The Abc Of Trading Those Newfangled Cfds

Sun Herald

Sunday April 30, 2006

Toni Case

THE TROUBLE with trading shares is that when the market eventually runs out of puff, so will your profits. And as the S&P/ASX 200 Index sprinted through 5300 points last week without even pausing for breath, the possibility of a market pullback seemed ever more present.

But Brisbane trader Maurice Taudevin says that even if the market were to fall unexpectedly, his profits would be protected. Indeed, he thinks he might even make money.

Taudevin trades contracts for difference (CFDs), a fairly recent product now on the scene that, although not yet a rival to share trading, is certainly taking the shine off options and warrants trading. The best thing about CFDs over share trading is that you can profit in both rising and falling markets. So CFD traders don't care whether the market hits 5500 or retreats to 4500, since they can make (or lose) money either way.

Now while this mightn't seem very handy during the bullish conditions of late, CFDs can be used like an insurance policy to protect the profits you've already made. Or you might want to punt on out-of-favour shares falling lower.

Taudevin says he wakes up early every morning, exercises, cleans his downstairs trading room and, while drinking a cup of herbal tea, revises his portfolio of CFDs. After listening to the morning market wrap, he's set to trade.

He estimates that he's made a hefty 70 per cent return on his money in the past six months. Clearly, the retired engineer has had an impeccable run.

But the skill to trade CFDs doesn't come overnight. Taudevin traded both options and warrants for more than two years before taking up CFDs. He has developed a mechanical trading system that, although not quite on automatic pilot, is as close as it can be. At least it takes the emotion out of having hundreds of thousands of dollars at stake on a single trade - and, Taudevin says, the decision to buy and sell has to be totally unemotional. "It gives me the confidence to pull the trigger," he says.

What is a CFD?

Apart from the convoluted name, contracts for difference are really pretty simple. They are like the Rambo of share trades - bigger and gutsier. But watch out if you get on the wrong side of them.

CFDs are derivatives, so you can lump them with options, futures and warrants. The word derivative simply means the price is "derived" from an underlying instrument. For instance, the price of a CFD can be based on the price of a domestic or international share, currency, index, sector or commodity.

Impatient traders, or those seeking an action-packed trading experience, tend to prefer trading derivatives because of the leverage involved. They're interested only in profiting from price movements, and don't give a hoot that derivatives don't entitle you to ownership over the share or commodity you buy.

In fact, derivatives such as CFDs are so highly leveraged that it takes only a small price change in your favour to send your profits sailing. Admittedly, the reverse can be pretty harrowing, to say the least.

Most firms let you buy a CFD with a 10 per cent deposit, lending you the remaining 90 per cent.

So rather than forking out $10,000 to buy 125 shares in Rio Tinto, at $80 a share, you could spend $1000 on CFDs for the equivalent exposure. Or if you are really bullish on the big miner you could spend your $10,000 savings on $100,000 worth of CFDs based on Rio Tinto shares.

It's not surprising that the biggest recruits to CFDs have been options and warrants traders - clearly people comfortable betting large sums of money.

Taudevin calls options trading "scary money". In comparison, he says, trading CFDs is just like trading shares.

The biggest difference between options and CFDs is that an option has an expiry date, which affects its price, while CFDs don't expire. You could hold a CFD for a year or more if you wanted to. Most traders, however, hold them for less than a week, since there are finance charges to pay on the borrowed funds.

The price of a CFD is the same as the underlying share. If Rio Tinto shares are trading at $80, a CFD on Rio Tinto shares should also trade at $80. This makes calculating profits and losses on CFD trades a cinch, and is why they have been likened to share trading, only for the more risk-loving among us.

Certainly a big advantage is that you can short-sell a CFD as easily and for the same cost as buying it. Short selling simply means selling with the intention of buying back at a lower price. If the price drops in the meantime you scoop.

Taudevin recently short-sold the S&P/ASX index to protect his portfolio of CFDs. If the market fell, Taudevin figured he'd make money on the index, even if his portfolio of CFDs also declined.

How do I start trading CFDs?

If you think you've got the stomach and skill to trade CFDs, it's just a matter of signing up with a CFD provider. The only problem is that there is a dizzying number to choose from.

British firm IG Markets was the first to offer CFD trading in Australia back in July 2002, closely followed by another well-known British name, Man Financial.

Today, there are close to 20 firms offering CFDs, including Macquarie Bank, CMC Markets, E*Trade, Marketech, First Prudential Markets, Tricom and Sonray Capital. Every day another player seems to bob up in the crowded pool of CFD firms, so finding the best one for you will take some time.

One of the obvious points of comparison between firms is the types of securities they let you trade. For example, while Macquarie offers CFDs on Australian shares only, firms such as CMC Markets offer them on international shares, foreign exchange, indices, sectors and commodities.

And depending where you intend to trade from, you might choose a web-based platform (that can be accessed over the internet), or a software-based platform that can be downloaded onto your computer terminal, either at home or in the office.

But most importantly, don't choose a provider on headline commission rates alone, as this is just one cost to consider.

Other costs to take into account are the daily interest charges on borrowed funds, monthly platform fees, which can be as high as $99 a month, monthly charges for live market pricing (if any), monthly exchange fees to the ASX (if any), and lastly whether the CFD provider adds a spread to the quoted market price. In other words, will the price you pay for a share CFD always equal the underlying share? Some CFD firms add a small commission for themselves when they quote you CFD prices, and they will admit as much in their product disclosure statement (PDS).

But once you've decided on a provider, some firms such as IG Markets can have you trading CFDs within minutes of submitting your online application form. After emailing you a password to access their online trading platform, as scary as this might sound, you can even use your credit card to submit your first trade.

But not all CFD firms are so readily accessible. Most require an initial deposit of between $1000 and $10,000, transferred via Bpay, bank transfer or cheque, that will take up to two business days to clear. They also like to know what level of trading experience you've had, because first-timers without a trading plan, or at least a well-researched trading methodology, clearly shouldn't launch their trading careers on CFDs.

How can I survive trading CFDs?

Battle-hardened CFD traders often admit that survival, or remaining in the game, is their first goal. Second to survival is, of course, to make some money out of their trading activities.

Now, while you might outlay $10,000 to buy $100,000 worth of CFDs in a particular share, you are actually risking $100,000 on the trade. This small fact shouldn't be forgotten, because, if a stock runs into financial difficulties and suspends trading and you can't sell out of your position, you could lose the lot.

Most times, however, it's likely that the stock would slip lower over consequent days, triggering a margin call on your account. And if you didn't meet your margin call, your CFD provider would close you out of the trade before your losses really started to mount. Nevertheless, it's best to take control at the outset over how much you could potentially lose.

Most traders use stop loss orders to control risk. A stop loss is an order to sell a share at a predetermined price, or conversely buy a share if you are short-selling a CFD.

For instance, say you bought Rio Tinto CFDs at $80, you could put in a stop loss at $78, which, once triggered, would toss you out of the trade whether you liked it or not.

Taudevin, who trades with CMC Markets, uses stop losses on every trade.

"Even before I put in a trade I have already calculated my stop loss level and as soon as I have put in the order, I automatically put in the stop loss as well," he says.

The majority of CFD firms charge you on submitting a stop loss and again should you move it later.

However, as with an insurance policy, most traders feel more confident knowing upfront how much they could potentially lose. And especially if you are new to trading CFDs, having a stop loss in place is a fundamental tool for survival.

CFDs v share trading

CFD trade:

A CFD trader, let's call her Jenny, decides to buy 100,000 CFDs in company XYZ at $2.67 each. Her position is worth $267,000, on which she will pay an entry brokerage fee of 0.15 per cent, or $400.50.

Jenny decides to adopt a 10:1 leverage, so she uses $26,700 of her own money. The rest is in effect on loan from her CFD provider.

Twenty days later, shares in XYZ have gone through the roof, and Jenny decides to sell out at $3.11. Her position is now worth $311,000, so her exit brokerage cost is $466.50 (at 0.15 per cent commission).

Jenny also has to pay interest on the $240,300. At an annual interest rate of 7.5 per cent, her interest cost for 20 days is about $988.

The result of Jenny's investment is as follows:

Gross profit: $44,000 ($311,000-$267,000).

Brokerage cost: $867 ($400.50+$466.50).

Interest cost: $988.

Net profit: $42,145, ($44,000-$867-$988).

Return (as a percentage of original $26,700 invested): 158 per cent.

Share trade:

A share trader, John, also decides to buy 100,000 XYZ shares at $2.67, costing him $267,000, which he will need to outlay upfront. He sells at $3.11, taking his portfolio to $311,000. Assuming John's brokerage is the same as Jenny's ($867), the result is:

Gross profit: $44,000 ($311,000-$267,000).

Brokerage cost: $867 ($400.50+$466.50).

Interest cost: $0 (he hasn't borrowed any money).

Net profit: $43,133.

Return (as a percentage of original $267,000 invested): 16 per cent.

© 2006 Sun Herald

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