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What is a CFD? Contracts for difference are a popular derivative in the marketplace. When you own a contract for difference, you own a contract over the difference between the price that you purchased the contract for and the current price of the contract, ie you own a contract over the performance of the equity. That is, if you purchase a contract for difference at $1.43 and the price rises to $1.55, then your contract is for the difference between the purchase price of $1.43 and the present price of $1.55, which is 12 cents in profit. If the Contract for difference had decreased in value, then you would be obliged to pay for the difference between the purchase price and the current price. Rather than buying the shares, you purchase a contract over the movement in the stock price and this is revalued or "marked to market" in real time. A CFD gives you all the advantages of trading shares without having to physically own the share. It is a contract that mirrors the performance of the stock or index, is traded on margin, and like physical shares your profit or loss is determined by the difference between the prices you buy and sell at. Contracts for difference also incorporate any adjustments for corporate actions, such as dividends and stock splits. What are the benefits of CFDs? CFDs are traded on margin, which is a more effective use of your capital since you only have to allocate a small percentage of the value of your position to secure a trade, whilst still maintaining full exposure to the market. In effect you are able to magnify the returns on your investment. CFDs brokers charge low commssions, which means that you do not have to pay high priced brokerage on either long or short transactions. Because you are trading the price movement of the equity or index without physically owning it, it is as easy to sell a share or index Contract for difference, as it is to purchase it. This allows short selling to be done just as easily as buying a CFD. Therefore a Contract for difference trader has the opportunity to benefit from both bull and bear markets as well as short-term intra day movements. Just as CFDs mirror the price movement of the physical stock market, they also mirror any corporate actions that happen in the underlying stock or index (dividends, share splits or consolidations). Which means the owner of the equity CFD will take delivery of dividends, and participate in stock splits, just like they would if they owned the physical share. It also means that if a share goes ex-dividend (meaning a dividend is due to be paid) while you are short a share, then you are obliged to pay for the dividend in that same way as if you are short the physical share. You are not entitled to any voting rights since you do not actually own the stock. Short selling CFDs Short selling using Contracts for difference is the same as selling CFDs which you already own. There are no limitations on the way you transact Contracts for difference or on shortsellable Contracts for difference. It is possible to short sell any available Contract for difference however some Contract for difference providers may have a restricted short sell list and enforce restrictions on the amount of a stock that may be short sold. You don't have to shortsell on an uptick like in the share market it is possible to shortsell at any price the stock is trading at. This offers major advantages over the traditional techniques of short selling. Tradeable Contracts for difference Most Contract for difference providers offer CFDs over the key sectors, major stock indices and the stocks in the major share indices in the most important markets. Many brokers offer thousands of different instruments in Australia, Asia, the UK, Europe and America. Costs linked to Contracts for difference There's a small commission cost to open a Contract for difference position, the price of a Contract for difference will be the same as that of the underlying stock or index on the stock market. This means that buying a Contract for difference is essentially the same as investing in the underlying stock apart from the low cost of brokerage, which makes Contract for difference trading ideal for individuals with low account balances. Contract for difference positions carried overnight incur financing costs for the entire value of the position. Traders who are long Australian Contracts for difference will pay interest and clients who are short will receive interest for their positions. The interest rate payable is based on the cash rate for the country where the stock is listed. If the base interest rate of a country is less than the financing cost charged by the Contract for difference broker for going short no interest is going to be charged on short positions. An example of this is in Japan where rates of interest are near 0%. In this instance no interest is chargeable on short positions. If you hold a CFD overnight, you're charged interest on the whole value of the position because the Contract for difference broker hedges your position by financing the purchase of the underlying stock in the market. They then pass on the interest to you the client at a premium. The rate of interest charged depends on the market that's being traded. If you happen to be short a CFD, then you will collect interest on the full value of the position for each day that you choose to hold your position overnight. For those who have a well-balanced trading system where you are short and long for around the same amount of time, you'll effectively only pay only a small interest charge for overnight positions.
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Ben McGrath is a professional Contract for difference trader. He deals with Australia's most popular Contract for difference broker IC Markets. Ben has published a number of books and guides on CFDs, you can download and read his most recent guide to CFD trading for free.
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