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Understanding CFDs With CMC Markets
In the Spotlight | 21 April 2011
By: Xavier Lim
Articles (51) Profile

Still remember that terrifying Great Recession period, when our local bourse plunged 63% from 3,906 to 1,456?

In a bear market, betting against the market seems to be a “correct” thing to do. But how can an investor/trader profit from the downtrend?

In an exclusive interview with Gavin Ward, Director of Asia of CMC Markets, he shared with us the easiest, most straightforward way of profiting when the market goes up or down by using Contracts for Difference (CFDs).

Shares Investment: What is CFD and how does it work in practice?

Gavin shares his view on trading CFDs

Gavin Ward: CFDs are financial derivatives which allow investors to speculate on the price movement of the underlying instruments without owning the physical assets. It allows investors to take advantage of both prices moving up or moving down. CFDs originated in London in the early 1990s, mainly used amongst hedge funds and institutional investors as a hedging tool against stock exposures but have now evolved into a retail product. Fundamentally, CFDs allow you to trade shares, indices, FX (foreign exchange) and commodities, all of which people are very familiar with but with the advantages of leverage and the ability to go short.

What are the advantages of trading CFDs over other financial products like warrants and futures?
CFDs can be traded long or short
When you buy a CFD (go long), you are expecting its price to go up so you can sell it later at a higher price, for a profit. When you sell a CFD (go short), you’re expecting its price to go down so that you can buy it back later at a lower price, for a profit. Being able to trade long or short is one of the most attractive features of CFDs. It means you can trade long with the aim of making money on a rising market, or trade short looking to make money when the market is falling. Short selling physical shares is a more complex and costly procedure than short selling CFDs.

No maturity
Unlike futures or options, CFDs do not have a built-in maturity date. A CFDs investor can hold the position as long as he has the enough equity. This avoids price decay which afflicts futures and options when it draws near to the expiry date.

Small minimum contract size
Both futures and options require a large minimum contract size in order to enter the position. As for shares trading, the minimum trading size for CFD share is just 1 share, or 1 contract size of the underlying index. This provides a low entry threshold for investors without the need of a large initial capital outlay.

Wide range of trading instruments
Another main advantage of CFDs is the range of underlying instruments available for trading. Futures are mainly traded for indices and commodities, whereas options are complex derivatives for only limited instruments. Since CFDs simply mirror the price movement of the underlying physical instrument and the contract is one to one with the CFDs provider, it is not costly and always flexible to add new instruments.

Price simplicity
Option pricing can be difficult to understand for the average trader as it requires a firm grasp of underlying concepts such as maturity date, interest rate, volatility, strike price etc. Due to its black box pricing system, different parameters can generate very different prices. Compared to CFDs, options also have price decay when nearing its maturity date, while CFDs prices simply mirror the prices of the underlying instrument.

Lower trading costs
Trading costs when trading CFDs are relatively low. At CMC Markets, traders can enjoy commission free trading on indices, commodities, treasuries and FX CFDs. For shares CFDs, commissions are as low as 0.10%, with no GST and clearing fees. Furthermore, traders do not need to pay financing charges when they take a short position.

What are the risks involved in trading CFDs?
As with all investments, trading CFDs include risks. Two of the key risks that investors trading CFDs should be aware of are market and liquidation risks.

Market Risk
The main risk in trading is the risk that the price movement of the underlying instrument between the opening and the closing goes against you. For CFDs trading which offers margin trading, the leverage effect can result in increased risks significantly. This is the reason why most CFDs providers offer free risk management tools such as “stop loss orders” to mitigate a trader’s downside risks.

Liquidation Risk
In the event that the trading losses exceed a CFDs trader’s available equity, a margin call would be issued to request for additional funds to allow the trader to continue holding the position. If the funds are not provided and the markets continue to work against the trader’s position, the CFDs provider may liquidate the position at a loss for the investors to safeguard traders against further excessive losses.

What is the edge CMC Markets can offer to traders, especially professional traders?
The key advantage we have is the ease of use of our platform and we are constantly improving it. We’ve made an investment of US$100m over the last 2 to 3 years to develop a new platform, which will be released later this year in Singapore. Our other main advantage is our emphasis on providing education to our clients – we currently have free education courses for all of our clients which cater to their differing levels of trading knowledge. It is in our interest to ensure that our investors are successful and confident in their trading so that they continue to trade.

Opening Position

The total outlay with CMC Markets is significantly lower than with Traditional Broker Y for the same exposure to market.

Closing Position

Lower net profit is received from Traditional Broker Y due to substantially higher commissions and GST.

Coming to you on the 23rd of April, Shares Investment will be organizing a seminar with CMC Markets to speak on the mechanics and strategies in profiting from FX. During the seminar, you will learn to utilize FX to diversify your investment portfolio and enhance your trading returns. Be sure to seize this insightful opportunity.

Armed with an arsenal of investment knowledge, Xavier is the Senior Research Editor at Shares Investment.

Please click here for more information about this author.


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