In Part 2 – What to expect…
With all CFD brokers, it is necessary to open an account before you can trade CFDs. When opening an account, you will be required to include your trading experience and a basic statement of financial position. Besides being required by law, this information will be used by the broker to assess your ability to trade CFDs. CFDs are a highly leveraged instrument, so it is important that you have stock market experience before you begin trading them.
As of March 2012, ASIC have made it compulsory for all Forex and CFD brokers to conduct a questionnaire for people looking to trade in CFDs and the Forex markets. Generally speaking, this questionnaire will be available to you once you have filled in your initial application form.
Each broker will use a different trading platform to trade CFDs. All platforms will give access to live price information for the instruments that you are trading. Fees and charges vary from broker to broker and can be dependent on the instrument you are trading.
The first model introduced into Australia was a market maker model. A market maker CFD broker will receive an order from its client and then confirm the CFD trade with the trader. It then has a wide range of options open to them to hedge the underlying position. This includes offsetting orders against other traders, buying shares, buying options, warrants or futures to ensure that it remains in a market-neutral position. In the market maker model, pricing approximates the underlying market.
In the second model, DMA, the CFD broker receives an order from its client and then buys or sells the underlying share. Once the share is bought or sold, it confirms the CFD trade to the trader. Every position is protected by buying or selling the underlying instrument. In the DMA model, pricing is identical to that in the underlying market.
There is a huge debate in the CFD world over which model is ‘better’, but this competition is more from a marketing angle than a trading angle. There are some key differences between the way the two operate and a thorough understanding of these will help you to make an informed choice of which style you prefer.
Order execution used to be a major difference between CFD brokers with Market Maker models using an all or nothing order (Fill or Kill FOK), whilst partial fills have always been possible with a DMA broker. Market Maker models have now updated their order execution process and now offer what is commonly called a Volume Weighted Average Price (VWAP) allowing you to get partial fills on lower liquidity stocks. This is a very positive move and now brings Market Maker brokers in line with their DMA counterparts.
A market maker is not bound to follow the underlying market. If a share is trading at bid 20.15 and ask 20.16 on the ASX, the DMA broker must offer these exact prices, while the market maker can specify its own pricing. In most circumstances, the market makers do follow the underlying depth exactly, but it is possible that they could add liquidity and trade more volume than exists at a price level. The DMA model is completely transparent and means the underlying pricing is exactly what is happening in the market: there is no discrepancy between underlying prices and prices quoted by the CFD broker.
The DMA model allows a trader to participate in the opening and closing auctions. Traders using a market maker CFD broker have to wait for the market to begin trading before their CFD trades are executed. This could create more slippage or issues with liquidity on some shares.
A market maker can offer guaranteed stops, which execute at the stop level even if the market did not trade at this price. These are commonly referred to as Guaranteed Stop Loss (GSL) orders and are not normally available in the DMA model. In DMA, the shares are executed in the underlying market, so it is not possible to trade at a price that does not occur in the underlying market. Macquarie is the exception to the rule offering both the DMA model and guaranteed stops.
DMA is normally limited to trading Australian shares, while the market makers will offer a much wider array of trading instruments from international shares to indices, sectors, currencies and commodities.
There are a wide variety of CFD brokers available and their numbers are growing every month. In Europe there are more than 50 CFD brokers and more and more of these brokers are offering a service in Australia.
When choosing a CFD broker, there are several points to consider. Obviously, whether brokers offer market maker or DMA models will have a big impact on the company you choose. The easiest way to choose between these two models is to determine what you are likely to trade. To trade overseas shares, indices or currencies, you will have to choose a market maker model because DMA is not offered for these instruments. If you choose to trade ASX shares only, then you can choose either execution model.
The choice now comes down to whether you wish to use guaranteed stops and once again pushes towards the choice of a market maker platform. On the other side of the coin, if participating in the opening and closing auctions is important to you or your trading strategy, then you will be choosing the DMA model. If it is important for you to see the orders you place appear and execute in the underlying market, then again your choice will be to use a DMA broker.
These suggestions will help you choose the appropriate broker or certainly narrow down your choice. Some brokers offer both forms of execution, which could be great for the indecisive trader. However, an indecisive trader is an oxymoron, the same as legally drunk, airline food or government organisation.
Unfortunately not all CFD brokers will have all the tools and resources you require to implement your trading system(s) and the reality is that you will need more than one CFD broker to handle your business.
Some of the features of the Market Maker model, like accessing all the world’s markets from the one account, will prove popular but may not give you the transparency in pricing that is available from a Direct Market Access (DMA) model.
As a result of the subtle differences each CFD broker has, it is very common for active CFD traders to have more than one CFD trading account. There is no need to get tied down to one CFD broker whilst you are building your trading business and it is very easy to open an account with another broker and be confidently placing orders within a day or two.
It is not uncommon for professional traders to use between 2-5 different trading platforms at the same time. Remember your goal is to find the service that helps you meet your trading and financial goals, not remain loyal to one broker because you like the staff there.
Coming up next…
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