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How to trade contracts for difference to make a difference in your investment portfolio?

-Sargon Elias, general manager, CMC Markets

Tuesday 2nd October 2007

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Many people think that you can only make money in the stock market when share prices are going up. While this thinking is still true most of the time, it is also true that you can make money in the stock market when prices are going down.

Wonder how you can do this? Contracts for difference (CFDs) which have been recently introduced in New Zealand by CMC Markets, are gaining popularity as a tool for investors to make money in a falling market.

CMC Markets, which started as a foreign exchange (FX) trading company in the UK, has recently opened an office in New Zealand to service the growing number of CFD traders in the country.

Sargon Elias, general manager of CMC Markets New Zealand said the company’s move to New Zealand was due to rising demand for the product.

“We have existing clients in New Zealand being serviced by our Asia Pacific team. But as we talk to our clients the message we got from them is that they need a local presence in New Zealand, so we decided to expand our operations here. And true enough, we are getting more people asking and wanting to know more about CFDs. We are holding regular CFD seminars and we’re getting a lot of calls asking about CFDs everyday,” Elias said.

What are CFDs and how do you trade them? The simplest way to understand CFDs and how to trade them is to think of them as share trading with the added benefits such as margin trading and the ability to go short.

Trading CFDs on margin means you only have to put up approximately 3-5% of the total value of the trade you want to get into in order to open a trade. For example, if you want to buy 2,000 shares of Telecom NZ which is trading at say $4.70, you would need $9,400 plus about $25 for brokerage fee. If you trade Telecom NZ share CFDs you would only need to pay up 5% of $9,400 which is $470 plus a brokerage fee of about $10.

This means trading CFDs on margin can get you started into trading with only a small capital requirement.

Phil Biggs, who started as a futures trader in the UK, discovered CFDs when he moved to New Zealand a few years ago. Phil is among the growing number of New Zealand investors and traders who are taking advantage of the leverage feature of CFDs.

“I was attracted to CFD because it’s a leveraged product. There are times that I want to have 10 trades in a session and I don’t have enough capital to open all positions, the leverage definitely helps,” Biggs said.

Another attraction of CFDs is that it gives you the ability to make money in a falling market by short selling or going short. This means selling a CFD with the view of buying it back at a lower price and making a profit in the process.

Short selling or going short is the exact opposite of going long or buying share CFDs. When you short sell, you expect the share price to go down when you can buy it at a lower price than when you sold it.

Here is an example to make it clearer. Telecom NZ shares are trading at $4.70. With the recent market volatility and uncertainty in the telecom industry, you think that the share price will go down in the near future. You decide to short sell Telecom NZ share CFDs with the view to buy it back later at a lower price. After one week the price of Telecom NZ share CFDs has gone down to $4.20 and you decided to close your position and pocket the 50 cents gain.

Here’s how you would have made money by short selling:

Telecom NZ share CFD

Open trade by selling short at $4.70
You sold 2,000 Telecom NZ share CFDs
Total cost = $4.70 x 2,000 x 5% + $10 brokerage/commission
Total = $480

After one week the price has gone down to $4.20 and you decided to close your trade.

Close trade by buying at $4.20
You bought 2,000 Telecom NZ share CFDs
Total cost = $4.20 x 2,000 x 5% + $10 brokerage/commission
Total = $410

This will translate to a 14.5% profit in one week for a $480 initial outlay.

Trading on margin and the ability to go short are not the only benefits you will get from trading CFDs. There are other factors working in favour of CFDs, helping it to be the trading instrument of choice compared to other derivatives. These factors include:

Easy to understand and easy to trade – trading CFD is similar to and is almost identical to trading shares. The only difference is that you trade CFDs on margin, so you only need a fraction of your trading capital to open a trading position. This makes CFD trading an easy transition for those who have experience trading shares in the past. This is one of the biggest reasons why traders are taking up CFD trading because they can use all their knowledge in share trading when they make the shift to CFD trading.

Can be traded on margin – For most people the ability to trade on margin is the top attraction to trade CFDs. Trading CFDs on margin means you only need a small fraction of your trading capital to open up a CFD trade. For example, with CMC Markets, you can trade some share CFDs from 3% - 5% margin. Some CFDs attract 10% margin while FX and commodity trades attract only 1% margin. This means traders can open either more or bigger positions than they can normally open with limited trading capital. Trading on margin is best suited and is very popular with traders who have several years of experience in trading and who know how to use this feature to their maximum advantage.

Can be traded long or short – Another attractive feature of CFDs is that it allows traders and investors to buy or sell. This means people can still make money even in a falling market by short selling CFDs. Short selling physical shares could be complicated (due to the uptick rule) and expensive (due to additional fees and charges from regular stock brokers) compared to short selling CFDs.

Access to international markets – the coming of CFDs to New Zealand has opened up a whole new level of trading because it gives investors and traders access to international markets like the US, Europe, Australia, UK and Asia – which were not easily accessible before.

Low commission – CFD trading attracts very low commission compared to trading shares. CMC Markets charges only $10 for trades of up to $10,000 – this is very low compared to paying about $20 - $30 when trading shares with a stock broker.

*Sargon Elias is general manager of CMC Markets New Zealand, an online trading company that is the largest share, index, sector and margin FX CFD provider in New Zealand. CMC Markets is a global leader in financial trading with offices on four continents, providing clients in more than 100 countries with 24-hour online access to 18 international markets.

CMC Markets launched the world’s first online, realtime Foreign Exchange trading platform in 1996 and in January 2000 it became the first company to offer online commission-free Contracts for Difference (CFDs). This started a revolution in trading around the world.

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