A guide to CFDs

BY STEPHEN CALDER

You may have heard of contracts for difference or CFDs. They let you profit on changing prices, whether they are going up or down. The prices can be of shares, commodities such as gold or oil or the value of a currency.

In the right hands, CFDs can bring the kinds of rewards most traders only dream of - annual gains of 60 per cent and even higher have been reported by a select few. With application and some experience, a good trader should be able to consistently outperform the market and, in time, earn enough to make it a full-time job.

Conservative investors can make use of CFDs as a way of reducing risk, rather than taking on risk. For example, if you think the shares you just bought are good value in the long term, you can use CFDs to help cushion the effect of an expected short-term drop in their price, a practice known as hedging.

Although hedging is designed to reduce risk, it only does so if carried out intelligently. Hedgers need to develop the same market-reading skills as traders.

Unfortunately, many who trade in contracts for difference do so for entirely the wrong reasons. They hate their day job. They want to be their own boss and make easy money.

It doesn't usually work out that way, especially if you jump straight from your day job to trading or retire and then take it up.

Trading takes special skills, along with discipline. Without them, it can take a long time or a short time to whittle away the capital in your trading account until you either give up or get the education you should have started with.

WHAT ARE CFDs?

When you trade a CFD, you agree that you'll profit if you buy shares and the price goes up and you'll lose if the price falls. In each case the actual profit or loss is the rise or fall in the share price times the number of shares you agreed on.

As well as shares, you can trade CFDs over share indices such as those that gauge the markets in Australia, the US, Britain, Europe and Asia. CFDs also can be traded over changes in the relative values of currencies, such as the Australian dollar against the US dollar, or the US dollar against the euro. You can trade CFDs over commodities, too, the most popular being gold and oil.

COSTS

The costs of trading include a commission (for shares only), a funding cost (if you buy shares), and the spread, or difference between the bid and offer price at the time you trade.

If you buy and sell immediately, the spread is the difference between what you paid and what you receive. If you sell share-based CFDs, you receive interest.

There is often no commission for trading currencies and commodities; the charge in this case is the spread. There may also be a funding cost or interest received.

Leverage is one big attraction, and risk, of CFDs. You only have to put up a fraction of the value of the shares, currency or commodities that you buy. If you buy a CFD over shares, putting up 10 per cent of the value, you make a 100 per cent profit if the shares rise just 10 per cent. Similarly, if the shares fell 10 per cent, you would lose your whole starting amount.

That's 10 times the gain or loss compared with purchasing the shares themselves.

CFDs also allow you to sell short (agree to sell what you don't yet own), which lets you profit from falling share or commodity prices, just as buying provides profits from rising prices.

Although there are other ways to get leverage and other ways to sell short, CFDs are aimed at non-professional traders, with manageable contract sizes and affordable fees making them easy to use.

But ease of use doesn't mean easy profits. The combination of leverage and short selling can be an explosive mixture, since leverage multiplies losses as well as profits.

Putting up only 10 per cent of the value of a trade means you lose your whole deposit if the share or commodity you buy then falls by 10 per cent. And you can lose more than your starting amount if the price falls further.

BEFORE YOU START

Nearly every CFD provider will tell you that in order to use CFDs safely you need certain minimum knowledge and you need to develop skills that may be alien to those who have never traded before. The skill sets that work in an ordinary business environment are not necessarily useful in trading.

One reason for this is that feedback from the market is mixed: even if you always keep to the rules of your strategy you will win on some trades and lose on others. That's inevitable and is as true for the smartest, most experienced traders as it is for the novice.

Most people are used to getting the same, not different, results from doing the same thing. But this does not always happen in CFD trading.

The goal in trading CFDs should be first to preserve capital and second to come out ahead on average. Ideally, we want a ratio of about four dollars won for every dollar lost.

What seems to go against common sense is that we don't know - and don't need to know - which trades, of all those we enter, will end up making money. What we do need to know ahead of time is exactly under what conditions we will enter a trade and under what possible scenarios we will get out again.

To trade safely in the market, you need to put some time into learning everything you can about three major aspects.

•  Know the instruments you use to trade and their providers. Look closely at the products before you sign up to trade them. Knowing the provider is as important as knowing the product and you may have to shop around, trying several, before you find one that suits you.

• Learn to read the market. "You have to get into the nitty gritty of the product and have a good understanding of how the entry and exit rules, and risk management of your planning methodology, work together with one another," says an analyst and trader educator at CFD provider CMC Markets, David Land.
  "Your strategy needs to be able to address the appropriate number of positions, the total leverage, and the application of stop-loss methodologies."

• Learn the principles of risk management.

- © Fairfax NZ News