Being in Australia for 3 years, I came across a lot of new things when it comes to wealth-creating strategies. One of it is CFD Trading. What is CFD Trading you ask? Well, to begin with, CFD trading is similar to share trading. Very very similar indeed.
CFD stands for Contract for Difference. The definition, as stated in Wikipedia.com, is a contract between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.)
CFD was invented in the UK in 1990’s and was introduced in Australia in the year 2002.
To trade CFDs (plural for CFD), you need to have an account with a CFD provider. You will then be able to trade CFDs on a wide range of securities such as Shares, Forex, Futures, Commodities, Bonds, and etc. Let me give you an example:
“You are of the opinion that the shares of Company A will rise from the current price of USD1 to USD2 within the next month. You then decide to purchase 1000 Share CFDs of Company A. In the next month, the share price did increase to USD2. Thus, you made a profit of USD1000 from that transaction (before brokerage and other charges).”
If you’re thinking “Hmm, it looks the same as ordinary share trading. So, why should I trade CFDs???”, well, read on.
The main reason why people trade CFDs is ….. surprise surprise…. LEVERAGE. Leverage means, you can open a position that is worth more than what you currently have in cash. Most, if not all of the CFDs, need you to only pay a certain portion of what the position is worth. This is called MARGIN. For shares, margin rate for companies can be between 5% to 100%. For companies with 10% margin rate, if you have USD1,000, you can open a position worth USD10,000.
Back to the previous example, in ordinary share trading, you would have to pay the full amount USD1,000 to purchase the shares. However, for CFDs, assuming the margin rate is 10%, you will have to put up only USD100. With a profit of USD1,000, you have effectively made a profit of 1000%!! This figure may look good to you, but read on.
Other reasons why CFDs are so attractive is the fact that you can trade wide range of securities on a single account. Yup, you heard that right. There’s no need anymore to have separate accounts for shares, FOREX, futures, and etc.
CFDs also allow traders to go long or short. Long means buy low, sell high. Short means sell high first, buy low later. More on this topic on another day.
Enough about the attractiveness of CFDs. Let us now talk about the risks.
Knowing about the risks of CFDs is enough to deter most people to trade this instrument. The primary risk is the possibility of losing more than what you have. This is the effect of leverage. Using the example of Company A, let’s assume that the price in fact decreased to USD0.50. Assuming you bought 1000 shares, you would have lost USD500. However, bear in mind that to purchase Company A’s Share CFDs, you had to pay only USD100. If USD100 was all that you got in your account, you now owe your CFD provider USD400. Percentage-wise, you have made a loss of 500%!!
The easiness and flexibility of CFD trading can also equates to overtrading. Overtrading is when a person trades more than they need to which can result into loss of objectivity in judgement and mounting transaction charges.
As for myself, I took up CFD trading a few months ago. All I can say is, it has been an enjoyable though sometimes stressful experience. Being in the possession of a good trading plan and a bit of experience is paramount to SURVIVE in the world of CFD trading. Take note that I used the word SURVIVE instead of SUCCEED. As we go along throught my future posts, you will understand why.
To sum it up, if you don’t have any experience whatsoever with the financial markets, NEVER EVER TRADE CFDs. Learn about them first and grab some experience in share trading before jumping into CFDs. Word of advice: CFD Trading is VERY VERY RISKY and not for the faint-hearted.