Purchase Order Finance

Understanding CFD finance is much easier when you understand the whole process of trading a CFD. A small margin requirement is all that is required to buy a CFD which covers any loss you make on the position. As the underlying instrument moves the margin amount will also vary. The margin payment that you make does not cover the cost of the underlying position.

To hedge your position the CFD Provider will buy the underlying stock when you enter a CFD and to do this has to front up with the full purchase price. In effect the CFD Provider is lending you the cash while you hold the CFD position open.

Buying CFDs And CFD Finance

When you buy a CFD the CFD Provider will charge you interest on the money. The rate of interest is applied to the face value of the position, i.e. the number of contracts times the current price.

As an example if you bought 1000 MSFT using CFDs at $23.00 then interest would be charged on $23,000. Trading long the interest is charged on the full position. This is CFD finance in action.

CFD Finance On The Short Side

On the other side of the coin if you sell a CFD short you effectively receive the cash for that sale. While it does not end up in your bank account it does end up in the CFD Providers bank account if they sell the underlying stock.

So selling 1000 CFD contracts of CBA at $33 would mean that you would receive interest on $33,000. This is how CFD finance works when trading short.

How Much Will CFD Finance Cost?

The rate of interest does vary between brokers but they all work with a similar concept. Long positions pay interest at a set rate plus a margin of 2 – 3 % while short positions you get paid interest at a set rate less a margin of 2-3%. The set rates used are normally the LIBOR or the RBA rates. (LIBOR – London Interbank Offered Rate and RBA – Reserve Bank of Australia Cash Rate)

The interest rate difference from the margin that the CFD broker charges is one of the ways the CFD broker makes money. CFDs could be considered to be a complicated way of lending money for the CFD broker.

How Are CFD Finance Charges Calculated?

CFD finance charges apply to positions that are left open overnight and not to CFD positions that are entered and exited on the same day. Intraday trades do not attract CFD finance charges.

The rate of interest is very low relative to the impact of movement in a CFD position. With current interest rates at about 6% per annum fluctuations in the CFD position can easily be more than this in a day.

Many novice traders blame CFDs for their losses and even may say CFDs suck. Losing money can trigger an emotional response and novice traders may blame someone else for losing money.

Contracts for Difference (CFDs) are not responsible for your losses, it is the decisions you make as a trader. Take responsibility for your trades as you have total control over when you enter and when you exit from the trades.

The Impact Of Leverage

CFDs trade on leverage where a small amount of money down gives you access to a large position. This can result in very quick gains or losses as the market moves. If you lose money trading CFDs do not blame CFDs and say that CFDs suck.

Limiting your risk is essential when trading CFDs and stops are one way to do this. If you are not yet using stops in your trading it is time to start.

CFD Brokers Deliberately Hit Your Stops

Some traders think CFDs suck because the broker knows where your stop sits and can then move the price to these levels. After hitting your stop the market then turns around and moves again in the direction you expected. Despite being correct you end up losing money.

CFD brokers are not inclined to chase your stops as they have other more important things to do. Sometimes a trade will hit my stop and reverse and at other times it will move very close to the stop and reverse. It can go either way. Place your stops thoughtfully and in a place where they will not be hit by normal movement.

A CFD broker cannot push the market around, it is the sum total of all the traders that move the market. Sometimes this will hit your stop no matter how carefully you place the order.

Re-quotes Are Unfair

Market makers can re-quote prices if the market moves rapidly from the current price or there is not enough volume at the underlying price to trade a position. New traders often think they are being ripped off and consequently that CFDs suck. You are not being ripped off the market maker is simply quoting you a price at which the whole order can be executed.

The difference between where you want to get in and where you do get in is known as slippage and is accepted as normal when buying stock. Some of the stock is executed at the cheaper price, and some at a higher price providing an average price higher than where the order was placed.

Market makers execute the complete order or nothing. They do not execute partial fills as a stock broker would. To allow them to execute the whole order a price is re-quoted that will allow them to execute the whole trade. Re-quotes are not designed to rip traders off, they simply reflect the reality of execution in the underlying market.

Trading Is Your Responsibility

It is wrong to blame CFDs as the cause of bad performance, it is always the trader. Just as blaming the market is futile, saying CFDs suck does not address the underlying cause of the problem.

A trader must take responsibility for his or her results and with this belief system in place it is possible for the trader to change their outcomes. If you think the rest of the world is driving you crazy, you will have to send the rest of the world to a psychiatrist for you to get better.

Interestingly, most CFDs do not trade on a Contracts for Difference market. The Australian Stock Exchange has created a market for CFDs but as at the end of 2008 the volume traded on the ASX CFD market represented only 1% of the total CFDs traded.

CFDs Trade On Over The Counter Market

The majority of CFDs trade OTC or Over The Counter and do not actually trade on a CFD market at all. When you enter a contract with a CFD broker you must then exit the contract with the same broker. You cannot close out a position entered with one broker through another CFD broker.

The prices that you can trade a CFD at are usually the same as the underlying market as the CFD brokers mirror the underlying market with their quotes.

Hedges In The Underlying Market

While no formal Contracts for Difference market exists, other than the ASX CFD market, the CFD broker may, or may not trade the underlying instrument on the underlying market to protect the position they have taken with the individual trader. This is known as hedging a position.

If a trader was to buy 300 shares of BHP, the CFD broker could simultaneously buy 300 shares of BHP on the ASX market. By doing this any gain or loss made by the trader on the CFD position equals the gain or loss made by the CFD broker. The broker is said to be fully hedged.

The Direct Access Model of execution requires the CFD provider to hedge very position that is entered. The market maker model does not require this and it is up to the CFD Provider how they hedge the position. They may hedge individual positions or the overall portfolio.

CFD Positions Are Not Guaranteed

If you are trading CFDs through one provider you must open and close the position with the same provider. It is important that when it comes time to close that position that the provider is still around to close it. If you have made a large gain on a position it would be nice to be able to access it.

Many CFD brokers are publicly traded companies so it is easy to gauge their financial condition. Not all the companies are publicly listed and it is a lot harder to find the information on the unlisted company’s financial status.

CFD Market

Even though there is no CFD market it has very little impact on individual traders. Orders placed with a CFD provider are traded at market prices and the orders may even be traded on the underlying market.

Many traders are seeking high probability trading strategies for trading CFDs. The attraction of these strategies is obvious as the more often a strategy is correct, the easier it is to trade.

The impact of leverage is not as great as these strategies are less likely to have losing streaks so the drawdown is reduced.

But beware of chasing high probability strategies as you may be looking for the key to successful trading in the wrong place.

Its Not About Being Right

It is not just the win% that makes a trading strategy work, it is a combination of the win% and the risk reward. Looking at only one of these measures in isolation is a sure way to fail.

Consider the following trading strategy that is profitable 95% of the time. The strategy wins $100 on each profitable trade, so from 100 trades the strategy makes $9,500 trades on average. But what happens on the other 5% of the trades.

If the strategy loses $2,500 when it doesnt work then from 100 trades it will lose $12,500. Overall the strategy, even though it is right 95% of the time, loses money. It is the combination of risk reward and hit rate or win%.

Losses Still Happen

Typically high probability trading strategies follow the following formula, they take small profits when they are available and run very large stops. FAP Turbo, the forex trading robot, uses exactly this strategy to get a 95% hit rate.

All goes well until you experience a series of large losses. The losses can be reduced by tightening the stop loss, but this is very likely to reduce the number of times the strategy wins.

It Is All About Balance

Trial a series of different parameters for stops to find out what level gives the best results. In this way you can determine what works the best for both the win% and the risk reward.

In my own trading I have tested a variety of chart pattern breakouts. The best trades breakout and keep going in the direction of the move. Because of this tight stops work ell with chart pattern breakouts as they improve the risk reward results. Profit targets on the other hand improve the win%, but actually reduced the overall profitability.

It Is About Making Money, Not Being Right

Trend based trading strategies often have win% of just 30%, but the risk reward is usually 3 or more. The combination of a low success rate works if the average wins are big enough relative to the average loss to deliver a profitable strategy.

Scalping relies on a high win% usually 70% or more, but usually have a low risk reward where profits are equal to losses. This is another profitable strategy.

Successful trading is about making money, not about being right. Ensure the strategy you use is profitable overall. It is not just about getting a high probability trading strategy.

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