CFD · CFD trading in a nutshell. Primarily CFDs are a short-term trading tool, with a May 2010 Investment Trends report indicating more than 90 per cent

Cartridge & JessenCFD

S

CFDs Made Simple is the essential guide for anyone who wants to make money trading CFDs.

Jeff Cartridge is a private trader and investor with a wide variety of investments in shares, CFDs and property. Jeff has conducted presentations for companies including E*TRADE, CMC Markets, Cube Financial and Pavilion Securities, and for the Trading & Investing Seminars & Expo. He is also the author of Supercharge Your Trading with CFDs.

Ashley Jessen is an experienced and successful trader with specialised knowledge in the trading and educational fi elds. He is an expert teacher of how to plan, construct and implement winning trading systems.

www.wiley.com AU$27.95 NZ$31.99

INVESTING

A beginner’s guide to contracts for difference success

CFDs

Jeff Cartridge &Ashley Jessen

SIMPLE, EASY TO UNDERSTANDSTRATEGIES ANYONE CAN USE FOR SUCCESS!

Contracts for difference (CFDs) offer an opportunity to make your money work hard for you with the potential for large returns on little outlay. This book includes the information you need to know to get started trading CFDs, and it provides tried-and-true strategies anyone can use.

Inside you’ll fi nd information on:

➤ types of orders and how to place them➤ using leverage to your advantage➤ managing risk➤ CFD providers (direct market access versus market makers)➤ avoiding the common mistakes many CFD traders make➤ strategies for success.

If you’re ready to make the move from trading shares to trading CFDs and maximise your success without all the stress, this is the book for you.

and

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CFDs

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Jeff Cartridge & Ashley Jessen

A beginner’s guide to contracts for difference success

CFDs

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First published 2011 by Wrightbooksan imprint of John Wiley & Sons Australia, Ltd42 McDougall Street, Milton Qld 4064

Offi ce also in Melbourne

Typeset in Berkeley Book 11/13pt

© Jeff Cartridge and Ashley Jessen 2011

The moral rights of the author have been asserted

National Library of Australia Cataloguing-in-Publication data:

Author: Cartridge, Jeff.

Title: CFDs made simple: a beginner’s guide to contracts for difference success / Jeff Cartridge.

ISBN: 9780730375685 (pbk.)

Notes: Includes index.

Subjects: Futures. Margins (Futures trading) Stocks — Prices. Stock options.

Other Authors/Contributors: Jessen, Ashley.

Dewey Number: 332.6322

All rights reserved. Except as permitted under the Australian Copyright Act 1968 (for example, a fair dealing for the purposes of study, research, criticism or review), no part of this book may be reproduced, stored in a retrieval system, communicated or transmitted in any form or by any means without prior written permission. All inquiries should be made to the publisher at the address above.

Cover design by Peter Reardon Pipeline Design <www.pipelinedesign.com.au>

Printed in Australia by Ligare Book Printer

10 9 8 7 6 5 4 3 2 1

DisclaimerThe material in this publication is of the nature of general comment only, and does not represent professional advice. It is not intended to provide specifi c guidance for particular circumstances and it should not be relied on as the basis for any decision to take action or not take action on any matter which it covers. Readers should obtain professional advice where appropriate, before making any such decision. To the maximum extent permitted by law, the authors and publisher disclaim all responsibility and liability to any person, arising directly or indirectly from any person taking or not taking action based upon the information in this publication.

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v

About the authors vii

1 Introduction to CFDs 1

2 Why use CFDs? 29

3 CFD trading costs, dividends and corporate actions 47

4 Getting started in CFDs 65

5 Before you start trading 83

6 Placing your orders 107

7 Core CFD trading skills 123

8 Room for improvement 151

9 Common CFD mistakes 169

10 What makes a successful CFD trader? 189

11 Strategies for success 209

Glossary 241

Index 249

Contents

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vii

Jeff Cartridge is a private trader and investor with a wide variety of investments in shares, CFDs and property. He has been featured in and written articles for the Sydney Morning Herald, Courier Mail, YourTradingEdge magazine, AFR Smart Investor, Wealth Creator magazine and the Compare Shares website. Jeff has conducted presentations for clients including E*TRADE, CMC Markets, Cube Financial and Pavilion Securities, and for the Trading & Investing Seminars & Expo. He is also the author of Supercharge Your Trading with CFDs.

Ashley Jessen is an experienced and successful trader with specialised knowledge in the trading and educational fi elds. He is an expert teacher of how to plan, construct and implement winning trading systems. Ashley has been instrumental in helping the growth of some of the largest trading companies such as CMC Markets, MF Global and HomeTrader by teaching both simple and effective trading strategies that are easily implemented.

Ashley and Jeff have created the website <www.learnCFDs.com> to assist CFD and share traders in learning simple, effective and profi table trading strategies. Between the two of them, Ashley and Jeff have taught tens of thousands of people in Australia and New Zealand about trading and investing.

About the authors

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1

In this chapter we look at the basics of trading CFDs and uncover the products available when you start trading CFDs. The basics we cover in this chapter lay the foundation for later chapters.

What is a CFD?Contracts for difference (CFDs) are relatively new fi nancial products that derive their price from the underlying share or index they’re tracking. In trading circles CFDs are referred as an over-the-counter product.

Tip An over-the-counter product means they’re not traded on the offi cial stock or futures exchanges around the world. Having said that, the Australian Securities Exchange (ASX) was the fi rst stock exchange in the world to introduce exchange-traded CFDs in November 2007, providing traders with an opportunity to trade exchange-listed CFDs.

Introduction to CFDs

chapter 1

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2

CFDs Made Simple

Essentially a CFD is a contract between you and your CFD broker to exchange the difference between the price you open the contract at and the price you close the contract at CFDs mirror the performance of the share or index you’re tracking, enabling you to (hopefully) profi t from a positive move in your chosen direction, whether it be long or short. For example, if you buy a share CFD (a type of CFD) at $1 and sell the share CFD at $2, your profi t is $1 minus your trading costs. That’s CFD trading in a nutshell.

Primarily CFDs are a short-term trading tool, with a May 2010 Investment Trends report indicating more than 90 per cent of CFD traders hold their positions for less than one month. According to the same report, 75 per cent of traders used technical analysis to determine what to buy and sell.

CFDs and the derivative connectionFinancial derivatives are instruments that get their price from something else. Many people associate the word derivatives with the futures market where, for example, the futures price of gold derives from the actual price of gold.

Since the global fi nancial crisis (GFC) derivatives have received extremely bad press, with many claiming they were responsible for the GFC. While derivatives did play a massive part in the global meltdown, it’s best to gain a good understanding of what a derivative is so you can be informed about them. The truth is most people around the world use a derivative product every day. Credit cards are used worldwide every day, but very few people would consider a credit card a derivative. In fact a credit card is a derivative of cash, enabling consumers worldwide to purchase goods and services without actually having cash. In the futures market you can trade crude oil futures without having to take delivery of 1000 barrels of oil, which is the equivalent of one contract of Brent Crude Oil Futures. So the crude futures market is a derivative of the actual price of 1000 barrels of oil.

While this explanation is simple, please keep in mind that misusing derivatives can result in signifi cant fi nancial losses in a


3


similar way to running up large credit card bills and not paying the balance.

TipGenerally speaking derivatives are complex instruments best left to the professionals, but CFDs have really simplifi ed the product, allowing traders to get up to speed quickly.

CFDs derive their price from the underlying sharemarket. For example, share CFDs derive their price from the underlying sharemarket; commodity CFDs derive their price from the under-lying futures market; and foreign-exchange CFDs derive their price from a multitude of banks and market makers around the world.

A short history of CFDsInstitutional traders were fi rst to develop and use CFDs, which were invented in the 1990s by a London derivative brokerage fi rm called Smith New Court. CFDs were developed as a way for clients to short sell the market while using leverage. As a bonus, traders were able to avoid stamp duty.

TipLeveraged trading allows you to trade much larger amounts than you normally could when trading an unleveraged product like shares. A $10 000 share trading account allows you to trade up to $10 000 in positions, but a $10 000 leveraged account (such as CFDs) allows you to trade more than the $10 000 cash you have in your account.

GNI, a large European-based trading fi rm, introduced CFDs to the retail market, enabling traders to execute trades on the London Stock Exchange without having access to it. In Australia CFDs did not launch until 2002, when IG Markets opened their doors. IG Markets was followed very closely by CMC Markets, which traded under the name of DealForFree.com


4

CFDs Made Simple

and took the Australian trading market by storm, giving accessto the top 200 shares at 5 per cent margin, commission free.

During those formative years the CFD market grew quite rapidly, with one of the largest CFD brokers opening more than 1000 accounts per month. CFDs were literally on the tip of every trader’s tongue, and investment magazines and newsletters everywhere were talking about them.

In Australia in May 2010 there were about 39 000 active CFD traders, which is an increase of approximately 22 per cent from the year before. Although recent growth may appear a little conservative, in 2007 the number of active CFD traders doubled as stock markets around the world came to a peak. The two companies with the largest market share are IG Markets and CMC Markets, with Commsec a distant third. Australia has approximately 20 CFD providers, which benefi ts every trader as they’re all vying for our business, pushing down their rates and improving their service.

TipCFD providers and CFD brokers are terms used inter-changeably and refer to the same thing.

Where do CFDs trade?International opportunities are just part of what is on offer when you open a CFD account with any mainstream CFD broker. One of the most exciting elements of trading CFDs is the opportunity to trade all those international shares you have heard of but thought were out of reach for an Australian trader. Shares like Microsoft, Google, Vodafone, Coca-Cola, General Electric, HSBC and BP are all available to trade and are literally two clicks of the mouse away.

TipTrading international shares is very simple, but generally speaking your costs are a little higher, and profi ts and losses may be held in the currency of the country you’re trading in.


5


Previously if you wanted to trade any of the international markets around the world with your local stockbroker the fees ran as high as 3 per cent of the value of your position. If you wanted to buy $20 000 worth of Microsoft shares in Australia, brokerage would range from $75 up to $600. Nowadays most CFD brokers will allow you to trade $20 000 of international shares anywhere from $20 to $40 per side, with minimum brokerage as low as $10 per side.

Tip‘Per side’ refers to one buy or one sell. A ‘round trip’ refers to a full buy and sell together.

CFD brokers enable you to trade shares from a wide range of world stock markets including:

Australia

Finland

US

France

Spain

Japan

New Zealand

Norway

Canada

Germany

Portugal

Austria

Hong Kong

Denmark

Sweden


6

CFDs Made Simple

Ireland

England

Singapore

Holland

Italy

Switzerland

South America.

In addition to these stock markets, you also have access to the following CFDs:

sector CFDs

index CFDs

foreign-exchange CFDs

commodity CFDs

interest rate or treasuries CFDs.

Tackling the CFD market for the fi rst time can be daunting enough without having to try to learn 22 different international stock markets, plus indices, commodities and foreign exchange. Become an expert in your local market and have a consistently profi table methodology fi rst, then consider accessing opportuni-ties available in other parts of the world through CFDs.

TipLearning to crawl before you walk rings true when trading CFDs. Concentrate on just one or two markets and trading very small at fi rst.

The basics of trading CFDsSetting the appropriate foundation before jumping into CFDs is important. In the following section we discuss the key basics that you need to understand to confi dently trade CFDs.


7


Making a profi t with CFDsProducing consistent profi ts regardless of which market you’re trading is the number one goal of all traders. In theory, making a profi t with CFDs cannot get any simpler:

buy low and sell high (long trade)

sell high and buy low (short trade).

TipShort selling (also known as short trading) is the opposite of trading long: you look to profi t from a fall in the price of the instrument you’re trading.

Uncovering the mechanics of making profi table trades is the focus of this book and is covered in chapter 11.

Making a loss with CFDsLosing trades, irrespective of the market you’re trading, are never nice but are part of trading the markets. Allocating risk to trades, knowing every trade you take could be a loser, provides an excellent emotional grounding and ensures you have a tendency to be risk averse. Successful traders generally win on 40 to 60 per cent of their trades, which means some of the best traders in the world are losing 40 to 60 per cent of the time.

Profi table trading is not about winning 90 to 100 per cent of the time, because for the most part this isn’t possible. Instead you’ll fi nd the best traders ensure their wins are two to three times the size of their losses, which leads us to the golden rule of trading success: cut your losses short and let your profi ts run.

Business as usual — trading longUnderstanding the power of CFDs is quite simple. CFDs are just like trading the underlying market except you need only a small amount of money upfront. Most traders are very familiar with trading the long side of the market. Trading long, or buying, is


8

CFDs Made Simple

generally the fi rst thing you learn when it comes to Economics 101 or any time you enter the market because it’s the simplest way of trading. Your goal is to buy fi rst because you believe the share, CFD or index you’re on will rise in value and you’ll be able to sell it at a higher price in the near future.

TipTrading long is simply the act of trying to profi t when the market you’re trading rises in value.

For example, you might decide to buy Newcrest Mining shares at $40 with the hope of making a profi t as Newcrest rises in value. Ideally you’ll be able to take your profi ts and close your position at, say, $45 over a couple of days or weeks, which would result in a profi t of $5 for every share you have. If you have 1000 shares then your profi t would be $5000, excluding any trading costs involved in the transaction. If Newcrest Mining shares happened to fall from $40 to $37 then you would lose $3 per share. Over 1000 shares you would stand to lose $3000, excluding any trading costs.

As you can see, trading long is business as usual and you don’t need to understand any elaborate calculations or rules and regulations to work out how to trade long. Instead it’s the short side of the market most people get stumped on, so let’s take a look at the basics of trading short.

Turning things upside down — trading shortShort selling, or trading short, gives you the opportunity to profi t when the markets are falling. If you’ve been around the markets long enough you would know the markets tend to fall a lot faster than they rise. The old saying ‘up the escalator and down the elevator’ rings true as markets tend to rise gradually, then when fear and greed hit, the market sells off very, very quickly. The recent GFC saw the most incredible amounts of volatility ever seen in the past 30 years. At one stage the moves were so dramatic the Australian dollar fell 7¢ in one night. In order to


9


translate these volatile, fast-moving markets into dollars in your account you must learn how to profi t from falling markets.

TipShort selling, trading short, going short and shorting all refer to the same thing and we use these terms interchangeably.

CFDs are so simple to understand that anyone with basic familiarity with the stock market should be able to short sell.

Tip Before you think to yourself ‘trading short is too hard’, stop and understand we have seen thousands of people with much less intelligence than you successfully open and complete a short trade. You can do it!

A fun exampleImagine you’re visiting the sunny Gold Coast for a short business trip in winter. As the weather is so nice you decide to head to the beach and catch a few rays, but you forgot your towel so you borrow one from the person you’re staying with. While you’re at the beach you notice a couple of kids walking with their parents along the shore when a freak wave topples one of the kids, drenching them in the process. With kids screaming everywhere and no-one else in sight, their mother asks if she can buy your towel and gives you $20.

You just sold something you didn’t even own (your friend’s towel) and now you need to get another towel to replace it. So you pop across the road to the clothes shop and fi nd towels on sale for $10 each and grab one similar to your friend’s towel. Your short sell transaction is now complete. Your profi t is the difference between your buying and selling points, which is a tidy $10. What if the opposite had happened and the towel now cost $30? In this case you would have lost $10 in the transaction.


10

CFDs Made Simple

Note: Jeff did visit from New Zealand and we went to the beach during winter, where my six-year-old daughter was toppled over while fully clothed.

TipDon’t take your kids to the beach during winter fully clothed and let them play in the sand on an incoming tide.

Opening a short position using CFDs is as easy as clicking the sell button to open a new trade. This challenges people’s mindsets because most traders are used to buying fi rst to open the trade and then selling to close the trade. This is what we call trading long. The opposite is trading short and involves selling the share or index fi rst to open the trade and buying back to close the trade. This is illustrated in fi gure 1.1.

Figure 1.1: profi table long and short trades

Sell to openSell to close

Profitableshort trade

Profitablelong trade

$2

$1 Buy to open Buy to close


11


TipTrading long: buy fi rst and sell second to close your trade because you believe your position will rise in value and you’ll make a profi t. Trading short: sell fi rst and buy second to close your trade because you believe your position will fall in value and you’ll make a profi t.

Dangers lurking — the major risks with CFD tradingLeverage, a lack of knowledge and ignorance of using stop losses are by far the biggest risk factors when it comes to trading CFDs. It goes without saying that ego and greed are two of the biggest killers to any trading account, irrespective of whether you’re trading CFDs, shares, foreign exchange or futures. If you let your emotions take over your trading you’re likely to use too much leverage, ignore placing stop loss orders, or trade at times when you’re better off staying out of the market. Keeping your ego in check and trading within your means gives you the greatest opportunity to succeed as a trader.

TipIf you’re not sure if you have an ego, ask your partner.

Financially and emotionally the most challenging aspect of trading is suffering, then recovering from, large losses. CFDs are a leveraged product, giving you the opportunity to accentuate your wins and magnify your losses. The large losses can cripple your confi dence and provide the greatest setbacks. Throughout this book you’ll hear us mention many times the importance of trading at lower levels of leverage and keeping a very close eye on your risk management rules. We discuss risk management further in chapter 5 and position sizing rules in chapter 7.

Not everyone should rush to set up a CFD account, so let’s take a look at who should be trading CFDs and who shouldn’t.


12

CFDs Made Simple

Who should trade CFDs?Experienced traders and new CFD traders alike have a fantastic opportunity to take advantage of the many benefi ts CFD trading has to offer. Over the years the same question asked at every introductory CFD seminar we give is, ‘If I have never traded shares before, should I get started trading CFDs?’

Understandably there’s a lot of fear around trading CFDs due to the leveraged nature of the product, knowing that it’s possible to lose more than your initial capital. Controlling the amount of leverage on your account lies solely in your hands. You have the option to trade at higher levels of leverage and trade in a risky fashion, or trade at lower levels of leverage and limit your risk.

TipWhen starting out it’s important to trade in small position sizes, in markets you’re familiar with.

The best people to make the transition to trading CFDs are those who understand buying and selling shares on the local market, and are familiar with stop loss strategies and sensible risk management rules. Stop loss strategies tie in with your risk management, allowing you to limit your risk and cut your losses if and when your positions turn against you. If you’re not familiar with stop loss strategies then sticking with an unleveraged stock market account is the best policy until you familiarise yourself with using stops.

Experience is clearly important before jumping in and trading CFDs, but we have one other suggestion for those who’ve never traded shares or CFDs before. Let’s start by asking a question: ‘What would be your worst case scenario if you bought one Commonwealth Bank (CBA) CFD at $50 and the trade went against you by 10 per cent over a fi ve-day period?’ Table 1.1 shows this scenario.


13


Table 1.1: total loss on a CBA CFD of 10 per cent over a fi ve-day period

Number of CFDs 1

CBA CFD price $50

Total exposure $50

Margin 5 per cent

Your cash outlay (margin) $2.50

CBA drops by 5 per cent over fi ve days

Close the trade at $45

Brokerage to get out $10

Loss on trade $5

CFD fi nancing over one week Approx 5¢

Total loss including brokerage, commission and CFD fi nancing $25.05

The answer is a staggering $25.05 (including all trading costs). However, if you did the same trade with a stockbroker who charges $19.95 per side, you would add about $20 in additional commissions, extending your loss to $45.05. Clearly you won’t need to take out a second mortgage in order to cover those losses, but it does highlight that you can trade really small amounts and never run into the problem of jeopardising your account.

Trading one CBA CFD may be as appealing as watching grass grow, but you can gain valuable trading experience on the local markets, regardless of experience, and your potential losses can be relatively small.

Tip When starting out, trade only small positions so you have real money on the line, while ensuring any potential losses will be insignifi cant should the majority of your trades go against you.

Who shouldn’t trade CFDs?Over the years we’ve witnessed both extremely profi table traders and those whose tales of woe never seem to end. Greedy traders


14

CFDs Made Simple

with a get-rich-quick mindset, who throw caution to the wind when it comes to effective risk management strategies, should not be involved in trading CFDs.

Most troubling for us are traders who make fantastic profi ts over a short period of time, become greedy and not only give their profi ts back but wipe themselves out totally. By far the most notable and public example of large gains followed by sharp, quick losses was in a local trading competition run by one of the larger CFD brokers in Australia. With $100 000 up for grabs and only two months to generate returns, one enterprising trader managed to take his account from $5000 to $150 000 in six weeks and then proceeded to whittle the account to less than $10 000.

Discipline and successful trading go hand-in-hand every step of the way, particularly when trading CFDs. If you’re not disciplined with using stop loss strategies in a leveraged environment then you should seriously consider whether CFDs are the right product for you. Trading with leverage has inherent risks built in and the most important point is knowing you can lose more than you start with if trades happen to move against you. If you’re not strong enough to cut your losses at the appropriate times or fi nd yourself always using ‘mental stops’ then perhaps you need to upgrade your skills before making the switch to CFDs.

Tip Greed and leverage do not go hand in hand. Removing your ego and any greedy impulses will give you a fi rm foundation with which to be a profi table CFD trader.

Different types of CFDsOpportunity abounds when you fi rst step up to trade CFDs. In this section we discuss the various CFDs that are available to you as a CFD trader.


15


Share CFDsShare CFDs are usually the fi rst port of call for those traders venturing into the derivative world of CFD trading. Undoubtedly you’ll fi nd them the easiest to understand because the CFD price derives directly from the physical share price. If you’re comfortable with trading shares on the local stock market, then trading CFDs on shares is an absolute breeze. Trading share CFDs is just like trading normal shares except for a few subtle differences:

ownership

commissions

margins

fi nancing.

Ownership

The fi rst thing you’ll come to realise when trading CFDs is there is no direct ownership when you purchase share CFDs. Instead of receiving a contract note from your broker indicating your purchase price, the purchase amount and the day of purchase, you’ll get an email statement every day indicating where you bought or sold.

TipRemember, a CFD is a contract between you and your CFD broker to exchange the difference between your entry and exit prices.

Commissions

Generally speaking commissions on CFD trades are half what you would normally pay when trading shares on the ASX. Any time you can reduce your fi xed costs in any business is a great thing and will always positively affect your bottom line. This is one of the key reasons CFDs have enjoyed a rapid and constant growth since their introduction in Australia in 2002.


16

CFDs Made Simple

Margins

Margin is the amount of money your CFD broker will ask you to put up front as a deposit in order to control the full amount of share CFDs you want to trade. Margins are discussed in more detail in chapter 3.

Financing

Financing is a small fee your broker charges every day you hold the position overnight. Financing is discussed in more detail in chapter 3.

Index CFDsLiquidity, volatility and extremely low margins are by far the greatest reasons CFD traders fl ock to index CFDs and the key reason why they’re the second most traded product in Australia behind blue-chip share CFDs. The only reason index CFDs aren’t the most popular comes down to market awareness. Everyone has heard of BHP Billiton, National Australia Bank and Woolworths, but very few people understand how to trade the indices.

TipLiquidity refers to the amount of volume traded on a share. If very few people trade the share it has low liquidity. If a lot of people trade the share, like BHP Billiton for example, then it is highly liquid.

What is an index?

An index is a group of shares that have a common element tying them together which is then weighted and given a price. For example, the Dow Jones Index is made up with the top 30 companies in America and the price of the index is weighted according to the size of each company. The Dow Jones Index moves according to the movement of each share in the index. For example, if the majority of the shares rise then the Dow Jones Index will rise in value also and vice versa.


17


TipLocal traders call the ASX 200 the XJO. The All Ordinaries Index (All Ords) or the XAO is a benchmark of the top 500 shares on the Australian market.

On the Australian market you’ve probably heard of the ASX 200 (often referred to as the XJO) which is a benchmark of the top 200 shares on the ASX stock exchange. Traditionally this index is traded via the futures market and is called the SPI 200 contract. Remember, a CFD is a derivative that derives its price from the underlying share or index it’s tracking. In this case, index CFDs simply track the local futures market and provide pricing based on the SPI 200 contract.

Tip Instead of trying to fi gure out which individual share to buy, perhaps trading the broader index is more appropriate, especially if you believe the Australian market as a whole is going to rise over the next couple of days, weeks or months.

Other common index CFDs you may be familiar with are:

S&P 500 (US)

NASDAQ (US)

Russell 2000 (US)

FTSE (UK)

DAX (Germany)

CAC 40 (France)

NIKKEI (Japan)

Hang Seng (Hong Kong)

Straits Times (Singapore)

Shanghai Composite (China).


Documents

CFD · CFD trading in a nutshell. Primarily CFDs are a short-term trading tool, with a May 2010 Investment Trends report indicating more than 90 per cent