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We know they are useful but what are the weakness of CFDs? Contracts for difference (CFDs) were introduced to the retail market in Australia in the early 2000s. At that stage two providers, CMC and IG markets, were the only choice for most traders. CFDs rapidly replaced Exchange Traded Options as the most popular derivative, offering high leverage on the commonly traded stocks. They are now offered by a multitude of providers over an increasing range of stocks, Forex (Foreign currency) and indices around the globe. The time and money CFD providers have spent (advertising and) developing user-friendly platforms that make them easier to trade have made many traders feel comfortable utilising them in their trading strategies.
Despite their widespread usage and acceptance and the positives that they have bought to derivatives trading in Australia, it is crucial that anybody who trades derivatives understands that there are some weaknesses with CFDs. We will examine these today.
- They were developed in the UK - The UK has particular tax situations that are not applicable in Australia and most importantly, there are no franking credits in the UK, so if you hold a CFD in Australia the franking credit is not applicable to you.
- Prices 'aint prices - We constantly highlight the difference between Direct market access and market makers. We have become increasingly aware that certain CFD providers are muddying the waters, claiming direct market access when they deliver a hybrid product, or attach other terms such as 'average' stop loss prices as detailed above. Make sure you read and understand the terms and conditions from your prospective CFD provider.
- Interest payable on the whole transaction - Unlike margin lending (or any shares gearing) the CFD trader is paying interest on the total transaction amount, regardless of the margin that they have contributed. Interest cannot be prepaid so tax management is not as easy as margin lending.
- Inflexible leverage levels - The CFD provider sets the leverage (margin) level applicable to each stock. The trader has to accept this level and try and formulate risk management strategies around the level. This leverage level can be amended as the provider sees fit, therefore if the CFD provider increases the margin required mid-trade the trader has to contribute more money (margin) to the transaction to avoid being closed out.
- CFDs for Index, currency and commodity trading - CFDs seem to offer an easy path into trading commodities, currency and indices. In fact, CFD Forex trading is big business as it is traded across the globe 24 hours for five and a half days and easily has the most market liquidity of all traded instruments. Please click here to read an overview of the rapidly growing Forex CFD market. It is important that the trader is aware of exactly what they are trading. For example, whilst the ASX200 index (XJO) is used as the benchmark index for Australian shares there is no CFD provider that offers the XJO index. This also carries over to futures - the Sydney Futures Exchange (SFE) charges a huge amount of money for quoting the SPI200, therefore most CFD providers cut costs by providing a product that 'reflects' the SPI200. Please click here for an overview of index CFD trading.
- CFD accounts are 'stand alone' - CFD platforms were developed in Europe and are 'white labelled' by local offices in Australia. Therefore CFD providers have not had the ability to integrate their CFD platforms into legacy share brokerage platforms (if they possess them).
So in summary, CFDs have been instrumental in bringing high levels of leverage to the retail trader market and introduced the retail trader to Forex and Index trading like never before. However, as described above there are weaknesses.
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