Contract for difference (CFD) trading enables individuals to profit from an underlying asset's upward and downward price movements without owning it.
While CFD trading offers the potential for significant gains, it is essential to recognise the inherent complexities involved. Incorrect speculation can result in substantial losses exceeding your initial investment.
Consequently, engaging in CFD trading demands a comprehensive understanding of the market and a thorough assessment of the associated risks before proceeding.
This guide will teach you about CFDs, their benefits and drawbacks, the best CFD trading platform and broker, including the steps to follow to place your first CFD order in Australia.
1. What Is CFD Trading In Australia?
Contract For Difference (CFD) is a financial instrument enabling traders to speculate on the price movements of an underlying asset. Traders profit when the price of the asset moves in the direction stated in the contract.
According to ASIC, CFDs are derivative investments. They derive their value from other assets: stocks, currencies (forex trading), cryptocurrencies, indices, and commodities such as gold, iron ore, oil, and wheat.
CFDs are not standardised contracts, and their uniqueness lies in the fact that they do not require the acquisition or ownership of the underlying asset.
Instead, they are solely based on changes in the asset's value. This distinctive feature allows traders to engage in CFD trading beyond regular market hours, opening up opportunities to maximize their investments.
2. What Type Of Assets Can You Trade Using CFDs?
You can trade CFDs in a range of asset types as the market in Australia is growing. These includes:
3. Is CFD Trading Legal In Australia?
Yes. It is legal to trade in CFD in Australia. However, you must open a CFD trading account with a regulated broker. Ensure the broker is regulated and check for an Australian Financial Services license number. It ensures your investment remains safe.
4. How Do CFDs Work?
You can trade CFDs in two different ways. One way is going long, and the other is short. Going long implies you expect the value of the underlying asset to increase over time, and going short means you expect it to reduce with time.
When your speculation aligns with the market movement, you receive payment based on the difference in value. Conversely, if your speculation proves incorrect, you must cover the difference.
It's crucial to remember that any mistaken assumptions can result in losses exceeding your initial capital, primarily due to the application of leverage in CFD trading.
Since the CFD is a legally binding agreement, if the market goes against your prediction, then the CFD provider:
Ask you to pay the additional money to keep your position open. It could result in further losses.
You may close your CFD position at the current value, which may lead to losing all your invested money.
CFDs don't have an expiry date, and any party can close out an open position or sell an asset. Daily CFDs don't have expiry dates. However, they are subjected to overnight financing charges.
Forward CFDs expire at a future date, and the spread includes the financing-related cost.
5. Key Concepts Behind CFD Trading
CFDs quote the buy and the selling price:
The Sell Price/ Bid Price: It is the price at which you open a short CFD
The Buy Price/Offer Price: It is the price at which you open a long CFD
The difference between the two prices is called the "Spread".
CFDs are exchanged in standardised contracts, also called "lots". The contract size varies based on the underlying asset traded.
You can usually buy CFDs in multiples of 1000s, and every CFD has its price. Generally, the cash expense is 5% of the CFD value. The initial expense calculation is the price of the CFD Contract x the Number of CFD contracts bought x 5%.
For commodities CFDs like Silver, they trade in lots of 5000 troy ounces. In the case of stock CFDs, the contract size represents 1 x share in a company.
Unlike derivatives, CFDs don't have a set expiry. It allows traders to decide when to book a profit or loss. If you keep your CFD position open after the daily cut-off time, you will have to pay an overnight funding charge.
Profit And Loss
The two parties who enter a CFD contract gain or lose based on whether the value of their underlying asset rises or decreases.
Gain or loss in the contract = (Open price - Close price) * the number of underlying shares/other assets formalised in the contract * value of each contract – (overnight funding charges / guaranteed stop fees/commission).
6. Steps To Buy And Invest In CFDs In Australia
Here are six CFD trading steps you will need to follow to start CFD trading:
Step 1: Open And Fund An Account with A Broker
Once you decided on a CFD trading platform, fund your account via credit card, debit card, BPAY, or PayPal to place the initial CFD trade.
Some platforms offer demo accounts to help newbies practise with AUD 20,000 virtual funds to build market confidence in a risk-free environment.
Step 2: Learn How CFDs Work
The second step before trading CFDs is to learn how they work.
Understanding the concept of CFD trading, its terminologies, how it differs from other forms of trading, and its strategies can help you trade effectively.
Consider taking a 45-minute beginner-level free CFD trading course by IG Academy to learn about CFD trading, its benefits and risks, why to trade in CFDs, and how to make the most of your trades.
Step 3: Learn To Use A Trading Platform
CFD brokers provide a variety of platforms to fit your trading style and preferences. You receive access to plenty of features, including interactive charts, risk management tools, and personalised alerts to take trades wisely.
Before you place your first CFD trade, gain proficiency in accessing several trading platforms:
Mobile trading apps
Step 4: Choose A Market
Step 5: Develop A Trading Plan
Once you have created your account, you must develop a trading plan that includes your motivation, objectives, ideal trade, attitude to risk, acceptable loss, desired profit, and available capital and risk management strategies.
Step 6: Place Your First Trade
Having decided which market to trade in, you now need to learn how to open, monitor, and close your first position.
To do this, first, decide whether you want to go long or short. "Buy" if you think the price will go up, and "Sell" if you think it is going down over time.
Next, choose a trade size you can afford and add a stop loss that automatically closes your position if the market moves against you. It limits your potential losses.
You can choose from a range of risk management strategies, including:
After you open the position, your profit or loss will move following the underlying market price. Next, keep an eye on your open CFD position on the platform and monitor price changes leading to any loss or profit.
When you are ready to realise a loss or collect a profit, then exit the trade by clicking the 'close' button. If you did open a position on the buying side, you could close it by selling an equal number of contracts at the selling price and vice versa.
7. Benefits And Drawbacks Of CFD Trading:
Advantages of CFD Trading
Potential to make big profits due to leveraged products and smaller investments
Protection against loss
Facility to trade them across thousands of financial products and overseas markets
No expiry of CFD contracts
Risks of CFD Trading
CFDs are prone to liquidity, market, and counterparty risks that may only make them ideal for some.
CFDs depend on the market conditions of the underlying asset, making them a High-Risk financial instrument.
Leverage (trading with borrowed money) can lead to multiplied losses. A small price change against your CFD position can hugely impact your trading returns/ losses. As many retail clients lose their initial investment when trading CFDs, consider whether you can afford to lose your money
CFDs are complex to understand and execute, which makes them suitable for advanced traders.
It may have hidden clauses that the trader needs to be made aware of.
Sudden price movements in the market can make you win one moment and lose the next.
Consumer protections under Australian laws may not apply to overseas CFD providers as they do not have an AFS licence. It implies that you won't have access to independent dispute resolution via the Australian Financial Complaints Authority.
8. Main Types Of CFDs
You can access three CFD types: DMA, Market Makers, and Exchange-traded.
While the first two are the most common methods used in Australia and worldwide, the ASX provides exchange-traded CFDs.
The best way to trade CFDs requires you to understand each of these types of CFDs:
Direct Market Access (DMA)
Independent firms provide this type of CFD account, which allows financial agencies or investors to access liquidity to buy and sell securities directly without involving dealers and brokers.
You can specify your trading goals and modify them without contacting a trading specialist.
Take more or less risk based on your previous performance, trading experience and skills.
The electronic environment enables faster transactions and fewer price discrepancies or differences than when placing an order with a dealer or a broker.
You can use buy/sell anytime when it suits you.
Ideal for skilled and experienced traders. Not ideal for inexperienced investors as the inability to read trends in time can risk losing money.
It offers a comparatively smaller offer range than other CFD trading types like a Market Maker.
Insufficient trading in the underlying market may prevent you from opening and closing CFD positions.
This type of trading creates its market and sets the buy and sell price for the underlying asset:
You do not have direct access to the market as with DMA.
Newbies can get advice from their broker or dealer on investing in CFDs.
The assets reach broader markets and a higher liquidity level in the market.
Higher liquidity enables you to trade even with inadequate trading in the underlying market.
It involves higher commissions and brokerage fees.
The broker can re-quote the prices after placing an order.
This CFD trading lets you trade CFDs listed on the Australian Securities Exchange through authorised brokers or dealers. Buyers and sellers don't deal directly but via the ASX24 that processes, registers, and clears all the trades.
The counterparty risk is lower on a gradual basis.
Newbies can use the consulting services of their dealers or brokers to perform the trade.
It charges higher commissions and brokerage fees.
Experienced traders can only trade indirectly. They must open an account with a brokerage platform before trading in CFDs.
9. Frequently Asked Questions (FAQs)
How Much Money Do You Need For CFD Trading?
The costs of CFDs depend on the market you prefer to trade in and the market liquidity. You generally must pay only a commission charge for stock CFDs and a spread for all others.
It is important to note that every market has a minimum number of contracts you must purchase or sell to place your trade. Traders also pay for guaranteed stops, financing costs to fund positions overnight, and extra fees for specialist tools.
What Is The Difference Between CFDs Trading and Regular Stock Trading?
Let us look at the CFDs Vs Stocks below:
The fundamental difference between trading in CFDs and stocks is that you buy and own the underlying asset when investing in shares. However, with share CFDs, you do not own them as you own the contract provided by the CFD provider and speculate on whether the share price will rise or go down without holding it.
Since CFDs trade with leverage, there are possibilities of losing more than your initial investment. However, in the case of trading shares, you make the full payment of the position upfront and can’t lose more than you invest.
Another difference between stock trading and CFD trading is that in the former case, you can trade only stocks and ETFs, and in the latter, you can trade in a wide range of asset types such as forex, indices, commodities, and shares.
CFD trading is also available during extended hours (after standard market hours). You can trade around the clock in several markets. On the other hand, with stock trading, you can only trade during stock exchange opening hours.
While you get the right to vote and participate in other corporate actions when trading stocks, you don’t get shareholder privileges with CFDs.
Are CFDs Good For Beginners?
Whether you are a new or an experienced trader/investor, CFDs can be a part of your strategy.
However, considering the complex nature of CFDs, only those CFD traders with good knowledge and experience in the financial markets can benefit from this financial instrument.
Inadequate knowledge can result in losses that exceed your deposits. CFD trading for beginners is only worth considering when knowing the financial markets in and out, the meaning of CFD trading, the circumstances, and the benefits, risks, and strategies associated with CFD trading.
Is CFD Good For Trading?
Yes and No. CFD trading is a great way to trade different types of assets and generate profits. It allows traders 24-hour access to various futures and cash markets. Taking a CFD position gives you the following features and benefits:
Diversify your portfolio with over 30 global indices, including stock indices, sectors, and more.
Open a position in numerous sectors, such as retail, mining, and banking.
Enjoy greater flexibility to select your position size for mini and standard contracts.
Trade with no expiry dates
Mobile and tablet apps are available to trade and monitor positions on the go.
Use leverage to take your investment capital go further.
Protect your physical portfolio from adverse movements (both falling and rising stock prices) through hedging and Short-sell.
Able to trade Australian and global shares from the same account
Use direct market access to trade inside the market spread.
How To Choose The Best CFD Trading Platform In Australia?
There are only so many CFD brokerages in Australia for everyone. It depends on individual needs and factors such as margin requirements, fees, spreads, etc.
Look for a CFD trading broker that offers the following:
Low spreads, transparent fees, leverage and margin requirements help maximize your position size.
Provide easy-to-use and intuitive platforms. Most CFD trading websites use the popular MetaTrader or MetaTrader 5 systems.
Should offer competitive prices
This should enable you to trade in a range of markets.
Should provide free access to ASX live data (without any additional charge)
Should process trades fast and reliably each time
Should check user reviews to gauge their satisfaction
Should provide negative balance protection
It should be convenient for beginners and allows opening a demo account.
It should provide ample research and trading tools such as trialling signals, charts, and other analysis tools to help you make lucrative trades.
Some of the features of the platform are:
Enjoy low and variable spreads as low as one pip for USD/JPY, and EUR/USD
Safeguard your investments with advanced risk management features, such as customizable stop loss, and real-time alerts
It offers a $100,000 demo account to experience risk-free CFD trading
Its CopyTrader feature enables you to imitate the trades of other traders automatically in real-time
Dedicated customer support 24 hours, five days a week
Is CFD Trading Taxable In Australia?
The CFD trading tax in Australia depends on whether you are operating as a business. You may owe tax if you make any profits from your CFD trading. It is mandatory to declare the total gain and loss to the Australian Tax Office (ATO).
The ATO states that if you are a small business operating as a sole trader, you must keep a record of income and expenses. The amount of tax you owe will depend on how much profit you make.
The CFD trading taxes in Australia work the same way as taxes on other instruments, such as forex and stocks. A loss can be offset against your total tax liability and carried forward, while profits will be taxable.
What Are The Differences Between CFDs and Futures?
Let us look at the CFD vs futures below:
Both are financial derivatives for speculating on markets without owning assets, but they work very differently.
Types of Trading:
Primarily OTC trading
|Ways of Trading:||Long/Short||Long/Short|
|Tradable: Commodities||Stocks, ETFs, forex, indices commodities||Forex, indices, commodities, bonds|
|Leverage:||High leverage (1-100)||High leverage (10-20)|
|Trading Hour:||24 hours a day||Fixed|
|Extra Expense:||Yes (Overnight fee)||No|
Is CFD Trading Difficult?
CFD (Contracts for Difference) trading can be difficult, particularly for new adopters who aren’t familiar with the terminology and the importance of research and discipline to succeed in CFD trading.
Practising with a demo account can be helpful for first-timers before they trade with their own money. It will help them learn the basics of trading, identifying buy and sell signals, predicting short-term price direction, and using “leverage” that heavily influences a trading strategy.
You can only form an effective trading strategy when you understand the market and the financial instrument.
Like any other trading method, CFD trading can be risky and difficult initially, but with regular practice, you can master the skills and generate decent gains from the trade.
Can You Make A Living Trading Contracts For Difference (CFDs) in Australia?
Some people do make a living by trading CFDs in Australia.
However, money can always be lost as financial markets can become unpredictable. You must have trading expertise and experience to become a good trader. Most people lose money when trading CFDs.
How Are CFDs Different From Options?
To understand the differences between these financial instruments, check the comparison between CFDs and options below:
CFDs offer a broader set of markets for trading in comparison to Options.
CFDs are relatively more transparent as the price of a CFD contact moves one-for-one with the underlying market.
Compared to CFD trading, which is margin trading, options incur a lower trading cost as they are inherently leveraged.
The lack of financing costs makes Options a better trading choice as they can be held long-term at a lower price. However, having the same CFD contract could quickly incur huge funding charges that apply daily to CFD positions.
An Option can turn worthless, causing the trader to lose his initial investment after it expires. CFDs are different from this, as they come with no expiry date.
Options are much more difficult to understand compared to CFDs. Also, since they are sold as a separate trading instrument and premium to which they relate, traders are prone to losing them in multiple ways.
Who Should Invest in CFDs?
CFD trading is not for everyone. Only experienced traders well-placed to understand and handle market volatility and take calculated risks can benefit from the profit-taking opportunities through CFDs. Sophisticated investors also use it to manage risks through hedging.
Your ability to succeed in trading CFDs will depend on your market knowledge, trading abilities, experience, financial health, and attitude.
Before trading in CFDs, ask yourself questions to assess your ability and preparedness to trade this novel product and make an informed decision.
Do you have good analytical skills to forecast the asset’s price movement?
Do you understand the leverage, margin levels, risks, and fees?
Are you clear on how much you can afford to trade (potentially lose)?
Do you have a solid strategy, rather than trading based on emotion or for a thrill?
What Is The Lowest a Stock Can Go?
A stock's lowest is zero, but it can't go negative.
What Happens When A CFD Expires?
When a CFD expires, you exit from your trading position irrespective of whether it is in profit or loss.
Only forward CFDs expire at a future date, and financing costs incurred are included within their spread. Daily CFDs don’t expire and are subject to expenses like overnight financing charges.
What Are The Advantages of CFDs?
People trade CFDs for three main benefits:
You can choose between a long or short trade when trading CFDs and make a profit in either direction.
You can use CFDs to hedge your trading.
CFD trading is popular due to its heavy margin, allowing you to open trades for a fraction of the stock price. However, the leverage that can amplify your gains can also lead to huge losses. Due to this, it is essential to manage your CFD risk.
Is CFD Trading Profitable?
CFD trading can be profitable for selected traders.
Suppose you have trading experience, sound market knowledge, the ability to handle market volatility, emotional control, and a proper risk management plan. In that case, you may outperform the broader market by trading CFD assets like shares and commodities.
People who know a lot about the market and are good at trading can make use of CFDs. These are flexible tools that allow them to increase their profits even if they start with a small amount of money.
Is CFD Trading Just Gambling?
It depends on your trading approach and behaviour.
CFD trading is certainly not gambling if you:
Thoroughly analyse the market
Perform a technical and fundamental analysis of the assets you trade
Follow a strict trading strategy and makes prudent trading decisions
Analyse each trade’s outcome and make required changes to refine your trading strategy
Trading CFDs this way is not gambling but trading. However, if you adopt the below approach, then CFD trading is gambling:
Before speculating on the price difference, you must understand the product you are investing in.
If you trade at a rate that exceeds 7 to 10 times your CFD account’s size
If you use the high leverage in high volatility instruments.
In all the above cases, CFD trading is a gamble and can lead to significant losses more than your investment.
What Happens To CFDs When A Stock Goes Up?
The losses and gains in CFD trading depend on upward or downward stock price movements. Traders use CFDs to bet on whether the asset’s price will rise or decline.
So, your trading outcome when the stock rises depends on the direction of your speculation, i.e., whether you take a long trade (in favour of a stock price rise) or short trade (in favour of a stock price decrease).
If the trader who bought a CFD sees an increase in the stock's value, they will sell their holding. His trading profit will be the net difference between the stock’s buying and selling price. It will settle through their brokerage account.
On the contrary, if the trader believes the stock's price will fall, he will place an opening sell position. He can close the position only when he buys an offsetting trade. The net difference (of the loss) gets settled through their account in cash.
Why Do Most CFD Traders Lose Money?
Most people lose money because CFD contracts are usually highly leveraged and speculation-based, which makes them highly risky for novice traders.
Many inexperienced traders incur significant losses in CFD trading without proper market knowledge and trading strategy. Due to this, CFD trading isn't suitable for beginner investors.
Common characteristics that can result in investment loss in CFD trading:
Following the herd
Lack of patience
Insufficient market and CFD trading knowledge, such as leverage, risk management, money management, and position size
Trading without analysis
Trying to time the market without a thorough analysis and well-tested trading strategy.
Poor risk management
Overtrading and opening more trading positions without doing an analysis
Averaging a loss-making trade
Not keeping a trading journal
Thus, CFD trading is complex if you are new to it. It is best to practice CFD trading for at least one year before using your money. Understanding CFD trading risks can help you save from losing hard-earned investment income.
How Long Can You Hold A CFD Trade?
A daily CFD contract has no expiry date. It means traders can hold their long or short position indefinitely until they have the funds to buy it.
Holding CFDs for short-term positions is beneficial as long positions incur financing charges and get expensive after 4-6 weeks.
Can You End Up Owing Money With CFDs?
Traders can open both long or short CFD trading positions. Going long means you expect the value of the share to increase, and going short means you expect it to decrease.
If your assumption is correct, you receive the stock price difference; if incorrect, you will owe the difference. If you take leverage to place big trades, you can lose more than your initial capital and even have a negative balance.
Can You Lose More Than You Invest in a CFD?
Yes. It is possible to lose more than your initial capital while trading CFDs. CFDs are highly leveraged derivatives that don't aim for steady and long-term gains. They are traded with an aggressive tactic to make significant gains fast.
With leveraged CFD trades, minor changes in your asset value can wipe out your position fast. It could lead to losing your entire invested capital or your initial margin.
Let us understand it by an example: Traders require investing only a small percentage to open the CFD trade. It is called the “margin requirement." It can be around 5% of the total trade value or even less.
CFD traders need to put forward only 5% of the trade’s value and are entitled to benefit from 100% of the trading gains. It makes CFD trading attractive to many people.
Trading with leverage can also lead to loss. If your trade goes against your expectations, you must pay the CFD provider for the entire loss. It could far exceed your initial 5% margin requirement. Traders may also need to pay commissions on the trade that could amplify the loss.
However, working with a regulated, established, and responsible forex broker can prevent such. Such brokers forcibly liquidate your position if the margin shrinks fast and you don’t top up the funds in your CFD account.
Australia's financial market regulator, ASIC, revealed retail CFD traders lost over $774 million in just five weeks in 2020, and over 15k accounts fell into negative balance owing $10.9 million. Due to this, in 2021, the regulator imposed several conditions on CFD brokers to reduce Australians' exposure.
It limits how much leverage a broker can offer, ranging from 2:1 to 30:1 based on the underlying asset type. This leverage limitation aims to lessen the trader's CFD exposure and sensitivity to market volatility, reducing the speed and size of retail clients’ losses.
What Is The Most Serious Risk With CFD Trading?
Due to the highly risky nature of CFD trading and its potential harm, many major trading countries, including the US, have banned this practice. This advanced and highly-leveraged form of trading causes most people to lose money.
Additionally, there are three significant risks of CFD trading are:
Based on small market changes, there is a higher potential to lose the entire initial investment within a short span. You could win one minute and lose the very next.
The risk of funding your account to meet a margin call instead of cutting losses and exiting the position is that you might spend more than you can afford.
Risks of CFD balance going negative due to high leverage ratios, broker's fees, and costs, even if the broker liquidates your position.
CFDs are complicated to understand and trade. Due to this, only advanced traders should participate in the market. Also, they may have hidden clauses that the trader should know before trading.
To help retail customers limit their losses and avoid negative balances, the ASIC has put a limit on leverage ratios, ranging from 2:1 to 30:1. Also, marketing tactics to encourage CFD trades, like offering gifts or credits or gifts, have been banned.
CFD trading provides an opportunity to trade in thousands of markets without requiring large amounts of capital.
However, you must know that CFD is a leveraged product and losses can exceed deposits. Considering the risks involved, you should gain thorough knowledge before you trade CFDs.
|The advice and information on OzStudies.com is in general nature and should not be seen as a replacement for independent financial advice. We strongly encourage readers to consult with financial experts regarding their own financial decisions and investments.
Please note that the information presented on OzStudies.com is solely for educational purposes. Every individual's financial situation is unique, and the products and services we mention may not suit everyone. We do not provide financial advice, advisory, or brokerage services nor endorse buying or selling specific stocks or securities. It's essential to know that information might have changed since publication and past performance does not guarantee future results.
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