|Learn the basics of CFD trading with tips and tricks to help you place your first trade. The series is ideal for new traders entering the forex market.
|A focus on credit evaluation and risk management. Suited for advanced traders who want to enhance their knowledge and skills.
|Recommended for experienced traders, covering technical and graphical analysis, projections, and forecasts.
Risk management will play a major role in any successful trading plan. If you use a trading method that allowed you to be successful the majority of the time you would assume that you would be profitable right? What would happen if your average losses were 60% bigger than your average wins?
Despite the fact that more of your trades are profitable, the fact that your losses are larger would result in your account going backwards especially when you factor in transaction costs. This illustrates that the key to trading success lies not in achieving a greater number of profitable trades but in intelligent position sizing, management of your trading capital and risk management. Careful consideration given to these factors can ensure you are not over exposed to the market and that any losses incurred are kept relatively small.
As a side note, you should recognise as early as possible that losing trades are an inevitable part of trading. As a trader we always aspire to increase the number of profitable trades and minimise the number of losing trades but the truth unfortunately is that there are too many factors influencing share prices at any given point to predict the outcome of a trade with any real certainty. Rather than focusing on a futile aspiration of trying to maximise profitable trades it is advisable to instead focus on perfecting the things that you have a very high degree of control over. This, in simple terms, means controlling your risk.
Risk management plays such a crucial role in trading success because it allows you to protect your capital. It is essential that you know your stop-loss levels prior to entering a trade. It is best to know your exit price in advance for a number of reasons.
Firstly, it is a critical element in the position sizing methodology discussed previously. Secondly predetermining your exit level allows you to make a decision when you have no capital at risk. You may have found in the past that it can be very difficult to make a trading decision whilst you have a position open. This is because decisions can be influenced by your emotions. Instead of this, if you predetermine your exit level and ensure you exit at your predetermined price you should find the whole trading experience much less stressful.
In order for this model to work we need to know three things; our entry price, our exit price and our available capital.
A CFD is an agreement between two parties to exchange the price difference of a financial instrument. The profit and loss of a trade is determined by the difference in the entry and exit price of the underlying instrument from when the contract is opened and closed.
CFDs are a leveraged product, which allow the buyer or seller to gain full market exposure while only outlaying part of the full notional value of the instrument.
CFDs therefore offer the potential to make a higher return from a smaller initial outlay compared to investing directly in the underlying security.
Leverage usually involves more risks than a direct investment in the underlying instrument. It is important you understand that leverage has the potential to work ag
ainst as well as for you as using leverage magnifies your trading profits and losses.
CFDs have been used by professional investors for over twenty years and emerged first in the over-the counter (OTC) or equity SWAP market. Equity swaps were used by institutions to cost effectively hedge their equity exposure.
CFDs have become one of the most popular derivative products in the Australian and European financial markets.
The popularity of CFDs has been driven by:
CFDs provide all the benefits of share trading combined with added advantage of being able to utilise your unrealised profit, and only outlay part of the full notional value of your position.
To gain a thorough understanding of the mechanics of CFDs it is important for you to become familiar with the key features of the product.
CFDs are traded on margin and there are two different forms of margin that may be payable when trading CFDs – Initial and Variation Margin.
An Initial Margin is a deposit used as collateral to open a CFD position. The margin is held to ensure you can meet your obligations.
A margin rate is expressed as a percentage and is calculated based on the liquidity and volatility of the underlying security. Margin rates typically range between 3% – 100%. The margin requirement of a CFD position is calculated using the “mark to market” concept. This means that the current value of your position is assessed during each trading day. The margin required is adjusted to reflect the current market value of the position as the price of the underlying security fluctuates.
Additional margin amounts will be payable should you fail to maintain the required margin on your position.
Quantity x Price = Full Notional Value
1000 x $10 = $10,000
Full Notional Value x Margin Percentage = Margin Required
$10,000 x 5% = $500
Your Initial Margin is $500.
In addition to the Initial Margin required to open to hold a CFD position, you may also be required to pay an additional margin incurred by an adverse price movement in the market, this is known as Variation Margin.
The Variation Margin is based on the intraday marked to market revaluation of a CFD position.For example, if you have a long position and the price falls then you are required to pay a Variation Margin.
The Variation Margin is a percentage of the total position size and the amount required will cover the adverse movement in the value of your position. On the other hand, if you have a short position and the price falls, you would receive a Variation Margin equal to the positive movement in the value of the position.
Failure to pay a Variation Margin call can lead to the position being compulsorily closed out. You as the position holder are obliged to pay for any shortfall in funds if Variation and Initial Margins are insufficient to cover the shortfall.
Margins are calculated on an intraday basis to ensure an adequate level of margin cover is maintained. This means that you may be obliged to pay more if the market moves against you. If the market moves in your favour, your margin requirement may be reduced.
Margin payments are usually required within 24 hours of being advised; in some circumstances margin call payments may be required on shorter notice. If you do not pay in time, your CFD provider can take action to close out your positions without further reference to you.
Financing is the daily cost incurred for holding an open position overnight. The financing rate is applied to the full value of your position and paid or received daily on long and short positions. If you hold a long ‘buy’ position you will be required to pay a financing charge, if you hold a short ‘sell’ position you will receive financing income.
Financing rates are calculated by your CFD provider by adding or subtracting a margin percentage from the RBAIOCR (Reserve Bank of Australia Interbank Overnight Cash Rate) and dividing the resulting amount by 365, representing the number of days in a year. The resulting percentage is then multiplied by the full notional value of the position to give you a daily financing rate.
RBAIOCR + Margin (long position) / number of days in year = Daily rate
(4.5% + 2%) / 365 = 0.0178%
Full Notional Value x Daily Rate = Daily Financing Payable
$10,000 x 0.0178% = $1.78
Your nightly financing rate is $1.78.
In the case of a short position you would receive the financing rate. In the calculation above you would simply subtract the margin from the RBAIOCR rate.
CFD commission is calculated based on the full notional value of the position with a minimum charge. Commission rates will vary between CFD providers.
Full Notional Value x Commission rate = Commission charged
$10,000 x 0.10% = $10
Your commission charge would be $10.
Leverage or gearing is like borrowing, it allows you to increase your potential return on a trade as you are able to increase your exposure whilst only contributing a fraction of the total value of the position.
Products such as shares are not leveraged and have a leverage ratio of 1:1. CFDs can have leverage ratio of up to 33:1 meaning that every $1 invested has the effect of multiplying the profit or loss by 33.
You deposit $10,000 in your CFD account and hold five CFD positions that are each worth $10,000 (your total exposure is equal to $50,000), you have leveraged your initial capital by five times (or 5:1) leverage.
In the above example your maximum loss could be $40,000 in addition to your $10,000 initial deposit, however this would only occur should all of your five CFD positions fall to a zero value, this is highly unlikely but it illustrates the potential downside of using aggressive leverage.
To further illustrate the potential dangers of leveraging too aggressively we will look at another example which is something of a worst case scenario. If you decided to open the largest position possible using your available capital, assuming you are trading a share CFD with a 5% margin rate you could potentially open a $200,000 position. In this case it would take only a negative price movement of 5% in the underlying share price to completely eliminate all of your trading capital. A movement of 5% is well within the realms of possibility and could happen on a single trading day.
This example highlights that the higher your leverage ratio the more susceptible you are to adverse price movements. This example also highlights that employing a high leverage ratio means that all or the majority of your capital is tied up in maintaining your margin.
A small negative price movement will require the payment of additional margin, and you will need to deposit additional funds to cover the additional margin requirement. This is known as a ‘margin call’ and happens when you have no free equity in your trading account.
The leverage ratio you use should depend on your experience. If your initial trading capital of $10,000 grew to $20,000 then the same 3:1 leverage ratio would allow you to gain exposure to the value of $60,000 rather than the original limit of $30,000. Successful trading and capital growth will allow you to increase your market exposure while employing conservative leverage levels. Experienced traders who watch the market closely can use higher levels of leverage.
If you have additional trading reserves readily available, higher leverage ratios could be employed. You may have $30,000 allocated for trading in a separate account but hold only $10,000 in your trading account. You could consider leveraging the total $40,000 capital at 3:1 allowing you to gain market exposure of $120,000. If you employ this strategy it is important to monitor your CFD account closely to ensure you do not fall into margin call due to lack of free equity in your CFD account.
Trading CFDs requires you to monitor three important values to assess the balance of your account, the deposit required to maintain your positions and the trading resources to take new positions. These values are referred to as Gross Liquidation Value (GLV), Initial Margin (IM) and Free Equity (FE). Your GLV and FE will decrease if your CFD position(s) move against you. A margin call occurs when your GLV falls below your Initial Margin or the amount you have in the account. Should this occur you must either close one or more of your open positions to reduce your initial margin requirement or deposit additional funds to fund your account.
Relatively inexperienced CFD traders should use a leverage ratio of 3:1. This level will allow you to gain additional market exposure whilst limiting the effects of any adverse market movements. The table on the opposite page illustrates how your maximum exposure amount changes as your equity fluctuates. The Gross Liquidation Value (GLV) is the total value of your account, irrespective of margin requirements. GLV is sometimes referred to as your Total Equity. This is the amount of capital in your account if you were to have no positions.