In Part 1 – What to expect…
Contracts for difference (CFDs) offer freedom of choice and a lifestyle that many people dream of with the ability to make money 24 hours a day from anywhere in the world and minimal restrictions on your daily life.
CFDs open up a whole new range of opportunities to the active trader. The access to leverage, the ability to trade long or short and the flexibility to enter and exit a trade at market prices when you choose are now available to all traders. This flexibility provides not only a fantastic opportunity and it also requires the trader to implement rules to ensure survival in the market.
Discover ways to Maximise your opportunities
CFDs allow you as a trader to multiply your wins and losses. Unlike with options or warrants, understanding the mechanics of CFDs and how to trade them is relatively simple. The key to your success is not this understanding, but your risk management and how you cope with the ups and downs as a trader. This should not be underrated. Coping with the psychological impact of large wins or large losses is a key component of your success when trading CFDs.
By the end of this course, you will be well equipped with the knowledge to enter the CFD market and overcome most of the common mistakes that traders make. However, to really master trading CFDs, you will need to start trading them.
A CFD is an agreement to exchange the difference between the entry and exit price of the contract. There is no restriction on the entry or exit price, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first. CFDs mirror the movement and pricing of the underlying share. A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Unlike trading a share, to buy $10,000 of a share using a CFD, you do not need $10,000, only the margin requirement, which could be as low as 3 per cent or $300 for a $10,000 position. This gives traders access to leverage, enabling them to amplify their returns (and losses) compared with movements in the underlying share.
CFDs offer the trader leverage by using a small deposit to control a large position. You can short sell a CFD either to offset any loss in the shares you own or to benefit from a fall in the value of the share. As the share price drops in value, the CFD increases in value. No longer do you have to sit and wait for the share to turn around and start to climb before you are making money. You can be making money regardless which direction the share moves in.
Buying shares on margin is similar to borrowing money through a margin loan to buy shares, or buying a house using a mortgage. To own a house, you are not required to have the full purchase price, only a deposit. This deposit is required by the bank to ensure that if they have to sell your house the bank does not lose money. CFDs offer a similar opportunity to a trader. Using CFDs, you can place down a deposit, known as a margin.
This margin requirement is used to protect the CFD provider if they have to sell a trader out of a position.
The initial margin requirement varies from share to share and broker to broker but a range between 3 per cent and 80 per cent of the face value of the share is expected. For indices or currencies, these margin requirements can be as low as 1 per cent of the underlying value of the security, if your CFD broker trades in these products. As the value of the CFD position changes, the margin will also change. Margin requirements are calculated each day. If the initial margin is 1 per cent of the face value of the contract, a $10,000 account can trade as much as $1,000,000 worth of CFDs. This amount of CFDs fluctuates in value significantly and can very quickly wipe out a small account.
The variation margin is a much more important number than the initial margin. The variation margin is your daily profit or loss on a position. As with the initial margin, this is calculated daily by a process known as mark to market. At the end of each day, any gain is credited and any loss deducted from your account.
Free equity is used to refer to the free cash in your account after margin requirements have been taken into account. If you deposit $10,000 into your account and you enter $50,000 worth of CFD positions at a 10 per cent margin, then your initial margin requirement is $5,000, leaving free equity in your account of $5,000. If the position moves in your favour by $500 during the trading day, then your free equity will increase to $5,500. If the position moves against you during the trading day by $500, then your free equity will decrease to $4,500. If your free equity moves to zero, you will receive what is known as a margin call. This is a request to deposit more money into your account or decrease the position that you are trading.
A great rule of thumb to use when trading share CFDs is to ensure that you only ever use a maximum of 50 per cent of your account balance as initial margin, leaving the remaining 50 per cent to cover your variation margin requirements. If your account balance is $10 000, then use a maximum of $5000 to meet initial margin requirements, allowing you to buy $50 000 worth of CFDs at a 10 per cent margin requirement.
A margin call occurs when your free equity falls below zero in your account. In this case, you will be contacted to place more money into your account or reduce your open positions. It may be necessary to exit some positions to create free equity in your account. Alternatively, you can deposit more money into the account to meet the margin call.
If you do not meet a margin call, the CFD provider has the right to close out any position that they choose to. Theoretically, the most you can lose is all the money in your account; however, if a share gaps dramatically against your position then you could lose more than your account balance. You will be liable for losses larger than your account size if this happened.
When trading in CFDs, you are in effect borrowing money, as you are when you place down a deposit to buy a house. There is no interest charge on positions that are closed the same day you bought them. If positions are held overnight then interest is charged, or credited if you are in a short position, on the face value of the transaction.
Interest rates vary from provider to provider and are usually based on the Reserve Bank of Australia (RBA) base rate plus or minus a margin. Typically, the interest rate charged for long positions is RBA base rate plus 2-3 per cent, and the amount of interest paid when you are short is RBA base rate minus 2-3 per cent. Some CFD brokers link their interest rates to overseas base rates. Check with your broker how interest rates are calculated. Interest will be paid on the free equity in your account at varying rates, depending on the CFD broker.
Coming up next…
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