Learning About Contracts For Difference

Welcome to Alpha's CFD Trading Education Centre. Whether you are just beginning to trade or you are a seasoned investor looking for new trading strategies, this Centre provides a wealth of information on the most relevant topics.

We will start by talking about some of the basic features of CFDs including some of their advantages and shortcomings compared to traditional stocks.

What are CFDs

Contracts for Difference are a stock derivative product that enables investors to participate in the price movement of an underlying stock or stock index without taking ownership of the underlying instrument itself.

CFDs offer some important advantages over traditional stocks that make them particularly interesting to short-term traders.

Trade CFDs on live tradable prices

CFDs can be traded directly on live (un-delayed) tradable prices, while conventional stocks often require you to establish an exchange agreement to trade on live stock prices.

A CFD price behaves exactly the same as the underlying stock price, but often the trading fee is already added to the Bid/Ask spread. In many cases, this is the only 'fee' you pay for trading the CFDs, so you know exactly what your profit or loss is, including trading fees, when you close positions.

Margin trading

Margin trading allows you to magnify small intra-day price swings by depositing a fraction of the trade value in collateral. Margin rates vary between CFD providers; we currently offers leverage of up to 10x (10% margin requirement) for stock CFDs where an investment of only $10,000 can be used to command a CFD position of up to $100,000.

Of course, margin trading can work against you as easily as for you, and while profits can be magnified so can losses. You should use leverage with caution.

Short selling to take advantage of falling markets

CFDs also offer the advantage that you can short sell a stock to take advantage of downward price movements as easily as buying the stock (going long). Executing a short sell is done in exactly the same way as a long trade and can be done on a live tradable price quote.

Short selling a stock CFD is subject to specific rules in some countries.

Eliminates stock trading costs

CFDs also hold the advantage that they are not subject to a number of costs that traditional stocks are subject to:

Custodian Fees

Most stock trading establishments charge a yearly custodian fee for holding foreign stocks to cover the administration of holding the stock for you. Additionally, you may also have to pay cross-board transfers for stocks and for other corporate action such as dividends and stock splits. CFDs are not subject to these costs, but are faster and more convenient to trade than physical stocks.

No Stamp Duty

As you are not physically buying stock, in many countries profits from CFDs are currently not subject to the same same taxation as profits from stocks. This is one of the major contributing factors to the popularity of CFDs in some countries.

If you hold a long CFD position on Ex-Dividend Day, you receive dividends for that CFD in the same way as if you held the stock. So when leveraging your stock investment on margin, you magnify dividend payments as well as price swings for the stock.

Note that if you are holding a short CFD position, you will be obliged to pay dividends on your position.

When you buy a CFD, you are effectively borrowing money to pay for the CFD and you own money is there only to cover potential losses from the CFD position. For long CFD positions held past the end of the day's trading on the exchange, you pay overnight interest on the amount borrowed and this must be taken into consideration. In reality, this can make CFDs suitable mostly for short-term positions as longer term, financing costs can eat into potential profits.

CFD positions closed before the end of day on an exchange are not subject to overnight financing charges, and CFDs are therefore well suited to intra-day trading.

Short CFD positions carry no financing charge and you may even receive a small interest component.

Leveraging your Investment 

The greatest advantage of margin trading is the ability to leverage relatively small investments for a much greater market effect. This is particularly attractive to short-term, intra-day investing where price swings are typically more limited than over longer periods. The amount you can leverage your investment depends on the trading provider; we currently allow a maximum leverage of up to:

• 10 times for stock CFDs - on the 21 stock exchanges we currently support For example, an investment of only USD 2,000 can be used to command the equivalent position of up to USD 20,000 worth of stocks on the market.
• 20 times for stock index CFDs - for the 11 major indices we support For example, an investment of only USD 10,000 can be used to command a stock index position of up to USD 200,000 on the market.

How Margin Trading Works

When trading CFDs, you deposit an amount with the bank which allows you to open and close stock positions for many times the value of your deposit. The amount you deposit is known as the 'margin collateral'.

When you open a trade position, this collateral is in effect untouched until you close the position again when the profit or loss is credited or debited to your account. In other words, this collateral is there to cover potential losses from your margin trading activities.

When you open a trade position, a percentage of your collateral is required to cover the position, and this amount is reserved in your account. The amount of collateral required to cover a position changes whenever the market price of the position changes. So if you already have open margin positions, the margin available for new positions is continually changing.

Margin Calls

Margin trading can work against you as well as for you, and under normal circumstances your account will not be allowed to go into debt. If the price of an instrument goes far enough against your position and your margin collateral is becoming insufficient to cover the resulting loss, you will be required to close or reduce positions, or to deposit more margin collateral to cover the new margin requirements. If you fail to take appropriate action, positions may be automatically closed on your behalf.

Margin Calculation Example

In this example we will use a stock CFD with a margin requirement of 10% and you have margin collateral of EUR 100,000 giving you up to EUR 1 Million available to invest on the market.

Say you buy CFDs for EUR 400,000 using 40% (10% * EUR 400,000 / EUR 100,000) of your available margin collateral. At this point, you have up to EUR 600,000 available to invest in other CFD positions.

If the market moves with your investment

If things go well, and the value of stocks in your CFD position go up by 2% and you close the position, you make EUR 8,000.

If the market moves against your investment

If the market value of your CFD position drops to EUR 320.000, your Available Margin drops to EUR 20,000 (EUR 100,000 - the loss (EUR 400,000- 320,000)) and now only covers 6.25% of your investment (EUR 20,000 * 100 / EUR 320,000) - you have exceeded your margin and must take steps to remedy the situation:

• Transfer additional funds of at least EUR 12,000 to cover the new margin requirements of EUR 32,000. Note that transferring EUR 12,000 will bring your Available Margin back to 10% of your position (10% of EUR 320,000) but if the CFD position falls further you will immediately have exceeded your margin again.
• Reduce the CFD position by selling the appropriate number of shares equaling at least EUR 120,000 to bring your position down to EUR 200,000. Again, this will bring your Available Margin back to 10% (on Margin) of your position (10% of EUR 200,000), but if the CFD position falls further you will immediately have exceeded your margin again.

In this edition of the CFD classroom, we give an overview of the basic types of CFD trades - to be expanded on in the following editions of the series.

In this edition, we will talk about the basic ways that you can trade CFDs. The method you chose depends on a number of factors including:

• which stock you are trading and whether your CFD provider is the market maker for the CFD of this stock
• whether you want to enter the market right now, or wait until the market price reaches a certain level
• whether you want to make sure your full order is filled or it is more important to be filled at a specific price
• whether you are participating by trading directly on the market prices in the Exchange order book

Trading CFDs on a displayed live tradable price offers very fast direct execution of CFD trades: When a CFD price hits a price you are interested in, you hit the Buy or Sell button and the full amount of your order is guaranteed at the price displayed. Trading on live prices is only possible if your CFD provider is the Market Maker for the CFD.

For the CFDs where we are the Market Maker, the price is displayed in green and you can buy or sell the amount of CFDs at the displayed price:

We will describe trading Market Maker CFDs more fully in the next edition of this classroom series.

Trade Orders

The other way to trade CFDs is by trade orders. Trading by order can be almost as fast and direct as trading on live prices, and by participating directly in the exchange order book, orders can be filled within seconds.

Use of Orders

Trading on live tradable prices is typically used for entering and exiting the market fast when you feel the conditions are right. Trade orders allow you to make a more strategic approach to trading and to plan your moves up front. Taking a more disciplined approach to taking a position, you would typically use:

• An entry order to trade when (if) the market reaches a specific price.
• A take profit order to close the position when the market price reaches a level you expect it to reach.
• A stop loss position to the position in case the market moves in the wrong direction. Note:This is always highly recommended, serious traders should always protect their positions and limit their losses in case of adverse market moves.

• Market Orders to trade as soon as possible at the best price currently obtainable in the market. This is typically used when tradable green prices are not available.
• Limit Orders to trade when the price hits or breaches a level below (for buy orders) or above (for sell orders) the current market price
• Stop Orders to trade when the price hits or breaches a level above (for buy orders) or below (for sell orders) the current market price.

When CFDs can not be traded on live tradable prices, they can be traded by placing orders. Trading by order can be almost as fast and direct as trading on live prices, and can be done by exchange order book participation.

Use of Orders

Trading on live tradable prices is typically used for entering and exiting the market fast when you feel the conditions are right. Trade orders allow you to make a more strategic approach to trading and to plan your moves up front. Taking a more disciplined approach to taking a position, you would typically use:

• An entry order to trade when (if) market reaches a specific price
• A take profit order to close the position when the maket price reaches a level you expect it to reach
• A stop loss position to the position in case the maket moves in the wrong direction. Note: This is always highly recommended, serious traders should always protect their positions and limit their losses in case of adverse market moves

There are three basic order types:

Market Orders

Market Orders trade to trade as soon as possible at any price obtainable on the market - use these only when you want to be filled as fast as possible and are not critical about the price you will be filled at.

Market Orders are typically used when direct trading on live tradable prices is not available, for example when your CFD provider is not the market maker for the CFD, the market is closed or for large trade volumes.

Limit Orders

Limit Orders are used to trade when the price hits or breaches a level you define (a sufficient quantity must of course be available for the trade to be executed). Limit orders are usually placed below the market for buy orders (so you buy when the price falls to a level you specify) and above the current market price for sell orders.

Limit orders to buy can also be placed above the market which will execute for the volume of stocks that exist at the market price or better. This guarantees the price you will pay will never be more than the limit price you specify.

Limit orders are typically used to:

• Enter the market when the market falls/rises (don't forget with CFDs you can short a stock as easily as going long) to an entry level you specify.
• Close a position to take profit, when the price rises/falls to the level you predict.

Limit orders do not guarantee that your position will be filled at all if the price never reaches the price you specify. And if the price does move as anticipated, there is no guarantee that the total quantity of your order will be filled, but Limit Orders do guarantee the price you specify or better.

Stop Orders

Stop orders are used in a similar way to limit orders to trade when the price hits a defined level, but are used to trade against the market. So stop orders are placed above the market for buy orders and below the current market price for sell orders.

Important: Unlike limit orders, stop orders are executed when the price hits or breaches a level but there is little or no guarantee that you will be filled at that price. When the price hits or breaches your specified price, Stop Orders become Market Orders and are then filled at whatever price is available in the market. So if only a few shares are available at the stop price you specify, the rest of your order may well be filled at another level. This uncertainty is sadly unavoidable but none the less bad news when you are trying to protect yourself against losses.

• The most common use of stop orders is to close positions to limit losses if the market heads in the wrong direction from that you predicted. For example if you are holding a short position, you would place a stop order to buy at a price above your entry price to close your position and limit your losses.
• Another use of stop orders is to wait for a market turn-around. So you might place a stop order to open a long (buy) position if the market is trending in the right direction and the price moves above the current price.

Linked Orders

To complete this introduction to basic trading mechanisms, we need to talk about linked orders.

• A limit order to open the position when the market hits the right price
• A limit order to close the position again to take profit if the market behaves as you anticipate
• A stop order to close the position to limit losses if things go wrong

If Done Orders

Take profit and stop loss orders should not be placed at the same time as the entry order as they might be executed before it. You would then be in an unpredictable position. They should be placed if, and only if, the entry order executes. We can do this if we link the take-profit and stop-loss orders to the entry order in an If done arrangement.

Furthermore, if the take profit and stop loss orders are active in the market, when one of them executes, the other will be left floating around and could execute a spurious trade. To prevent this, these two orders need to be linked together in another relationship called One Cancels the Other, often called 'OCO' for short. In this arrangement, as soon as one of the orders executes, the other order will be removed.

Frequently you want to place all 3 orders together; an entry order to open the position linked to 2 orders which are placed to close the position (either to take profits or limit losses) which themselves are linked as OCO orders. This is what we call a 3-way or contingent order.

As explained in a previous edition, the exact mechanics of making a CFD trade is dependent on the CFD provider and the trading platform, but we will take a walk through making a CFD trade using our CFD trading platform which is routed to the stock exchange.

Out of around 2,500 stocks available as CFDs from the 21 stock exchanges we support, we are currently the market maker for around 500 of the most popular. So if you are trading the major 'blue-chip' companies, we are likely to be the market maker (up to a maximum amount of shares). The remaining around 2,000 stocks and trades in stocks above our maximum amount are routed directly through to the exchange. It is trading these stock CFDs that we will be discussing in this edition.

If you have our demo download, why not open it up and try this out yourself.

At the stock exchange, an order book is maintained for each stock which contains - amongst other things - the number of shares that can be bought (at the Ask price) and sold (at the Bid price) at different price levels.

The current market price that shares can be bought and sold is at the top of the order book and is known as the 'Yellow Strip Price'.

As the order book can move faster than the data can be processed and routed to you over the Internet, the price displayed in the trading platform is only indicative of the current market price from the order book. The price displayed also takes into account the number of shares you entered for the trade. So for example, if only 500 shares of the German company Altana are available at the current market price of 44.90 and you want to buy 1000, the remaining 500 shares will be filled at the next price level 44.91. This price is called the volume weighted average price.

The overall price displayed will then be ((500 * 44.900) + (500 * 44.910)) / 1,000 = 44.905 EUR/Share. The 0.04 EUR/Share difference you can see between the price displayed 44.945 and the calculated price 44.905 is the trading commission added to the trading spread.

When trading CFDs that are being routed to an exchange, the CFD Trade module looks like this:

Instead of the simple Buy and Sell buttons, you now have to choose whether you want to place a market or limit order to buy or sell. You are also given options for placing orders join the current buy or sell price (sell at the current Bid price or buy at the Ask price).

When CFD trades are routed to the exchange, trading is done by trade placing trade orders in the order book. You need to decide and you need to decide what type of order best fits your situation:

• Market Orders (Buy @ M and Sell @ M buttons)
  Market orders pretty much guarantee that your full order will be filled, but not the price at which it will be filled. All being well, you will get the displayed Volume Weighted Average Price but it is also likely that the market has moved since then and the price will differ. If you want a trade that will fill at the best available price - for example, some important news about a company has been released that will affect the share price and you want in as fast as possible - use a Market Order.
• Limit Orders (Buy Offer and Sell Bid)
  Limit orders are used when you want to trade at the displayed price displayed or better. Limit orders do not guarantee you will get a position or that your complete order will be filled. So maybe only half of an order for 10,000 shares can be filled at the price you placed the order; the remaining 5,000 will be placed in a new order at the same price and wait for the market to hit that price again. Use Limit orders when you want a specific price, for example when the price of a stock is approaching a level of resistance and you expect a reversal in the near or immediate future. But be aware, you might not be filled.  

The CFD Trader module also offers buttons for joining the currently displayed Bid and Offer prices, so if the current market price at which you can buy a stock is 100, you would add your order to the order book to sell at 100. This is also done using limit orders that guarantee the price of your trade but not that you will be filled.

When using the Join Bid and Join Offer options, be aware that for the volume you are trading, the Volume Weighted Average price displayed might not be at the top of the order book but be an average of a number of levels.

If you would like more information please contact 03 8662 4009 to speak with one of our Financial Advisers