Chapter 1: Introduction to CFDs
In this chapter we look at the basics of trading CFDs and uncover the products available when you start trading CFDs. The basics we cover in this chapter lay the foundation for later chapters.
What is a CFD?
Contracts for difference (CFDs) are relatively new financial products that derive their price from the underlying share or index they’re tracking. In trading circles CFDs are referred as an over-the-counter product.
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An over-the-counter product means they’re not traded on the official stock or futures exchanges around the world. Having said that, the Australian Securities Exchange (ASX) was the first stock exchange in the world to introduce exchange-traded CFDs in November 2007, providing traders with an opportunity to trade exchange-listed CFDs.
Essentially a CFD is a contract between you and your CFD broker to exchange the difference between the price you open the contract at and the price you close the contract at CFDs mirror the performance of the share or index you’re tracking, enabling you to (hopefully) profit from a positive move in your chosen direction, whether it be long or short. For example, if you buy a share CFD (a type of CFD) at $1 and sell the share CFD at $2, your profit is $1 minus your trading costs. That’s CFD trading in a nutshell.
Primarily CFDs are a short-term trading tool, with a May 2010 Investment Trends report indicating more than 90 per cent of CFD traders hold their positions for less than one month. According to the same report, 75 per cent of traders used technical analysis to determine what to buy and sell.
CFDs and the derivative connection
Financial derivatives are instruments that get their price from something else. Many people associate the word derivatives with the futures market where, for example, the futures price of gold derives from the actual price of gold.
Since the global financial crisis (GFC) derivatives have received extremely bad press, with many claiming they were responsible for the GFC. While derivatives did play a massive part in the global meltdown, it’s best to gain a good understanding of what a derivative is so you can be informed about them. The truth is most people around the world use a derivative product every day. Credit cards are used worldwide every day, but very few people would consider a credit card a derivative. In fact a credit card is a derivative of cash, enabling consumers worldwide to purchase goods and services without actually having cash. In the futures market you can trade crude oil futures without having to take delivery of 1000 barrels of oil, which is the equivalent of one contract of Brent Crude Oil Futures. So the crude futures market is a derivative of the actual price of 1000 barrels of oil.
While this explanation is simple, please keep in mind that misusing derivatives can result in significant financial losses in a similar way to running up large credit card bills and not paying the balance.
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Generally speaking derivatives are complex instruments best left to the professionals, but CFDs have really simplified the product, allowing traders to get up to speed quickly.
CFDs derive their price from the underlying sharemarket. For example, share CFDs derive their price from the underlying sharemarket; commodity CFDs derive their price from the under-lying futures market; and foreign-exchange CFDs derive their price from a multitude of banks and market makers around the world.
A short history of CFDs
Institutional traders were first to develop and use CFDs, which were invented in the 1990s by a London derivative brokerage firm called Smith New Court. CFDs were developed as a way for clients to short sell the market while using leverage. As a bonus, traders were able to avoid stamp duty.
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Leveraged trading allows you to trade much larger amounts than you normally could when trading an unleveraged product like shares. A $10 000 share trading account allows you to trade up to $10 000 in positions, but a $10 000 leveraged account (such as CFDs) allows you to trade more than the $10 000 cash you have in your account.
GNI, a large European-based trading firm, introduced CFDs to the retail market, enabling traders to execute trades on the London Stock Exchange without having access to it. In Australia CFDs did not launch until 2002, when IG Markets opened their doors. IG Markets was followed very closely by CMC Markets, which traded under the name of DealForFree.com and took the Australian trading market by storm, giving access
to the top 200 shares at 5 per cent margin, commission free.
During those formative years the CFD market grew quite rapidly, with one of the largest CFD brokers opening more than 1000 accounts per month. CFDs were literally on the tip of every trader’s tongue, and investment magazines and newsletters everywhere were talking about them.
In Australia in May 2010 there were about 39 000 active CFD traders, which is an increase of approximately 22 per cent from the year before. Although recent growth may appear a little conservative, in 2007 the number of active CFD traders doubled as stock markets around the world came to a peak. The two companies with the largest market share are IG Markets and CMC Markets, with Commsec a distant third. Australia has approximately 20 CFD providers, which benefits every trader as they’re all vying for our business, pushing down their rates and improving their service.
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CFD providers and CFD brokers are terms used inter-changeably and refer to the same thing.
Where do CFDs trade?
International opportunities are just part of what is on offer when you open a CFD account with any mainstream CFD broker. One of the most exciting elements of trading CFDs is the opportunity to trade all those international shares you have heard of but thought were out of reach for an Australian trader. Shares like Microsoft, Google, Vodafone, Coca-Cola, General Electric, HSBC and BP are al...
