In the early days traders needing to borrow money to make investments had few choices, either borrow money from the bank to buy equities or phone your stockbroker and submit an application for a margin loan.
In 2003 traders and investors in Australia were given an extra option, CFDs. Since their introduction the industry has changed, CFDs being a simple type of margin lending have grown to be the fastest growing derivative product in the country, outstripping the growth experienced in the warrants market through the mid 1990’s.
No longer does a retail investor have to to apply for a bank loan or deal with costly full service brokers. CFDs have revolutionized the financial services industry, retail investors can now open a Contract for difference account on the net in minutes and be up and trading before the conclusion of the day, executing all of their orders in real-time on the internet.
Unlike margin lending CFDs are usually traded over the internet with the investors portfolio being marked to market in real-time during the trading day, this is substantially different to the end of day portfolio revaluations used by margin lenders. Real time portfolio margining ensures that traders can properly accurately manage risk throughout the trading day rather then having to wait for statements to be produced at the end of the trading day.
Like stocks acquired having a margin loan CFDs also offer the holder the ability to collect a dividend, however in the majority of cases franking credits aren't passed on to the holder of a Contract for difference unlike that of a margin loan. The reason franking credits are not passed on when holding a CFD is because the buyer of a CFD holds an over-the-counter derivative contract and never the physical share. Not owning the physical share when owning a CFD position also means that the purchaser of the Contract for difference is not entitled to voting rights in the listed company over which the CFD is quoted. A lot of Contract for difference traders only hold their positions open for a brief time frame and are not interested in voting rights or franking credits but instead are interested in making a profit from the short term price changes of the Contract for difference.
Among the most significant advantages of CFDs is that traders can always sell them as easily as they can purchase them, this means is that going long is just as simple as going short permitting traders to gain in falling markets. With conventional margin lending short selling is tricky and near impossible.
Contracts for difference are relatively inexpensive when compared to margin lending, typical brokers offering margin lending will charge 0.50% whereas a typical CFD broker will charge 0.10%. One thing to be cautious of are the interest levels charged by margin lenders and CFD providers. It is important to note that margin lenders will charge interest only over the amount borrowed whereas CFD companies will charge interest on the total notional value of the position, however, Contract for difference financing charges are typically lower. Financing rates are essential to think about when evaluating both products, however, this is less important for Contract for difference traders that only hold their positions for a brief period of time.
Usually Contracts for difference offer traders extra leverage than normal margin loans allowing traders to achieve a superior return on their investment. You must also be aware that higher leverage may also result in a rise in risk, this is normal with geared products. The leverage offered for CFD trading can be as much as 100 times (1% margin) whereas margin lenders will usually only offer roughly 10 times leverage (10% margin) or less. The leverage obtainable will vary between each CFD provider and margin lender. Leverage is usually determined on a stock by stock basis considering the market capitalization of the equity and liquidity.
As CFDs are an over-the-counter derivative product it's important to note that you do not own the underlying share or instrument over which the Contract for difference is quoted, this also means that you can not move your position to a different Contract for difference company or stock broker, you are only able to deal with the Contract for difference broker which you opened up the position with. When you buy shares on a margin loan the stocks are held in your name this means that you are able to move them freely from one stock broker to another.
CFDs suit short to medium term active traders seeking to take advantage of market movements in both directions, however, margin lending is better suited to people who are seeking long-term investment opportunities and wish to benefit from the tax benefits franking credits provide, along with voting rights. It's always imperative to keep in mind that both products are geared, you must ensure that you adopt a good money management plan and never utilize the leverage obtainable to its full capacity.
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The writer Craig Bushell is a professional CFD trader. Craig deals with Australia's most popular CFD company IC Markets. Craig has published numerous books and guides on CFDs, you are able to get a hold of his most recent guide to CFD trading and understand more about Contracts for difference at no cost.
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