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What is CFD Trading? (Australia 2024)
By
Will Ellis
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Last Updated on January 5, 2024
CFDs, or contracts for differences, are a kind of financial derivative in which the difference between the starting and closing prices of a trade is settled in cash. They’re an alternative investment to the physical delivery of goods or the exchange of assets.
While it is perfectly okay in Australia (ASX), contracts for differences trading is outlawed in the US because it is seen as a high-risk, high-skill trading strategy.
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Table of Contents:
- Definitive Summary
- How are CFDs used
- Trading on the future prices of commodities: CFDs vs Futures
- Countries that let you trade CFDs
- CFD Fees and Costs
- Advantages of CFDs
- CFD Challenges
- Bottom Line
- FAQs
Definitive Summary 📘
- Contract for differences pays out the difference between the settlement prices of open and concluded trades.
- As CFDs allow traders to bet on the short-term direction of a security’s price, they are especially popular in the foreign exchange (FX) and commodities markets.
- CFDs have a cash payoff, but due to CFDs’ advantageous margin trading features, investors often only need to put up a small portion of the contract’s notional payout.
Related guide: ⭐ Stock market basics
How are CFDs used? 📕
You can bet on changes in derivative and security prices using CFDs. Derivatives are financial investments that are derived from another asset. CFDs are used by traders and investors to speculate on the price of the underlying asset.
CFD traders have the option of betting on whether the price will go up or down. Those that expect the price of the contract to go up will open a “long” position, while those who expect it to go down will open a “short” one (how to short-sell).
Each time the underlying asset’s price goes up, the CFD buyer will want to get out of their investment. A net sum equal to the difference between the purchase and selling prices is determined. The brokerage account is where the investor’s gain or loss from trades is settled.
Conversely, if a trader thinks a security’s price is going down, he or she can open a sell position. They need to find a compensating trade to close the position. In a similar vein, the net gain or loss on return on investment (ROI) is paid in cash via their account 📁.
Trading on the future prices of commodities: CFDs vs Futures 🆚
ETFs are only one example of a product that may be traded using contracts for differences.
Traders will also utilise commodity futures contracts to bet on price fluctuations of goods like crude oil and corn. The parties to a futures contract agree at the outset that they will buy or sell an asset at a certain price on a predetermined date in the future.
Whilst CFDs allow investors to speculate on futures price movements, they are not futures contracts in and of themselves. Contracts for Difference trade like other securities, with buy and sell prices and no expiration dates for the underlying asset.
Conventions of Distinction traded over-the-counter (OTC) via a network of brokers that work together to balance market supply and demand for CFDs and determine fair prices. In other words, CFDs are not listed on the S&P 500 Index, NYSE or any other major exchange. It’s a tradable agreement between the client and the broker to swap the value of the transaction’s reversal for the initial price.
Countries that let you trade CFDs
CFDs are illegal in the United States. But there are plenty o other areas where this isn’t the case.
For example, they may be traded on the over-the-counter markets in the United Kingdom, Switzerland, Singapore, Spain, Denmark, France, Germany, South Africa, Canada, New Zealand, Sweden, Italy, Norway, Belgium, Thailand, the Netherlands, and Hong Kong’s special administrative region.
While CFDs are already permitted in Australia, the Australian Securities and Investments Authority (ASIC) has proposed new laws concerning the issuance and distribution of CFDs to retail customers.
ASIC’s goal is to better protect retail customers by concentrating on preventing and resolving issues with CFD products and sales practices that compound losses for retail customers. The ASIC’s mandate to intervene in the market with a new product was implemented in March of that year.
The Securities and Exchange Commission (SEC) in the United States governs trading, however, this does not prevent foreign nationals or permanent residents from engaging in this activity.
CFD Fees and Costs 💸
When you purchase and sell a contract for difference, you pay an expense known as the spread. The narrower the spread, the smaller the change in price that must occur before you start to produce a profit or incur a loss if the market moves against you.
An overnight funding amount will be added to or subtracted from your account if you hold a position beyond a specified time (the “Overnight Funding Time”).
When buying or selling assets that are denominated in a currency other than the currency of your account, a currency conversion fee is often charged.
One special kind of order that might help you manage risks by providing a stop level is the Guaranteed Stop Order. This costs extra to use.
If you don’t log in within a certain amount of time, you may also incur a fee.
Advantages of CFDs ✔️
Investors may take part in the ups and downs of the securities market with CFDs without having to take physical delivery of any asset.
Margin trading CFDs entails borrowing money from a broker in order to increase one’s leverage or the size of one’s position, adding to their own funds, to maximise earnings. Brokers often demand that traders maintain quite sizable balances in their trading accounts before agreeing to this kind of transaction.
Trading using borrowed funds In many cases, CFDs provide for more leverage than traditional trading methods. When trading CFDs, margin requirements are typically between 2% and 20%. Lower margin calls indicate that the trader can afford to take on less risk without sacrificing potential profits.
In many cases, CFD markets have less legal constraints than regular exchanges. As this is the case, the minimum deposit for a CFD trading account might be less. A minimum deposit of only $1,000 is often required to open a trading account with many brokers.
A trader’s return on investment (ROI) may be bolstered by the possibility of receiving cash dividends from the underlying firm, since CFDs are reflective of the performance of the underlying asset. Practically every CFD company sells goods in every sizable market across the world. All markets are accessible to traders via their broker’s platform.
CFDs facilitate the opening and closing of long, short, and buy/sell bets. Often, short selling is allowed while trading CFDs. It is possible to short an instrument at any moment. As the underlying asset is not being borrowed against or sold short, there are no associated costs.
In addition, commissions for trading CFDs are often very low, if not nonexistent. For the broker to make a profit, the trader must pay the higher ask price when buying and the lower bid price when selling or shorting. The broker’s commission is the difference between the asking and selling prices. In summary:
- ☑️ CFDs allow investors to trade a wide variety of assets, including exchange-traded funds (ETFs), stock indices, and commodities futures.
- ☑️ Investors may mimic the buying and selling of an asset using CFDs without having to actually own the item.
- ☑️ CFD traders may take advantage of leverage by depositing a small percentage of the total transaction value with their broker and trading with the rest.
- ☑️ CFDs facilitate the opening and closing of long, short, and buy/sell bets.
CFD Challenges ⚡
If the underlying asset is very volatile or prone to big price fluctuations, there may be a sizable discrepancy between the bid and ask prices.
You won’t be able to profit from the little price changes that come with trading CFDs if you have to spend a lot to join and exit a trade, which will lower your winning trades and raise your losses.
Owing to the absence of regulation in the CFD market, investors should carefully evaluate their broker before putting any money in their account. The United States thus prohibits the trading of CFDs.
Since CFD trading is leveraged, investors who are in the red may get a margin call from their broker, requiring them to deposit more funds to cover the difference between their holdings and the margin requirements of popular shares and other assets.
Since CFDs are leveraged vehicles, investors might lose more than they initially invested if the underlying market declines. A trader will have to pay daily interest on any funds borrowed from their broker in order to complete a deal. In summary:
- ❎ While trading CFDs, leverage may magnify gains but also magnify losses.
- ❎ At times of strong market volatility or change, a broker’s purchase and sell prices may diverge significantly.
- ❎ CFDs are illegal in the US, so traders have to put their faith in their broker and hope for the best.
- ❎ When an investor’s broker needs more money to cover a loss in a failed investment position, they issue a margin call.
Bottom Line 📑
Overall, a contract for differences is a highly malleable instrument that provides investors with all the benefits of ownership in a security without really requiring them to buy the asset. Additionally, CFDs provide investors access to a wider range of securities, commodities, and indices than may otherwise be available to them.
CFDs, or contracts for difference, provide more leverage than traditional trading, which might significantly amplify earnings. But, when losses do occur, they will be magnified, and you may stand to lose more than you originally invested.
Traders new to the world of contracts for difference (CFDs) should proceed with caution. This is why savvy investors with years of experience tend to be the most successful CFD traders.
FAQs 📚
Compared to stock trading, how different are CFDs?
Unlike trading shares, which entails actually buying the underlying asset, contracts for difference (CFDs) enable investors to speculate on market price swings without really buying the underlying asset. In contrast, when buying and selling stocks, true ownership of the underlying company is obtained.
How do CFDs work in a nutshell?
By using CFDs, investors may speculate on the movement of a security’s price without having to actually own the asset. A Contract for Difference is characterised by two separate transactions, one between the customer and the broker.
The first trade creates an open position, which is subsequently closed by the second trade in reverse. Buying anything in the market (going long) requires closing the position (going short) in the end. If the first deal was a sell, the final transaction will be a buy (short position). The trader’s net gain is the sum of the price differentials between the initial and closing positions.
What are the top advantages to CFDs?
Traders may take advantage of lower margin requirements, better access to global markets, and no limits on shorting or day trading using currency-for-currency (CFD) trading, making it a very flexible tool. Trading CFDs is quick, simple, and may be done in the trader’s own currency.
Is it safe to invest in CFDs (and what are the risks)?
When trading CFDs, you may have a lot of leverage, which may be both a tremendous benefit and a major risk. Although CFDs are often traded with leverage, or borrowed funds, the trader is able to “gamble” with money that is not really theirs.
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