Opportunities & Pitfalls of CFD Trading
Low Commissions Shorting Stocks Convenient Finance Low Margins Guaranteed Stops No Time Decay
Overtrading Wide Spreads Interest Margins No Safety Net No Franking Credits Dividends on Short Stocks Index Trading
With a standard commission rate of 0.10% and minimum commissions as low as $10.00, contracts for difference (CFDs) offer a low-cost entry to share trading. Commsec, Australia's largest online broker, by comparison offers commissions of $19.95 on trades up to $10,000; $29.95 up to $20,000 and 0.12% above $20,000.
CFDs also offer you the option of shorting stocks at the same low commission rates, enabling you to profit from falling as well as rising markets. Shorting via CFDs normally offers a wider selection of stocks than the +/- 200 normally available through your online stockbroker.
Leverage is built into the CFD product, making finance more convenient than arranging a margin loan through your broker.
Margins range from 5% on the ASX 20 to 10% on the ASX 200, compared to the one-third required by online stockbrokers such as Commsec.
Guaranteed stops are one of the biggest advantages of CFDs. For a fee you can insert a safety net below your stocks, guaranteeing your exit at a set price. This protects you from stocks gapping through your stop loss levels in a thin market, and your stop orders being filled at much lower prices. Like insurance on your house or car, most of the time you will not need the guarantee, but it can save a lot of money if you ever do.
There is no time decay with CFDs as there is with options: the instrument does not expire at a set future date.
The biggest pitfall facing CFD traders is overtrading. The high leverage makes it easy to take large positions which your capital base does not justify. It is critical that you use proper money management and apply the 2 per cent (or 1 per cent) rule to your overall position and not just the margin.
Not all CFD providers offer the same service. Some offer Direct Market Access, where you place your trades directly in the market, while others act as a market maker, creating synthetic bids and asks that loosely track the underlying market. There is no harm in this, provided that the market maker offers straight-through processing, where they guarantee that bids and offers will match the underlying market. Otherwise you may be quoted wider bid-ask spreads than the actual market; in effect a hidden fee.
Interest is normally charged on your entire long position at 2% to 3% above the overnight cash rate published by the Reserve Bank of Australia (RBA) — and paid on your margin and short positions at 2% to 3% below the RBA cash rate. The difference between the rate charged and paid is called the interest rate spread and varies between 4% and 6%. When trading CFDs, interest rate charges are likely to amount to many times your total commissions paid. If a CFD provider had to offer me a choice between zero commissions and a 1 per cent reduction in the interest rate spread, I would choose the latter. This may not work for everyone, but I equate every 1% on the interest rate spread to a commission rate of 0.10%.
As with futures, your position is not limited to the amount of the margin. In extreme cases, you may be called on to make up the shortfall if a stock price had to crash and the CFD provider was unable to fill your sell order. Traders who do not have sufficient capital to cover a margin shortfall should consider guaranteed stops.
CFDs are not suitable for long-term traders/investors as they do not offer franking credits on dividends. Your account will be credited with the dividend but you do not receive the tax benefit of the franking credit.
Conversely, if you are shorting stocks, watch out for dividend declarations. If you are short a stock on the effective date, your account is likely to be debited, not only with the dividend amount, but with the franking credit due to the stock lender.
It may seem convenient to trade indexes rather than individual stocks. Consider, however, that if you short the ASX 200, you are shorting every stock in the index, including top performers like Woolworths [WOW] and BHP Billiton [BHP] and contra-cyclical sectors such as gold, which may rise in a bear market. It makes more sense to target individual stocks in weak sectors.