How to Trade Almost Any Asset in the World from a Single Account Using CFDs

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1 How to Trade Almost Any Asset in the World from a Single Account Using CFDs

2 How to Trade Almost Any Asset in the World from a Single Account Using CFDs Shae Russell, Editor INTRODUCTION TO TRADING CFDS As the name suggests, a contract for difference (or CFDs as they re commonly called) represents the difference between the price when you buy and when you sell a CFD of a share, index or a commodity. CFDs allow traders the opportunity to participate in the performance of an underlying financial instrument without the need to ever buy or sell it. In fact, CFDs have been in existence for 20 years and have become a popular trading method. Put simply a CFD is a contract between a buyer and seller. The buyer and seller agree to exchange the difference between the price of a share at the opening, then closing of a particular trade. As stated by the Australian Securities Exchange (ASX), the difference is determined by reference to an underlying asset a share, index, foreign exchange (FX) rate or commodity and the period over which the CFD is held. The CFD is a popular financial tool because it allows investors to buy or sell a contracted amount of shares in a given stock, at a certain price for any period of time. There is no physical delivery of a CFD contract. Nor do you have any of the additional benefits of owning a share such as attending the AGM. You do, however, take part in dividends and any corporate actions such as bonus shares. All CFD trading is settled in cash. Money either flows into or out of your account depending upon the success of your trading. UNDERSTANDING HOW LEVERAGE WORKS Leveraging means that you use a percentage of your money, and the CFD provider lends you the remaining amount. 1

3 In other words, when you open a trade, you place a deposit (generally this is a percentage of the total value of the trade) upfront. And the CFD provider will lend the remaining value of the trade. This is called a leveraged position because you re using leverage essentially borrowing money from the CFD provider to make up the entire value of the trade. For instance, if you put in 5% of your own money to open a trade of the market value, the CFD provider makes up the remaining 95%. The value in this is that even though you have only submitted 5%, you are entitled to the same gains or losses as if you had paid 100%. Different providers will ask for different percentages. In addition, there are ways to reduce the amount of leverage you use. However and I ll clarify this again below even though the CFD provider lends you the remaining amount of money to meet the full trade size, you are always responsible for the full value of the CFD trade. UNDERSTANDING THE UNDERLYING ASSET The underlying asset is simply the underlying security or the reference asset. That is, the price of a CFD derived from a physical asset in the market. Such as a share on the ASX, FX, commodity or index. The price of the CFD will mirror the price of the underlying market. But because leverage is involved the returns (and losses) can be far greater. It s important to note that CFD traders do not trade or own the underlying asset. CFD trades simply involve betting on the future price of a particular asset. Most CFD providers offer a wide range of underlying markets. All CFD providers have a Product Disclosure Statement (PDS). Some are more detailed than others. While the document may appear long, it contains vital information inside. A reputable CFD provider will have detailed information on costs, markets, trading examples and highlight the risk of CFDs. Make sure you take the time to read it before you open an account. WHAT DOES A CFD TRADE LOOK LIKE? Let s say the current level of the Australian Index is 5,100 points. If you believe the market is going to move upwards that is trade higher you would take out a long position. 2

4 In other words you a entering a CFD trade and think the S&P/ASX200 will move higher than its current level of 5,100. Because CFDs are leveraged, you don t need to outlay the full $5,100 to open a position. Instead you place a deposit. This is what the CFD providers will call your margin. Most indices are highly leveraged. It s quite common to see an index leveraged at 99 to 1. If this is the case, that means your deposit or margin is only 1% of the value of the trade to open it. For example, if you wanted an exposure (the total value of your trade) to be around $50,000, you would buy 10 Aussie Index contracts. Which means 10 contracts times 5,100 gives you an exposure to the market of $51,000. With 99 to 1 leverage, you would pay a margin of just $510, which is 1% of the total value of the trade. If the index does rise from 5100 points to 5400 points in the next three weeks you would have made a significant profit of $3000 ($300 per CFD x 10 contracts). This is a very large increase over your $510 investment. Not a bad return by anyone s standards! That s impressive. But if you get it wrong your losses are magnified too. Say the index falls 300 points to 4,800. This means you ve lost $3,000. Which is your initial investment and much more. Get the idea? Now if you don t like the thought of losing $3,000 on your $510 investment, keep reading. JUST BECAUSE YOU CAN USE THIS MUCH LEVERAGE DOESN T MEAN YOU SHOULD As I said before, CFDs are a highly leveraged trading tool. Using 99 to 1 leverage is the quickest way to the poor house. When it comes to trading CFDs we suggest sticking with 2 to 1 leverage. Let s use the same example as above. If you buy 10 Aussie Index contracts at 5,100, you have a total position size of $51,000. However using 2 to 1 leverage, your initial deposit is $25,500. As you can see, this is a substantial amount more than if you used a 1% margin. In all honesty, if you can t afford to cover at least half of the trade up front, then don t. Instead start with a smaller trade size. 3

5 WHAT IS SHORT SELLING CFDS We just discussed an example of buying CFDs in an index such as the Australian Index CFD. You can also sell CFDs, or I should say short sell, because there s an important difference. This a tricky concept when you first start out. You have to understand this concept before you can trade CFDs, and many people struggle with this to begin with. Prices can go two ways, up and down. We have gone through what to do if you think an index is going up, but what about if you think it is going down? How on earth can you sell an index that you don t have? It s simple. Because you re not actually trading in the physical underlying security you are merely taking a position on how you think the index will perform. Basically, you are selling a price difference. You aren t selling the actual security. When you short sell a CFD, you take the view that the market is going to fall. Ideally, you re right, and the market falls. To close the trade, you simply buy back the CFD. Short selling with CFDs isn t difficult because you re simply trading the price difference. However, if you re new to CFDs and not comfortable with short selling, the simple solution is don t. On the rare occasions we make a short selling recommendation in Currency Wars Trader, you don t have to follow them. Instead you can use the other strategies we offer until you become familiar with this type of trade. I highly recommend you paper trade our short selling positions (see the paper trading guide) to track them. Over time, this will increase your confidence by understanding how short selling works. A WORD OF WARNING UNDERSTAND THE RISKS Which brings us to losses and the golden rule of trading. The rule is: Never, ever trade with money which you cannot afford to comfortably lose. You ve heard it a thousand times now BELIEVE IT. The best guard against this is a realistic view of life not a belief that there is a magical or mystical force at work. This is science, linked with randomness (called luck ). CFDs can be incredibly risky. It s vital you understand this. Your risk is NOT limited to your stake. Your losses could be considerably more. Let s go back to the Australian Index CFD trade to show you what I mean. 4

6 Say you buy 10 contracts at 5100, or $51 a point. A total trade size of $51,000. If you are highly leveraged at 99 to 1, you ve only paid $510 upfront as a deposit. However the market moves against you and is now at 4,200. That s $900 per contract. Times that by ten contracts and it s a $9,000 loss. Eek! That s going to hurt. It s also far more than your initial $510 deposit. What you have to remember, with any CFD trade you may have, you are always responsible for the total value of the trade. Don t let the tiny deposit fool you. If you take out a $50,000 trade size, you need to be able to back that up if the market moves in the opposite direction of your trade. Look, the above is an extreme example. In fact, there s a good chance the CFD provider would have cut the trade. But they will hold you accountable for any money owing. Again, this is why we don t recommend using 99 to 1 leverage. Keep it small. Before opening any position, ask yourself if you can afford to lose the amount you re exposed to. If you can t, stop right there. Unlike options, where you generally need to take out 100 contracts at a time, the minimum CFD contract is 1. This gives you the ability to get a feel for trading. You can start by buying or selling one contract at a time. In time, when you become more comfortable with leverage, you can buy more contracts. Make sure you understand the risks you are taking before you get into this. Don t place trades you do not understand. HOW DO YOU PLACE A CFD TRADE? To place a trade, you just call your CFD provider, or log on to their trading platform and enter the trade. An example of a trade, explained more fully later, is: I want to buy 10 Australian index CFD contracts. This is called Buying or Going Long. Actually, you would say something more like this: John Smith speaking. Buy 10 Australian Index contracts The is your unique code number allocated to you when you join. The 5100 is the quote they have just given you for the Australian index contracts. That s it. Your trade has been placed. You will receive a confirmation of your trade. Remember, most dealers will take the time to help walk you through a trade. When 5

7 you call them, tell them you re new to this. Everyone has to start somewhere. In addition, most CFD providers have extensive online tutorials to show you how to get started with your first trade. From there you can look at more detailed tutorials. One or two CFD providers even have a client services team that will talk you through how to place your first trade over the phone. Take advantage of this information. It s been created to help someone just like you. And finally, you don t even have to call a dealer. Most brokers have online trading platforms. HOW MUCH CAN YOU TRADE? This depends strictly on how much you have deposited into your account. Of course, it is important to remember that if the bet goes against you, you MUST be able to pay the full value of the trade. Most of the time losses will simply be deducted from the cash in your trading account. Always, make sure you have the money to cover your losses. Never risk money you cannot afford to lose. The trades you are allowed to place depend upon your means (income and savings) and the cash that you have available in your account. DO YOU NEED ANY HARD CASH TO START? Yes. Here s why. When you open an account you will need to make a cash deposit that will be used as security against any trades that you make. It is important to remember that when trading CFDs you can lose more than the balance in your account. If the market moves sharply against you, the CFD provider will you and may telephone to ask for additional funds to cover your losses. You must be prepared to pay the margin call as it s known, or close out your trade and take the losses. CONTROLLING THE RISK USING CONDITIONAL ORDERS Conditional orders are simply your way of telling the CFD provider what action you wish to take should the market move in a certain direction. Take a stop loss order. For many CFD traders stop loss orders are an integral part of their trading activity. In basic terms, a stop loss order can be placed with your CFD provider that serves to limit your downside risk. 6

8 An example of a normal stop loss order transacted over the phone would be: Buy 1000 TLS at $5.50, stop $5.10. The CFD provider would interpret this order as follows: Buy 1000 shares of Telstra at a price not exceeding $5.50 per share. If at any time the price falls below $5.10, then sell immediately at the best price without waiting for my instructions. Looked at another way, you are saying: Buy $5,000 worth of Telstra shares, but bail me out if my losses exceed $400 (1,000 x 0.40) I don t want to risk more than that. It is possible to operate such risk-limiting orders through your CFD provider. There are several variations. Another conditional order is a Limit Order. For example: You buy 1000 Telstra shares at $5.50. However, you place a limit order to sell them should the price reach $5.90. When the Telstra CFD trades at $5.90, your limit order is activated and your Telstra CFDs are sold. Limit orders are a way of taking some profit. Using these types of orders removes the need to be constantly watching the market. Obviously you always monitor your trades, but conditional orders take away the need to watch every market tick. THE ADVANTAGES OF USING CFDS TO TRADE THE WORLD MARKETS There are several distinct advantages in using a CFD broker, compared to a traditional stockbroker. 1. You can make small trades, much smaller than the usual minimums allowed in trading shares and futures directly. 2. You can deal 24 hours a day. Even at 3 am! Most stockbrokers don t take kindly to being woken at this time of the morning! 3. You can deal immediately. They quote a price and if you take it, the deal is done on the spot. You do not have to wait for the deal to be executed in the underlying market. 4. Finally, with the exception of Share CFDs, there is almost no commission to pay! They make their money on the spread of their quotation. You should also be aware of something called a Financing Charge, which is applicable when trading CFDs on Shares, Sectors and Indices (but not on Commodities). Put simply, because you are effectively borrowing funds from your CFD provider in order to trade the performance of an actual share, you need to pay interest to the CFD provider. Just like when you borrow to buy a house or a car. This is called financing and is usually referenced to a benchmark interest rate. 7

9 Finance charges vary depending on the CFD provider, however it can be about 2% or 3% above the relevant benchmark interest rate for that country. Check with your CFD provider to see their charges. All of this information will be in a CFD provider s PDS. If it s not, get another provider. This information should be clear and disclosed upfront. Always make sure to read the CFD provider s PDS. It contains all the legal information you need to know about CFDs. Thanks for reading. I hope this guide has given you a starting point for understanding CFDs. If you re unsure about anything, drop an to me at portphillippublishing.com.au or ask your CFD provider. Regards, Shae Russell, Editor, Currency Wars Trader Warning: While useful for detecting patterns the past is not a guide to future performance. The value of any investment, and the income derived from it, can go down as well as up. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you ve invested. While useful for detecting patterns the past is not a guide to future performance. Some figures contained in this report are forecasts and may not be a reliable indicator of future results. All advice is general advice and has not taken into account your personal circumstances. If in doubt of the suitability of an investment please seek independent financial advice. Please download and read our Financial Services Guide: Jim Rickard s Currency Wars Trader is published by Port Phillip Publishing Pty Ltd. Registered Office: Port Phillip Publishing Ltd Pty, Bridport St, Albert Park 3206 Port Phillip Publishing (ACN: ) (AFS Licence: ). All content is 2015 Port Phillip Publishing Pty Ltd. All Rights Reserved. 8

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