How to Trade CFDs

One of the most popular day trading vehicles are financial contracts called derivatives. Derivatives get their prices from the prices of an underlying asset.

There are 3 main types of derivatives:

Futures: a contract that gives you the obligation to purchase something at a future date for an agreed price. Futures are commonly used by farmers to lock in the price of their crops so they have some protection against price fluctuations, and  also by importers and exporters who can reduce their risk of currency fluctuations by locking in exchange rates before importing or exporting.

Options: a contract which gives you the option/right to buy or sell something at any time up to a future date for a fixed price. The buy option is called a call and the sell option is called a put. So if you think the price of an asset is going up, you would buy a call or sell a put on that asset (or even do both).  If you thought the price was going down, you would buy a put or sell a call.

These two derivatives are the most common but a third is also used: Stock Warrants. Stock Warrants are issued by a company instead of an exchange and gives you the option to buy more stock of the company at a future date for a fixed price, quite like options.

Options Markets:

• The most important and biggest options market in the US is the CBOE or Chicago Board Options Exchange where options on stocks are traded.
• NYBOT (New York Board Of Trade) for coffee, sugar and cocoa
• NYMEX (New York Mercantile Exchange for metals and petroleum
• CBOT (Chicago Board Of Trade) for corn, wheat, soybeans etc
• CME (Chicago Mercantile Exchange) for cattle, pork bellies etc

If you are looking for a trading option outside of traditional stocks and bonds, derivatives trading may be a good option. Derivatives pay off over a period of time based on the performance of assets, interest rates, exchange rates, or indices. The payoff can be in cash or assets and vary, of course, by performance and timing. In addition to stocks and bonds, derivatives can also be traded through in the money market, foreign exchange (forex), and credit.

Indicators affecting a derivative’s performance are varied, and depend on the type of derivative. These can range from the stock market index to the consumer price index to weather conditions and fluctuations in currency exchange rates.

Reasons to begin derivatives trading:

1. Less Risk than other Trades

When you trade in derivatives, you are not purchasing the underlying product or buying into the company, instead your risk is on the performance. There are two main types of derivatives: futures and options, which allow someone the option to buy or sell at a prearranged price. There are three main types of firms that use derivatives. These are investment banks, commercial banks, and end users, such as floor traders and corporations.

While you can still lose money in derivatives trading, the risk is much less of an investment. Als, you can get involved in derivatives trading for a much lower initial investment. Derivatives can also be a good way to add balance to your total portfolio, therefore spreading risk throughout a variety of investments rather than in only a few.

2. Variety and Flexibility

The nature of derivatives essentially means that the opportunities for trading this type of investment are limited only by the imagination. Those interested in derivatives training may want to begin by focusing on a particular area, such as currency trading. Some types of trading options are available around the clock, on a global scale. This is another reason some investors are drawn to derivatives trading. Getting involved in the global economy can be exciting, and it opens international options that may not be available through the traditional stock market.

3. They Can be a Good Short Term Investment

If you are looking for an investment opportunity that can pay off in a shorter time frame, derivatives may be a good option. While some stocks and bonds are long-term investments over the course of many years, derivatives can be days, weeks, or a few months. Because of the shorter turnaround time, derivatives can be a good way to break into the market as well as a good way to mix short and long-term investments. If you have a portfolio consisting of long-term investments, such as some stocks, and want an option to put your money to work now, derivatives may be worthwhile.

In conclusion, derivatives trading can be an excellent way to either break into the trading market or to complete an existing portfolio. It offers a wide range of options, including international opportunities.

What is a Derivative? A derivative is a kind of financial instrument that does not have it’s own value, but derives value from an underlying base. This base may be an asset, or an index, or even a phenomenon.

Derivatives don’t have an independent existence of their own. They exist as offshoots of either assets like stocks, commodities, residential mortgages, etc. or indices relating to the stock market, consumer prices, exchange rates, etc., or even phenomena like the weather conditions. They derive their values from these assets.

Types of Derivatives: Like there are two types of medicines, over the counter, and prescription, there are also two types of derivatives, the Over-The-Counter derivatives (OTD), and the Exchange-Traded-Derivatives (ETD).

Based on these two classes of derivatives, there are three kinds Futures, Options, and Swaps, that are covered below.

Futures and Forwards: These are financial contracts with a commitment to buy or sell an asset within a certain future date at today’s price. That is future buy/sell at current rates. While a forward contract is an example of an OTC derivative, a futures contract is an example of an ETD.

Options: These are contracts that entitle their owner to either buy or sell an asset without imposing an obligation to do so (buy or sell). The option to buy is known as the call option and that to sell is known as the put option. The price of the transaction is fixed at the time of making the contract, and is referred to as the strike price. Another feature of this contract is the maturity date. There are two options- the European option, and the American option. Under the European option, the owner may specify maturity date only as date of Sale; in the American option, Sale is allowed to take place on any date up to the maturity date.

Swaps: Under this type of contract, the underlying values of currencies, bonds, commodities, stocks etc., are exchanged on or before a specified future date.

Some of the major purposes of using derivatives are:

Risk Management/Hedging. The major purpose of using derivatives is to manage or counter risks faced in the business environment, especially that which cannot be dealt with conventionally. Hedging occurs when the risk of the underlying asset is transferred through the medium of the derivative from one person to another. A forward contract in a foreign exchange transaction like export and import is an example of hedging.

Speculation. Derivatives may be used to book extra profits, or profits out of the ordinary, by taking advantage of a favorable movement in the value of the underlying asset.

Arbitrage, is taking advantage of a lower current market value vis a vis, the future value of an asset.

In conclusion, derivatives can be used to either hedge one’s risk, to make super profits, or just settle for arbitrage. As these instruments do not have a value of their own, they are vulnerable to any kind of shift or change in the value of the underlying asset. Therefore they may not be very reliable in countering risks unless the issues affecting the values of the underlying asset are properly understood and provided for.

The popularity of trading CFDs has taken around the world by storm. There would have been very few people in the invesment community that could have predicted the success of this leverage product and even during the economic downturn, some of the leading CFD brokers are increasing trade volumes.

Largely the popularity of CFDs in Australia is the simplicity of the product itself. Contracts for difference or CFDs are exactly equal to the sharemarket trading, except that you need a small amount of money in advance.While the CFDs are a product of leverage, the amount is up to the users. This means any trader could make the trade as safe or as risky as that choose.

1,000 new accounts a month during the bull market

At the top of the bull market it was fairly common for some of the major CFD brokers in Australia to be opening around 1000 new accounts each month.During 2008 the world stock markets experienced a high level of volatility. Though this extreme many CFD brokers in Australia experienced the highest level of trade volumes and the largest number of openings for account at any time in its history.

Using CFD coverage and to reduce the volatility of the portfolio

One of the reasons for the increased interest in CFD trading in Australia is due to the fact that CFD can actually be used as a tool of coverage and allow investors to reduce their risk in theor existing share portfolio. As any trader knows the increased volatility comes from an increase in the number of opportunities.

So as you can see the popularity of Trading CFDs Australia has grown. Remember other derivatives such as options, warrants, and futures will remain good products to trade forward.