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Archive for July 13th, 2010

What exactly is a Contract for difference?
Contracts for difference are a popular derivative in the Australian marketplace. When you own a contract for difference, you own a contract over the difference between the price that you purchased the contract for and the present price of the contract, ie you own a contract over the performance of the share. That is, if you purchase a contract for difference 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 Contract for difference had decreased in value, then you would be obliged to pay the difference between the purchase price and the current price. As opposed to buying the shares, you purchase a contract over the movement in the stock price and this is revalued or “marked to market” in real time.

A CFD gives you all the benefits of share trading 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 decided by the difference between the prices you buy and sell at. CFDs also incorporate any adjustments for corporate actions, including dividends and stock splits.

What are the benefits of Contracts for difference?
Contracts for difference are traded on margin, which is a more efficient use of your capital since you only have to allocate a small amount of the value of your 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 brokers charge low commissions, which means that you don’t have to pay high priced brokerage on either long or short transactions.

Because you are trading the price movement of the stock or index without physically owning it, it is as easy to sell a share or index CFD, as it is to purchase it. This allows short selling to be done just as effortlessly as buying a Contract for difference. Therefore a CFD trader has the chance to profit from both bull and bear markets in addition to short-term intra day movements.

Just as CFDs emulate the price movement of the physical share market, they also mirror any corporate actions that happen in the underlying share or index (dividends, stock splits or consolidations). This means that the owner of a share CFD will receive dividends, and take part in stock splits, just as 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 share, then you are obliged to pay for the dividend in that same way as if you are short the physical share. You are not entitled to any voting rights since you do not actually own the shares.

Short selling Contracts for difference
Short selling using Contracts for difference is the same as selling Contracts for difference which you already own. There are no restrictions on how you transact CFDs or on short sellable CFDs. It is possible to short sell any available CFD however some CFD providers might have a limited short sell list and impose limitations on the quantity of a share that can be short sold. You don’t have to short sell on an uptick like in the share market you are able to short sell at any price the share is trading at. This provides major advantages over the traditional methods of short selling.

Contracts for difference that can be traded
Most CFD providers offer Contracts for difference over the key sectors, major stock indices and the stocks in the main share indices in the most important markets. Many providers offer thousands of different instruments in Australia, Asia, the UK, Europe and America.

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

CFD positions carried overnight incur financing costs for the entire value of the position. Traders who are long Australian Contracts for difference will pay interest and clients who are short will collect interest for their positions. The interest rate payable is determined by the cash rate for the country where the stock is listed. If the base rate of interest of a country is less than the financing cost charged by the Contract for difference provider 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.

If you hold a CFD overnight, you’re charged interest on the full 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 rate of interest charged depends on the market that’s being traded. If you are short a CFD, then you’ll receive interest on the full value of your position for every day that you hold your position overnight. If you have a well-balanced trading system where you’re short and long for around the same period of time, you will effectively only pay only a small interest charge for overnight positions.

You can find out more about trading contracts for difference by downloading your free contract for difference guide.