Applications of CFDs
Trading CFDs enables the sophisticated trader to achieve investment objectives which until recently have only been available to the institutional trader. For this reason CFDs are growing rapidly in popularity and are proving to be an attractive means of gaining exposure to the economic performance of individual equities without the need to invest in the physical share. Indeed just as CFDs are traded on the price and movement of the physical share market, they also mirror any corporate actions that take place in the underlying share.
If you hold a long CFD, you will be credited with an amount equal to the gross unfranked dividend on the underlying shares on the business day after the ex-dividend date (CFDs do not confer rights to any dividend imputation credits). Conversely, if you hold a short CFD, your account will be debited an amount equal to the gross unfranked dividend on the underlying shares on the business day after the ex-dividend date.
CFDs provide an excellent vehicle for short to medium term trading strategies and are the preferred trading instrument amongst hedge funds and professional traders around the globe.
Trading CFDs will amplify small market gains or produce a profit from falling markets.
Outright Long or Short
You can take both a long or short CFD position with equal ease. If you consider a stock to be undervalued, you can go long with a CFD on leverage and benefit from a rise in its share price (or possibly lose if the underlying share price falls). Conversely, if you consider a stock to be overvalued, you can go short with a CFD on leverage and benefit from a fall in its share price (or possibly lose if the underlying share price rises).
By doubling your opportunities you are able to profit* from both bull and bear markets and unlike other equity derivatives, CFDs do not have an expiry date.
*Trading derivatives has the potential for both profit and loss and is not suitable for all investors. The loss can be greater than the deposit.
Hedging
You may have an investment portfolio which includes shares that you wish to hold for the medium to long term. However, there will almost certainly be occasions when you feel some of these shares may fall in value in the short term. CFDs allow you to hedge your existing exposure to periodic stock market downturns without crystallising any capital gain on your original share holding.
Pairs Trading
CFDs have enabled traders to construct more complex yet often less risky trading strategies, such as pairs trading between two highly correlated stocks. For example St George Bank (SGB) and Suncorp (SUN) shares. Pairs trading aims to minimise stock and sector risk by substantially reducing market exposure. This trading strategy can be utilised equally well in both bull or bear markets.
Other Strategies
Beyond hedging and short term trading, CFDs can also be used for holding longer term positions as part of a buy and hold strategy although here there are some things to consider. The first is since CFDs are traded on margin, there will be a daily financing charge applied which could add up over the long-term. Another consideration is that you may be subject to a margin call should the market move against you significantly.
It is also worth noting that CFDs provide you access to a very wide range of market assets. Smaller CFD contract sizes also make it practical to trade markets like oil and gold where the underlying contracts in the futures market are substantially larger. For instance, on some CFD brokers the minimum commodity CFD lot size for US brent could be just 25 CFD contracts (which is the same as 25 barrels of underlying) which compares very favourably to a normal trading size of 1,000 barrels on the futures market. Even better, there’s never any risk of physical delivery with a contract for difference unlike futures so you don’t have to worry about barrels of black stuff being delivered to your doorstep!
