CFD Trading
CFDs are one way to trade the soaring highs and plummeting lows of today’s volatile sharemarket. With small amounts of capital you can make leveraged trades in shares from countries around the globe. While these are useful instruments in the hands of a skilled CFD trader, what are the perks and dangers that you should be aware of?
The Good and Bad of Leverage
CFDs, or Contracts For Difference, typically offer 10 – 20 times the leverage of a normal share investment. This means that you can gain similar exposure as straight share trading for one-tenth or one-twentieth of the cost. However, don’t confuse this with having only one-tenth of the risk – you carry the same amount of loss potential as owning the shares outright.
As an example, you want 100 shares of a certain gold company trading at $70 per share. This will cost you $7,000. The most you can lose is $7,000. If you purchase 100 CFDs, you may be able to get in with only 5% margin, which is $350 before some of your other fees. If the company goes broke and you are holding 100 CFDs, you are on the hook for $7,000. In addition to this, a small downside move of 5% could result in a 100% loss of your capital allocation for that trade. |
The point is this: you can trade smaller price moves for larger profit and less slippage with CFDs provided you use proper risk controls.
What do I mean by risk controls?
- Start by having a strategy of some sort and have a reason to trade these shares.
- Predetermine prices you would like to sell at for a profit or if the trade goes against you.
- Do not leave your selling up to how you feel on that particular day.
- Work out your initial margin fees, and any interest charges.
- Allocate only a percentage of your capital per trade, perhaps following the 2% rule.
- Know exactly how much profit you expect to make or lose based on your exits to determine your risk to reward ratio.
- Finally, practice enough times so you can calculate your percentage of winning trades. If you fail to plan, then you should plan to fail.
Dividends are Your Friend and Foe
Who doesn’t like dividends? They can be a welcome sight when your giant cash-generating company pays out hefty dividends per share. These can be a problem for CFD traders though as dividends are also paid out. Shouldn’t you be happy to get dividends that are leveraged? Maybe not.
Trading for dividends can be tedious at the best of times when share trading. There are franking credits, different taxation laws, the 45 day holding rule, and ex-dividend dates to consider. It isn’t all that complex but when you start trading dividends via CFDs it starts to get a little more complicated.
CFD dividends and franking credits (on ASX CFDs) are not true dividends and credits. They mimic the dividend and cash flows of share trading, and are considered cashflows. You are paid the dividend amount on the ex-dividend date instead of having to wait for payment when holding shares. But you must keep in mind that share price typically drops by the same amount as the dividend. There is no free lunch here. When trading ASX CFDs, you also receive a franking credit cashflow or FCC. You may not, however, receive the full amount of this as Designated Price Makers with CFD short positions do not need to pay the FCC. Your franking credit cashflow (FCC) will be reduced by the Net Open Short Position(NOSP) of Designated Price Makers(DPM) which you can view in the daily Net Short DPM Report. Seem like a confusing mess of acronyms and jargon?
The bottom line is this: if you have a dividend capture strategy that works well, you might be able to use leveraged CFDs to your advantage. If not, it might unnecessarily clutter and confound your ability to quickly and accurately calculate the technical aspects of your CFD trading including sell stops and profit targets.
Long-Term Trading and Interest Charges
Are you the type of investor that can forecast broad market movements over long periods of time but you struggle to determine in which direction the ASX sharemarket is heading over the next two to three weeks? If so, CFD trading might not be your best bet.
CFD trading carries open interest rates in addition to an overnight interest charge or contract interest– which is the Reserve Bank of Australia overnight cash rate. With combined annual interest fees currently around 6%, this is working against your long-term gains in the market when trading long. While short CFD traders receive the contract interest charges, they must still pay the open interest rate which results in a net amount being paid out. What does all of this mean? You need a robust short-term trading system – possibly swing-trading – to make CFD trading a viable option. If your system takes too long to generate profit – these could be eaten up in fees. If you trade too frequently for tiny gains, the profit will be consumed in transaction fees.
Swing-trading can be an emotional experience as you play on small volatile moves for days to weeks at a time. You need to have tight exit strategies, clear risk management rules, proper position sizing, and the discipline to go against a short-term trend.
Is CFD Trading Right For You?
None of this is meant to scare you off CFD trading, but you should go into it with your eyes open. Yes, you can make large gains when your trades work out. You can also lose when trades turn sour. Dividends (and franking credits when trading ASX-listed products) will affect your CFDs, which can work with your strategy or can work against you if you are not expecting it. CFDs have eroding value over time due to interest charges – but you didn’t really expect to leverage your dollar for free, did you?
If you understand the implications of these high beta instruments, CFD trading can be the right solution for short-term sharemarket traders. |
