By John Wasiliev
Contracts for difference, or CFDs, have been available to Australian investors for about seven years now. In this time they have completely changed what it means to be a trader or speculator in many different investments. Over this relatively short period, they have been embraced by both newcomers to trading as well as existing traders who have switched from other trading strategies.
Not so many years ago, for instance, being a share trader usually meant buying cheap shares known as penny dreadfuls. These shares were generally issued by companies involved in oil or mining exploration or in the development of new but as yet unproven technology. The shares that usually cost less than 50 cents were bought with the expectation the companies might strike it lucky with the result that the share prices might multiply 10 or more times over a short period and deliver a windfall gain. Alternatively, if this didn?t happen, the share prices could fall away to nothing which many did.
The high risk of this happening was the reason that any prudent advisers or brokers involved in this area of share broking stressed that the only money that should be invested in such shares was what you could afford to lose.
Buyers of penny dreadfuls were the main share market speculators. Their activities contrasted with that of investors who focused on buying much higher priced shares in well known companies like BHP Billiton, Rio Tinto, Telstra, Woolworths, Westfield and the big banks like the Commonwealth, the National, Westpac and ANZ Bank. These shares were generally bought for their dividends and dividend tax credits and long term capital growth potential.
These days however, while there are still speculators dabbling in penny dreadfuls most traders also focus on the big name companies. And they do so via ?cheaper? versions of these shares through financial products known as contracts for difference, or CFDs.
CFDs or contracts for difference offer an alternative way of trading shares and a host of other tradeable financial investments with a much lower outlay and lower cost than investing in them directly.
In addition to shares on Australian and overseas share markets, popular CFD tradeable investments include gold and oil, foreign currencies, managed funds listed on share markets and CFD versions of special contracts that trade movements in popular market indexes like the Australian S&P/ASX200, the American Dow Jones Industrial shares index and the S&P500 indices, the London Financial Times index and the Japanese Nikkei 225 Index. Index CFDs allow you to trade movements in markets as distinct from price movement of individual investments like shares.
You can acquire a CFD over leading Australian shares for an outlay of 5 or 10 per cent of the share price at the time you take the position. The outlays for CFDs over market indexes can be as little as 1 per cent of their value. The value of a market index is determined by multiplying each index point by a dollar amount that can range from anywhere between $25 and $1. With these lower outlays for CFDs comes their big attraction: with a CFD you can earn exactly the same dollar return as a direct holding in the investment that costs you the full price.
While a lower outlay is a major feature of CFDs, another is that you can acquire CFDs with totally opposite investment performance expectations. There are CFDs that will profit when prices fall ? called short positions - and CFDs that will profit when prices rise, called long positions. And the financial commitment that is involved in trading one side or the other is very similar. In fact if you acquire CFD that will profit when prices fall ? short positions - you can even earn some extra income.
A CFD in its most fundamental form is a trading product that allows you to buy something that will hopefully make a profit but may also suffer a loss that mirrors the performance of owning an investment as a direct investor. But it all happens without you actually owning the investment.
What you have is a contract with a CFD provider who agrees to deliver any profit you may earn as the difference between owning the investments and having an interest in a CFD. Your side of the bargain is to come up with the money and pay the difference if the trade goes against you.