Trading Education. July The Five Key Elements of CFD Trading. The Five Key Elements of CFD Trading INTRODUCTION

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1 READ OUR FULL RISK WARNING. Spread betting, Contracts for Differences (CFDs) & Foreign Exchange (FX) are leveraged products & carry a high level of risk to your capital as prices might move rapidly against you. It is possible to lose more than your initial investment & you may be required to make further payments. These products may not be suitable for all clients, please ensure you fully understand the risks associated & seek independent advice. INTRODUCTION CFD trading is a huge and growing industry. Since they began being traded in the 1990s, investing through the use of CFDs has proliferated to the extent at which they now account for around 25% of the stock market turnover in the UK. CFDs are extremely popular with hedge funds and private investors alike as they provide an excellent opportunity for significant returns. There are many benefits from trading CFDs, however they are a sophisticated derivative investment product and considered to be high risk. Therefore if you are thinking about trading CFDs, it is important that you do your research first. At Central Markets we believe that there are five key factors that investors need consider when trading CFDs. We also believe that following the five key elements will improve the prospects of success.

2 WHAT IS A CFD? CFD stands for contract for difference. A CFD is a margined contract between a client (the investor) and a CFD provider (at Central Markets we use Saxo Bank) to exchange the cash difference between the opening and the closing price of a trade. It is a derivative based on an underlying cash instrument and the investor does not actually take ownership of the underlying instrument. CFDs move in direct correlation to the price of the underlying security, usually with the bid and offer that the CFD provider gives being the same as the market dealing spread. It is possible to trade CFDs on securities such as equities, indices, exchange traded funds, commodities and currencies. CFD definition A contract for difference is an agreement between two parties to settle, at the close of the contract, the difference between the opening and closing prices of the contract, multiplied by the number of underlying shares specified in the contract. With equities, CFDs are traded in a similar way to ordinary shares. The price quoted by many CFD providers is the same as the underlying market price and the investor can trade in any quantity just as with an ordinary share. There will usually be a commission charged on the trade and the total value of the transaction is simply the number of CFDs bought or sold, multiplied by the market price. However, there are some distinct differences from trading ordinary shares that have made them increasingly popular as an alternative instrument to speculate on the movements of shares or indices. THE ADVANTAGES OF CFDs The ability to leverage the position The ability to sell short Being able to hedge your portfolio Reduced costs Margin Trading The returns generated from trading CFDs can be significant as there is the capacity to trade many times the value of the initial deposit. Margin trading is one of the most powerful attractions of CFDs. For example, on a margin requirement of 10%, a deposit of 10,000 is leveraged by ten times to gain exposure to 100,000 of shares. The normal margin requirement on FTSE 350 shares is 10%. However, some higher liquid shares have a 5% margin, while the less liquid companies can have a margin requirement of 15% or 20%.

3 Sell Short CFDs are an excellent trading tool to take advantage of stock market volatility. Especially during these uncertain economic times, the way the markets are moving makes it very difficult to make money by just sitting on positions. With CFDs is it possible to sell shares that you do not own. This is known as going short. This means that it is possible to make money with the market going down as well as up. Hedge Your Portfolio CFDs allow the investor the opportunity to hedge a long term position in a physical equity. With CFDs, someone that is holding a long term physical position can use a short CFD as a hedge for near term fluctuations. If an investor expects to see a decline in price then a short CFD position can be traded. The investor would then be able to profit from the decline in the price, therefore acting as a hedge for the deterioration in the long position in the physical stock, as it has offset the paper loss. You can also use a CFD to protect your long-term holdings against variable market conditions. It can be cheaper to open a short CFD position rather than sell the physical shares in order to buy them back later. Reduced Costs The charges involved with trading CFDs are lower than for trading physical equities. As the investor does not take physical ownership of the shares, CFDs do not incur stamp duty and there are also no custody fees. Although the profits are subject to Capital Gains Tax, these can be offset by losses. With CFDs there is no settlement and this can reduce dealing costs significantly. Many private investors are used to trading on a T+10 or even T+20 settlement, hoping to trade on a short term basis in and out within this settlement period. In this way, if a profit is made the investor can just pocket the difference with the shares sold before the settlement becomes due. However, there is a premium charged by brokers for extended settlement, possibly 1% in addition to normal dealing costs on physicals. The dealing costs could be as high as 3% or even 4% depending on the broker. With CFDs, the total dealing costs for an advisory service will often range from as little as 0.5% to 1.0%. However, there is an extra cost of trading CFDs that does not apply to physical equities. Financing charges apply on any overnight positions held in CFDs. The area of finance costs is covered later in the section titled The Disadvantages of Trading CFDs and is something that investors need to be aware of. In the example below we compare the difference in costs incurred by the investor between purchasing a physical equity and a purchasing a CFD. We also include a comparison of physical shares with the same exposure as CFDs. The example uses the investment in 1,000 BT Group physical shares. With BT Group trading on a 10% margin, the investor can gain exposure to 10,000 CFDs for the same deposit.

4 Action 200p Physical Shares CFDs Physical Shares with similar exposure as CFDs Opening Value 2,000 20,000 20,000 Opening Commission (0.5%) Stamp Duty (0.5%) Cost to open the position 2,020 2,100 20,200 After 5 days the BT Group share price has increased to 220p and the investor chooses to sell for a profit. Closing Value 2,200 22,000 22,000 (Gross Profit) 180 1,900 1,800 Closing Commission (0.5%) Finance Charges (LIBOR + 3%) Nil Nil Cost to close the position NET PROFIT (net of all costs) RETURN ON EQUITY 8.5% 88.8% 8.5% N.B. The example shows profit from a rising price, however if the price falls, the losses on the CFD are magnified. Other Advantages With CFDs, investors still get paid any dividends (90% due to the tax implications) on long positions. However, on the reverse side of this, dividends have to be paid out for short positions. Trade management is much easier with CFDs as investors can place stop-losses and price targets on trades which are not always possible with physicals.

5 FIVE KEY ELEMENTS OF SUCCESSFUL CFD TRADING There are many factors that are necessary to make a successful CFD trader. Some factors such as luck cannot be controlled. However, at Central Markets we believe that there are a number of things an investor can do that can help to ensure successful and profitable trading of CFDs. We believe that there are five key factors that are not beyond the control of the investor and should certainly be considered carefully prior to trading CFDs. 1) TAKE A VIEW It is important that investors do not blindly enter into CFD trading without an idea of strategy. In the absence of a well thought out strategy and/or a dedicated broker to act as a guide, trading CFDs can be a dangerous way to invest in the financial markets. In this way, knowledge is key. Investors need to have a good grasp of the factors affecting the financial markets in order to help mould an overall strategy. A positive working relationship with a broker is also highly recommended and ideally there would be a combination of both. When trading CFDs it is important to have a starting view and to have the conviction to maintain this view throughout the trade. Although it is possible that things can change depending on news flow, ultimately the investor needs to keep in mind the reasons behind why a trade was originally opened. When furnished with all the requisite information, if this view has changed, then have the courage to move quickly. However, if the original view still holds weight, then have the confidence and belief to keep in mind the end goal. The best traders are those that can cut the losers but also run the winners. The investor needs to be fully aware of all of the information on a specific story before the trade, during the trade and at point of exit. 2) RISK MANAGEMENT An important part of trading is knowing how much of the overall pot should be risked in any single position. There is no hard and fast rule as there are many variables involved in deciding what the ideal trade size should be. Theoretically, trade size should be proportionate to the amount the investor has available to trade. This will help

6 to prevent the ultra-high risk strategy of putting all on black or red. Although it is difficult to put a definitive figure on it, as a gauge, if the proportion is up into double figures, the trade size is increasingly towards the riskier end of the scale. Factors affecting trade size include size of the portfolio, risk profile, strategy, and the instrument traded. Generally, the smaller the overall portfolio size, the larger the trade size will become as a proportion of the portfolio, and vice versa. Equally though, risk profile is a key factor, with the more speculative investor willing to risk a larger proportion of the portfolio on one trade. Overall strategy also plays a part, for example if the objective is to make quick profits, or slower and steady gains. Additionally the instrument traded will impact on trade size, where for example a less liquid investment could require a smaller trade size in order to make it easier to both trade in and out. Furthermore, if the size of the pot reduces through the course of a bad run, then the investor will need to ensure the trading sizes come down to the reflect this. Careful consideration needs to be taken before a trade is placed. Investors do not want to risk seeing a large chunk of their portfolio blown up on a single position. 3) TIMING Timing is a crucial element to successful CFD trading. When trading on margin, if the position moves against you, the losses can quickly rack up. Many CFD investors use technical analysis to help guide the timing of their trades. For example buying a stock that is already hugely overbought and due a correction can often prove to be an unprofitable trade. Even the best stocks in the world do not go up forever and will often see corrections along the way. Timing the entry correctly can help to ensure that the investor does not suffer a painful short term loss on a trade that ends up being the perfect long term call. With markets increasingly susceptible to news flow, investors need to time entry perfectly. Trading in front of key economic data, such as US Non-farm Payrolls, can often be a risky strategy due to the increased volatility. Similarly, trading an equity CFD in front of key announcements such as final or interim results is also a high risk manoeuvre. Equally, if an investor is sitting on a profitable position and a key data release is approaching, it can often be prudent to take the profit. It is never wrong to take a profit as you do not know what is around the next corner. Timing is critical. The ability to time both the entry and exit of a trade can the difference between banking a profit and enduring an infuriating, head-scratching loss.

7 4) TRADE MANAGEMENT Trade management is an incredibly important feature that helps to create success in CFD trading. Trade management looks to remove (or reduce) the emotional side of trading by managing positions. This is achieved by the use of stop-losses. A stop-loss is an automatic order placed in the market that closes the trade should the market move against the investor and the position moves offside too much. While the pros and cons of stoplosses remains a hotly debated topic, their use should not be underestimated in CFD trading. Due to the higher risk nature of trading on margin, many CFD providers offer comprehensive stop-loss and Limit Order Facilities so that investors can manage their risk in fast moving markets. Stop-losses are usually set according to the overall profit target on the position. Depending on the risk profile of the investor, often the riskreward ratio of profit target to stop-loss will be between 2:1 and 3:1. At Central Markets we recommend that investors use stop-losses with their trades. The safety valve that they provide is important for the wealth management of private investors. Without a stop-loss, a trade can become very difficult to manage on the downside. Human nature can kick in and an investor may not want to cut a position due to the size of the loss. However, this loss could just become larger and larger, spiralling out of control. If nothing else, knowing the potential downside through having a stoploss in place will assist the investor in having a good night s sleep. Trade management can also involve the movement of stop-losses and price targets once a trade is running. A trade could be nicely on-side with a profit accrued, only for the market to turn and the price move sharply into a loss. In this way, for example in a long position, it can be advisable to move the stop-loss higher as the trade pushes into profit. Some investor strategies use trailing stops which are an automated stop-loss that tracks the price move higher and stays within a specified percentage move. Other strategies use the manual setting of stop-losses. Staying close to a position through the use of stop-losses can prevent a nice profit on a trade, turning into a painful loss.

8 5) KNOW YOUR BROKER The quantitative reason of finding a broker with acceptable charges (much of the time this is negotiable) is often important to investors. For the smaller investor, if the charges are prohibitive then it becomes incredibly difficult to make a profit. However, when it comes to finding a broker, many investors believe that qualitative factors are even more important than the dealing costs. The broker/client relationship and overall quality of service is vitally important to making a successful CFD trader. The majority of private investors do not have the time or capability to keep a constant watch on the market. They are subsequently not able to move with the breakouts and breakdowns as they happen. Current market conditions remain difficult and can be volatile and for this reason, often investors will find that having a real time broker with eyes and ears on the market can be crucial. The broker allows access to the market, but also with so much information and so many tools available to the modern investor, they bring with them experience, guidance and most of all another viewpoint on anything market related. For example, anybody can tip a stock to buy or sell, but very few can give you a running commentary or appraisal and keep you updated following execution. A relationship with a good broker should grow to the extent where a partnership develops with the investor. A good broker will build his or her knowledge with the investor, learning the investor s desirable trades and the opportunities that might appeal. Also, by acting as the eyes and ears for the client, the broker can react quickly and keep the investor informed on what is going on as and when an event occurs. There is no broker in the world that is 100% correct every time, sometimes losses will happen, however hopefully the broker/client relationship that develops can help lead to bigger profits and smaller losses.

9 THE DISADVANTAGES OF TRADING CFDs CFD trading does come with sizeable caveats. CFDs are a complex and sophisticated investment product. Only investors with a high appetite for risk should consider trading CFDs. As CFDs are a margined product they are a high risk investment where you can lose more than your original investment. It is possible that the investor can lose more than the original stake and they are potentially liable for the whole amount of the leveraged contract. For example, if someone is long of a 1000 CFD trade with a 10% margin and the company goes bust, the client is liable for a 10,000 loss. A certain amount of money needs to be kept on account with the broker in order to trade. If the investor has open trades with losses that exceed the margin limit (possibly 150% of the cash value of the account) then they will be subject to a margin call. The account will then need to either have additional funding or the investor faces the prospect of forced closure of trades in order to reduce the market exposure. While stop-losses can help to prevent significant losses, these limits may not be guaranteed in fast moving markets. Additionally, in volatile market conditions, the triggering of stop-losses may result in being unwillingly bounced out of a trade. CFDs are less suited to the long term investor. Holding a long CFD over an extended period of time will result in the finance charges building up and it may end up being more beneficial to have bought the underlying asset. Also, with no physical ownership of the shares the CFD investor has no voting rights. However, one thing to be aware of when trading CFDs are the finance charges. Holding a long CFD incurs financing charges based on the value of the position, the number of days the position is open and the LIBOR rate. Alternatively, the investor gets paid for holding short positions although as LIBOR is so low currently you still end up paying out. Finance Charges LONG You pay : LIBOR + 3% (if LIBOR is 1% the finance charge is 4%) e.g. Exposure to 10,000 CFDs for 10 days you would pay: (10 days / 365 days) x 4% x 10,000 = SHORT You are paid : LIBOR 3% (if LIBOR is 1% the investor will receive -2%, i.e. pay 2%) e.g. Being short of 10,000 CFDs for 10 days you would be paid : (10 days / 365 days) x -2% x 10,000 = (ie. you pay 5.48)

10 CONCLUSION We have explained what CFDs are. We have also looked at the benefits they give the investor, such as margin trading, the ability to go short, being able to hedge a long portfolio and lower costs. CFDs provide investors with the opportunity to make significant profits. However, CFDs are a high risk investment tool that can also result in significant losses in addition to huge gains. With this in mind, at Central Markets we believe there are five things that an investor should contemplate prior to and during CFD trading. Taking a view, focusing on risk management, looking at market timing, trade management and knowing your broker are all vitally important. We believe that following these five key elements will help investors to avoid those painful losses on the way to becoming successful at CFD trading. Risk warning for Financial Promotion. This report is issued by Central Markets (London) Limited, trading as Central Research (CR) of America House, 2 America Square, London, EC3N 2LU, which is authorised and regulated by the Financial Conduct Authority, No Trading in Contracts for Difference (CFDs) and/or Foreign Exchange may not be suitable for all investors due to the high risk nature of these products/services. The value of an investment in any of the above may be affected by a variety of factors, including but not limited to, price volatility, market volume, foreign exchange rates and liquidity. You may lose your entire initial stake and you may be required to make additional payments. Failure to do so can result in the closure of part or all of your position. The above investments are short term trading tools. Commissions on the above are charged on the whole leveraged (borrowed) amount (not just the deposit). Before you begin to trade, you should obtain details of all commissions and other charges. Extended runs of losses as well as profits can occur. You should make sure you can afford any potential losses before you begin to trade. Make sure you fully understand the risks involved and seek professional financial advice if necessary. You should only take a risk with money you can afford to lose. Do not rely on past performance figures. If you are in any doubt, please seek further independent advice. Remember, tax laws may be subject to change. Any person placing reliance on the report to undertake trading does so entirely at their own risk and CR does not accept any liability as a result. Information and research produced by Central Research, does not constitute a recommendation or offer to make a transaction in any derivatives or securities, and is intended to be general in nature. This report is prepared and distributed for information purposes only.

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