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A guide to Contract for difference investing

By: Ben McGrath

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What's a Contract for difference?
Contracts for difference are a popular derivative in the marketplace. If you own a CFD, you own a contract over the difference between the price that you purchased the contract for and the current price of the contract, ie you own a contract over the performance of the share. That is, if you buy a CFD at $1.43 and the price rises to $1.55, then your contract is for the difference between the purchase price of $1.43 and the current price of $1.55, which is 12 cents in profit. If the CFD had decreased in value, then you would be obliged to pay for the difference between the purchase price and the present price. Instead of buying the stock, you buy a contract over the movement in the equity price and this is revalued or "marked to market" in real time.

A CFD gives you all the advantages of trading shares without needing to physically own the share. It's a contract that mirrors the performance of a share or index, is traded on margin, and like physical shares your profit or loss is determined by the difference between the prices you buy and sell at. CFDs also incorporate any adjustments for corporate actions, such as dividends and stock splits.

What are the advantages of CFDs?
Contracts for difference are traded on margin, which is a more effective use of your money since you only have to allocate a small percentage of the value of the position to secure a trade, whilst still maintaining full exposure to the market. In effect it is possible to magnify the returns on your investment. Contracts for difference providers charge low commssions, which means that you don't have to pay high priced brokerage on either long or short transactions.

Since you are trading the price movement of the share or index without physically owning it, it's as easy to sell a share or index CFD, as it is to buy it. This enables short selling to be done just as easily as buying a CFD. Therefore a Contract for difference trader has the opportunity to profit from both bull and bear markets as well as short-term intra day movements.

Just as CFDs mirror the price movement of the physical stock market, they also mirror any corporate actions that take place in the underlying equity or index (dividends, share splits or consolidations). This means that the owner of the share Contract for difference will receive dividends, and participate in stock splits, just like they would if they owned the physical share. It also means that if a equity goes ex-dividend (meaning a dividend is due to be paid) while you're short a stock, then you are obliged to pay the dividend in that same way as if you are short the physical stock. You are not entitled to any voting rights since you don't actually own the stock.

Short selling CFDs
Short selling using CFDs is the same as selling CFDs which you already own. There are no restrictions on how you transact Contracts for difference or on shortsellable Contracts for difference. You can short sell any available CFD however some Contract for difference providers may have a constrained short sell list and impose restrictions on the quantity of a stock that can be short sold. You don't have to shortsell on an uptick like in the share market it is possible to shortsell at any price the share is trading at. This provides significant advantages over the traditional techniques of short selling.

Tradeable Contracts for difference
Most CFD brokers offer CFDs over the key sectors, major equity indices and the stocks in the major share indices in the most important markets. Many brokers offer thousands of different instruments in Australia, Asia, the UK, Europe and America.

Costs associated with CFDs
There is a small commission cost to open a Contract for difference position, the price of a CFD will be the same as that of the underlying stock or index on the stock market. This means that buying a CFD is essentially the same as investing in the underlying stock apart from the low cost of brokerage, which makes Contract for difference trading ideal for those with low account balances.

Contract for difference positions carried overnight incur financing costs for the whole value of the position. Traders who are long Australian CFDs will pay interest and clients who are short will receive interest for their positions. The rate of interest payable is determined by the cash rate for the country in which the stock is listed. If the base rate of interest of a country is less than the financing cost charged by the CFD broker for going short no interest will be charged on short positions. An example of this is in Japan where rates of interest are close to 0%. In this case no interest is chargeable on short positions.

When you hold a CFD overnight, you are charged interest on the whole value of the position because the Contract for difference provider hedges your position by financing the purchase of the underlying stock in the market. They then pass on the interest to you the client at a premium. The interest rate charged depends on the market that's being traded. If you are short a Contract for difference, then you'll collect interest on the complete value of the position for every day that you choose to hold your position overnight. For people with a well-balanced trading system where you're short and long for around the same amount of time, you will effectively only pay only a small interest charge for overnight positions.

Article Source: http://depositarticles.com/

Ben McGrath is a professional Contract for difference trader. He trades with Australia's most popular CFD broker IC Markets. Ben has published a number of books and guides on CFDs, you can download and read his most recent guide to CFD trading for free.

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