What is CFD Trading and is it a good idea?

Marc_J

Recently I opened an account with an online broker to invest a small sum of money (4 figures) in the stock market.

I can't find the exact link but I read on a Google Finance message about CFD Trading, wich I think stood for "Contract For Difference", they guy was going on about you being able to gain (or lose) ten times what you could actually afford to buy (in share price) as there's a 10:1 ratio somewhere along the line...and has the benefit of no stamp duty. It seems to be something along the lines of "short selling" which I heard a lot about recently, too.

I found http://www.iii.co.uk/cfd/ with a quick Google search but it's all a bit complicated....

Can anyone with any knowledge or experience on the subject shed a little light (or give advice) for a noob trader like myself to understand?

NeilW

Marc_J wrote: »

Can anyone with any knowledge or experience on the subject shed a little light (or give advice) for a noob trader like myself to understand?

A contract for differences is exactly what it says on the tin. It is a contract between you and somebody else where they think some share will go down and you think it will go up. You set a date in the future and on that date you check the numbers and depending upon which direction the share has gone one party gets some money from the other for the 'difference'.

You get roughly the same effect when you go to the bookies to put a bit of money on a horse. You have to put money on a horse to win in a particular race (which is a CFD). You can't put money on a horse to win in some race at some point (which is what you can do investing directly in a share).

It is a form of derivative, and is best avoided.

NeilW

tradetime

Personally I don't use CFD's (Contracts for Difference) but as I understand it they are a bit like Index futures contracts, index futures are contacts based on an entire index, such as the ftse. Since you can't take delivery of an entire index at settlement the contract is settled in cash, that being the difference between the index value at purchase and at expiry.
[FONT=Verdana, Geneva, Arial, sans-serif]A CFD works in the same way, except that you’re trading individual shares rather than a stock market index – and there’s no expiry date. You don’t buy the share, you buy a contract which reflects its market price. Then, just like a futures contract on an index, when you close out, your profit (or loss) comes from the difference between the opening and closing share prices – hence, "contracts for differences".

The 10:1 bit comes from the leverage built into the product. leveraged products can pose considerable risk to those who are not experienced in risk management, so I'd advise caution when dealing with them for the first time.

"Short selling" is entirely different in the fact that it is simply borrowing something to sell now with a view to buying it back at a lower price. I presume you can sell cfd's to open a position, thereby having the same net effect as a short. Shorting is another activity best avoided initially if you are new to trading as the risk of loss (unlike trading the longside) is unlimited.

Is it a good idea? That entirely depends on your experience and whether your any good at it. If you do not understand leverage, risk management and/or stock market trading, then it is probably a very bad idea since the leverage will magnify your losses. You only have to look at the current banking crisis to see what happens when you screw up risk management in conjunction with leverage.
On the other hand if you are experienced in the above, it is a very capital efficient way to make money since your outlay of capital is significantly lower than it needs to be with conventional trading.
Some info here.
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sabretoothtigger

In laymans terms this is one the riskest ways to gamble out there, more then horses or walking into a casino.

Add onto that the markets are the most volatile they have ever been. Its not an investment or trade since you never own anything.
Im not entirely sure if CFD is more or less risky then spreadbetting or basically the same

iii is a good company, nice offer but your'll lose money most likely. They actually give 100 as a start up I think, you could just trade that and see how you go, nothing ventured nothing lost

IG Index is them ? For an exception to the rule you could read this - http://www.marketoracle.co.uk/Article2499.html




Obviously 21 years ago, no internet and he had a guaranteed stop loss in action there which most dont offer now

fubar4164

I find it easier to think of it in terms of shares. You are speculating on the price of actual shares, and the price you buy & sell these "shares" is the value that they are currently being traded at on the markets, however, you are not buying the shares themselves (so there is no ownership of a physical asset and no rights to dividends etc), you're simply gambling on the way the prices will move.

The 10x yield comes from this fact. Since you're not buying any actual shares, you can enter into transactions by simply putting down a 10% deposit. The rest of the money is usually borrowed from the broker (for a small fee), and when you sell the CFD you reap the entire gain and simply pay the broker back the borrowed money and the interest on that. The gain or loss made on the CFD is entirely yours. Hence there is scope for massive gains & losses to quickly accrue.

You will still pay tax on the gains, even though there are no shares involved.

Blah99

sabretoothtigger wrote: »

Obviously 21 years ago, no internet and he had a guaranteed stop loss in action there which most dont offer now

Guaranteed stops are offered by all the spread betting companies I've used. I use IG Index mainly and they offer a controlled risk, guaranteed stop bet (can't remember the exact term).

The thing about guaranteed stops is that they're actually relatively useless. They always incur a wider spread and even higher fees, meaning that your profit is diluted and your risk is increased (higher movement in price required to gain similar return). If you set auto trailing stops you will usually be fine.

The one point where a guaranteed stop is a godsend is with a precipice drop or rise in price. Imagine you set a long bet on Acme corp, currently with a touch of 100 - 110p at £10/point. You set a stop loss at 90p and use a daily rolling bet, and for a couple of days the price bumbles around the 110p to 113p mark. Then the next day Acme issue a profit warning, and the spread gaps down to 75p-76p. That's a 35 point drop (110 -> 75), costing you £350. Your stop at 90p didn't close you out at 90p because the price never actually hit 90p - it just gapped down below your stop.

So in that scenario, if you had a normal stop you'd be £350 down. If you had a guaranteed stop at 90p you'd only be £200 down, because IG Index will guarantee to stop you out at 90p even if the price gaps past.

Remember this is only an example. You'd actually find that Acme Corp's touch with a normal stop is 100-110p, and at the same time the touch with a guaranteed stop would be 108-112p for example.

As someone else posted, spread betting and CFDs are leveraged products, meaning that whilst your upside can be geared in excess of your capital your downside is also geared.

If you're interested in this kind of stuff I suggest you read "The Financial Spread Betting Handbook" by Malcolm Pryor.

sabretoothtigger

If you set auto trailing stops you will usually be fine.

Which company offers these


Your right about gapping, I dont advise leaving bets open overnight tbh especially if new. Ive seen the sp500 gap in the middle of the day recently, occasionally a company will be nice and go back to a stop and honour it retrospectively where the price rose sharply but they didnt service it but thats pretty rare and they have no obligation afaik.

Often a stop loss will solidify your loss just as the price turns back on itself and far exceeds your original price point, in fact the market does this constantly

agsnu

GFT does, probably others too.

tradetime

sabretoothtigger wrote: »

, occasionally a company will be nice and go back to a stop and honour it retrospectively where the price rose sharply but they didnt service it but thats pretty rare and they have no obligation afaik.

Often a stop loss will solidify your loss just as the price turns back on itself and far exceeds your original price point, in fact the market does this constantly

Setting guaranteed stops to one side a "stop loss" should be a standard "stop market" effectively this is an instruction to execute a market order to close the position at best available price as soon as price trades at or on the wrong side of the stop loss, thus there would be no requirement for a firm to go back and close it at a better price, unless some considerable time had passed since it was triggered, and you could make a case that there was plenty of opportunity to execute at a better price If however someone is using stop limit orders to get them out, well that is insane.