade news flow, or apply fundamental analysis.
While not always the case, traders generally will not want to have
Understanding CFDs
Develop a basic understanding of what CFDs are and how they work. Understand how CFDs can work in your overall portfolio. Learn about the different types of CFDs available for trading.
CMC Markets | Understanding CFDs 4
their trading portfolio either entirely long or entirely short. If you
structure your trading portfolio entirely one way or the other, the
day-to-day oscillations of the market can have a marked impact
on the value of your portfolio. While portfolio volatility is easy to
talk about, it becomes more of an issue when you have real capital
invested.
In general there are long and short opportunities regardless of the
prevailing market conditions. Naturally, in a bear market there will be
more opportunities on the short side than on the long side, but it’s
best not to focus exclusively in that direction. Even if the market has
been consistently bearish for some time, if you’re too heavily short at
the wrong time you could easily suffer some significant drawdowns
if the bear market rallies.
Difference between the short-term trader and the investor:
• For the investor, the idea of weathering the ups and downs of
being in the market is part and parcel of the business.
• For the short-term trader, the objective is to try and capture
smaller moves of the market and then exit. Timing is an all-
important component of survival for traders.
CFDs can be traded long or shortWhen you buy a CFD (go long), you’re expecting its price to go up so
you can sell it later at a higher price, for a profit. When you sell a CFD
(go short), you’re expecting its price to go down so that you can buy it
back later at a lower price, for a profit. Being able to trade long or short
is one of the most attractive features of CFDs. It means you can trade
long with the aim of making money on a rising market, or trade short
looking to make money when the market is falling.
NB While you can go long or short in all currency, commodity and
index CFDs, not all company CFDs can be traded short. Generally,
short selling is available for CFDs over all the largest and most liquid
companies. You can check whether shorting is allowed on a company
CFD by consulting either the individual company overview in the
Product Library on the CMC trading platform or cmcmarkets.com.sg/
markets.
Dividends and corporate actionsFor many long-term investors, dividends remain one of the
determining factors in whether they invest in a particular share or
not. Therefore, dividends can be considered important when deciding
which stock to buy.
When you trade company CFDs on dividend-paying shares, you will
automatically be paid an amount reflecting the dividend when you
have a long position going into this date. The dividend payment
is usually shown on your CFD account when the underlying share
goes ex dividend. This is the date from which any new buyers of the
stock are no longer entitled to the next dividend payment. Payment
of the dividend amount compensates for the fact that, all things
being equal, the price of the underlying share and the company CFD
will fall by the dividend amount on the ex date. On the other hand,
if you have a short CFD position going into this date, the amount
of the dividend will be deducted from your CFD account. Other
corporate actions such as bonus issues and share splitting are also
automatically reflected with a cash adjustment on your CFD account
as soon as they’re implemented.
Reporting seasonThe reporting season refers to the time of year when publicly
listed companies update the market about their half-yearly and
yearly performance. It is also when companies may announce
their profit guidance for upcoming periods and when analysts and
investors reassess their own forecasts. Depending on a company’s
performance and projected profit, the reporting season can result
in volatility within the market. For example, if a company issues a
forecast that its earnings will be lower in the next half year, the share
price might fall as investors may be disappointed with this result.
On the other hand, if a company unexpectedly doubles its income
and profit expectation for the coming year, the share price may jump
higher as investors and traders take advantage of the good news.
As CFDs tend to move in line with the price of the underlying market,
movement in share prices during the reporting season may also be
reflected in CFD prices. As a trader or investor, it pays to be aware of
the possible impact of the reporting season on your CFD positions.
NB Reporting seasons vary from market to market.
Product trading timesWith CFDs there are thousands of products to invest in across all the
major shares and indices in the US, UK, Europe and Asia. Here is a
selection of different asset classes you can invest in:
uCurrencies, covering over 70 different currency pairs from
developed and emerging markets
uCommodities, including agricultural, precious metals, industrial
metals and energy
uGlobal indices, covering most regions including the Hong Kong
43, US30 and Japan225
uCompanies, from across the globe – you don’t have to stick with
the Singapore market
Some of the most popular and liquid trading instruments such
as foreign exchange, share indices and major commodities trade
continuously from early Monday morning through until Saturday
morning Singapore time. These markets tend to be at their most
active during the UK and US trading day. This can be a time-
management advantage for busy traders who may be working full
time while the local markets are open.
CMC Markets | Understanding CFDs 5
Fractional ownershipYou can buy and sell CFDs either by units or amount. You can also
trade from as little as 1/1,000 of a unit, or a specific monetary
amount. We refer to this feature of the CMC trading platform as
’fractional ownership‘, and it sets new standards in precision and
effective asset allocation. It can be a good way of getting started
with small trades while you become familiar with how CFD trading
works. With a traditional broker, the smallest trade size in units
would be 1 share or perhaps $10,000 in currencies. Using fractional
ownership you could decide to invest in a half or even a tenth of
a company CFD or 0.001 units in currency CFDs. It is important to
remember that you do not actually own the underlying asset.
Expiry datesAnother aspect of CFD trading involves expiry dates, or length of
holding time. Unlike some other derivatives that have expiry dates
and become worthless upon expiration, CFDs do not expire.
Short-term traders may trade CFDs for a few days, while medium- to
long-term investors and traders may trade them over a few weeks
or months.
Transaction costsThe difference between the buy and sell price quoted on our CMC
trading platform represents a transaction cost.
For example, say you wanted to buy the Australia 200 index when
the quoted sell price was 4,570 and the quoted buy price was 4,571.
If you were to buy 1 unit for 4,571 but then immediately sell at 4,570
before the price changes, you would incur a loss of $1. In other
words, the price has to rise by 1 point before you can break even on
the deal.
In this example, you can see that the smaller the spread, the less the
market needs to rise before you break even, so the less it will cost
you to enter the transaction.
NB For products like indices that trade 24 hours, spreads can widen
when the underlying exchange is closed.
There are no distinct commissions or transaction fees associated
with CFDs on the CMC trading platform. We have removed these
individual charges and built the cost of trading into the price quoted
on screen, providing greater transparency. This will have the effect
of slightly widening the spread between the buy and sell price on
company instruments compared to the underlying price quoted on
the exchange.
NB Other charges may apply and you should refer to our Risk
Warning notice and Terms of Business. All of these documents are
available on our website at cmcmarkets.com.sg/legal/cfds.
Holding costs
What are holding costs? For each CFD position that remains open at the end of a
calendar day (17:00 New York), a transaction holding cost will be
calculated and applied. The transaction holding cost comprises
two components: the borrowing cost, which is applied to the
unfunded portion of the CFD position, and the carrying cost,
which is equivalent to the cost of holding the underlying asset. The
transaction holding cost is applied to the total value of the CFD
position.
Holding cost = Borrowing cost + Carrying cost
NB If the CFD is not priced in your local currency, the current CMC
Markets currency conversion rate would be applied to the holding
cost total.
What are the borrowing costs?Applies to index CFDs, company CFDs and commodity CFDs only.
When you open a CFD position with CMC Markets, which you don’t
fully deposit as margin, a cost is applied to the value of the unfunded
portion of the position. We calculate the rate applicable to the
borrowing cost based on interbank lending rates.
Borrowing cost = (Total position value - Margin) x Borrowing rate
365
NB Borrowing costs do not apply to precious metals.
What are the carrying costs?Applies to commodity CFDs and currency CFDs only.
Investing directly in some assets carries an associated cost or
benefit of physically holding that asset for a period of time. For
instance, if you buy crude oil, there is interest, storage and seasonal
costs (or benefits) associated with holding that crude oil until the
delivery date. The carrying cost represents the cost involved in
holding an asset.
Carrying cost = Total position value x Carrying rate long / Carry rate short
365
NB For company CFDs and index CFDs, carrying costs do not apply.
Managing riskCFDs are speculative products that are highly leveraged and carry
significantly greater risk than non-leveraged investments such as
ordinary share trading.
CMC Markets | Understanding CFDs 6
Point of comparison CFDs Options Warrants
Traded on margin Yes – your choice No Yes
Can be traded long or short Yes Yes Yes - call/put
Dividend payment Yes No Yes – instalment warrants
Expiry date No Yes – can expire worthless Yes
Stop loss orders Yes No No
This table is a comparison of CFDs, options and warrants that may help you understand derivative products in relation to one another.
CFDs may not be suitable for all investors. It is possible to incur
losses in addition to any fees and charges that apply. These losses
may be far greater than the money you have deposited into your
account or are required to deposit to satisfy a margin requirement.
It is important that you fully understand the risks involved before
trading. You should carefully read our Risk Warning notice which is
available from our website at cmcmarkets.com.sg/legal/cfds. We
also recommend that you seek independent advice. You should
consider whether trading in CFDs is right for you given your personal
circumstances (financial, taxation and otherwise).
Our education servicesDemo account. Are you new to investing and looking to try a fully
functional investment and trading experience without risking your
own money? Or are you an experienced investor wanting to test out
new strategies in a risk-free environment? Whatever your reasons,
you can get access to our unlimited demo account in less than 60
seconds. We strongly recommend that you practise using the demo
account before opening a live account.
Ongoing education. CMC Markets provides extensive education on
charting, technical analysis and risk-management tools, all covered
in our free webinars.
How do CFDs stack up against other derivatives?As a financial instrument, CFDs have features that may make them
attractive to both traders and investors. They also carry significant
risks.
Transfer your existing knowledge to CFDsPossibly the greatest benefit for traders using CFDs is that their
price is in line with that of the underlying reference instrument. This
means that the methods of analysis you may have previously applied
to products such as shares can also be applied to trading CFDs.
Exposure to international marketsCFDs open up a whole new world of financial markets, including
those in the US, UK, Europe and Asia, which have not previously been
easily accessible to Singaporean traders. CMC Markets offers CFDs
on international companies, indices, commodities and currencies.
All financial markets, from the most simple to the most complex,
have individual features that may make them attractive – or
unappealing – to investors. If considered properly and traded
according to your personal risk profile, derivatives (including CFDs)
may play an important part in growing your investment portfolio.
How do they fit in your investment portfolio?After learning more about CFDs and their features, you may wonder
how they fit into your investment portfolio. Perhaps you have a
healthy share portfolio that you want to keep growing.
Portfolio diversificationEven if you’re a long-term buy-and-hold investor, CFDs can be used to
take advantage of short-term profitable moves in the market without
affecting your existing investments. This means that while your long-
term positions are growing over time, you can trade CFDs to deliver
profit from short- to medium-term trades. In order to diversify their
investments, some traders maintain their share/equity portfolio for
capital gains and ongoing dividend income while also pursuing a CFD
portfolio for short- to medium-term investment or trading.
The long-term investor is willing to ride the ups and downs of the
market with a view to capturing long-term gains. However, you may
be able to go quite a long way to smoothing your overall portfolio
volatility by utilising short CFD positions.
You can take on a short position with CFDs to cover the value of
shares that you have, but this is not the only option available to you.
If you consider some short-term methodologies based on technical
analysis, you may be able to take on short CFD trades based
on downtrending stock prices. Alternatively, if you follow a more
fundamental analysis philosophy you may look for sectors of the
market that will be most heavily impacted by current economic
conditions.
Investors with a view on commodity prices may at times find it better
to invest directly in commodity CFDs rather than taking a position
CMC Markets | Understanding CFDs 7
via a resource or agricultural company shares. Advantages of direct
investment via CFDs can include:
• avoiding company-specific risk, such as cost over runs on new
developments, or disappointing production due to drought or
other weather events
• participating more directly in short-term commodity price
fluctuations
• being able to profit from falling prices via short selling as well as
from rising prices
Types of CFDsThere are various types of CFDs. They include company CFDs, index
CFDs, currency CFDs and CFDs on commodities. You can easily
access the full range of instruments via the Product Library on the
CMC trading platform.
When you invest in global products that are not in your local currency,
funds are automatically converted at the prevailing CMC Markets
exchange rate to complete the transaction. Profit and loss will be
reflected and settled in your local currency.
International company CFDs
In addition to Singaporean shares, CMC Markets also offers
international company CFDs including US, European, UK and Asian.
This means you can trade company CFDs on Google, Amazon,
Walmart, Honda, Toyota, Vodafone, BMW, Porsche and other big
brands that aren’t available in the Singapore market. Trading
international company CFDs offers many advantages, including:
• access to bigger and more liquid markets with more trading
opportunities than those available locally
• low transaction fees, because you don’t have to pay the extra
administrative charges you’d pay to trade physical shares in
overseas companies
CMC Markets | Understanding CFDs 8
FAQs
Q What do the letters ‘CFD’ stand for? What are you actually
trading when you trade CFDs?
A CFD is short for contracts for difference. When trading CFDs you’re
actually trading the margin of price change, or the difference in
price from when you open the position until the time you close the
position.
Q What are the main advantages of trading CFDs?
A The ability to trade both short and long, cost-effective entry into
trading, low transaction costs, and the ability of CFDs to be traded
on margin. However, you should remember that investing in CFDs
also carries significant risks and it’s possible to lose more than your
initial investment.
Q Will you get a share certificate when you trade a company CFD?
A No, you’re not actually buying stock in that company, you’re only
trying to capture the price movement between the time you open a
CFD trade until the time you close it.
Q How many CFD products are available to trade with CMC Markets?
A CFDs are available on thousands of instruments, see the Product
Library on the CMC trading platform or at cmcmarkets.com.sg/
markets for full details.
Q Are stop loss orders applicable to CFDs?
A Yes. Unlike options or warrants, you can place a stop loss order with
a CFD trade.
Q Are there time limits for holding a position with a CFD?
A No. Unlike options or warrants you can hold a CFD trade for as long
or as short a time as you choose.
Q What is the approximate percentage outlay of trading CFDs
compared to trading shares?
A Each CFD has different minimum margin requirements, generally
ranging from 2% to 20% of the price for most CFDs, With the CMC
trading platform’s customisable leverage facility you can dial the
margin up or down to anywhere from using no leverage at all to full
leverage based on the minimum margin requirement. There may be
other costs to consider, including financing, but this depends on
how long you hold the CFD.
Recommended additional reading
Catherine Davey, Making Money from CFD Trading: How I turned $13k
into $30k in three months
Mark Douglas, Trading in the Zone: Master the market with confidence,
discipline and a winning attitude
Curtis Faith, Way of the Turtle: The secret methods that turned ordinary
people into legendary traders
David Land, CFDs For Dummies
Edwin LeFèvre, Reminiscences of a Stock Operator
Marcel Link, High Probability Trading: Take the steps to become a
successful trader
Jack D. Schwager, The New Market Wizards: Conversations with
America’s top traders
Martin Schwartz, Pit Bull: Lessons from Wall Street’s champion day
trader
Chris Tate, The Art of Trading: A complete guide to trading the Australian
markets
Frank Watkins, Exploding the Myths
Richard D. Wyckoff, The Day Trader’s Bible
© CMC Markets Singapore Pte. Ltd., Reg. No./UEN 200605050E. All rights reserved August 2011.
cmcmarkets.com.sg
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