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CHAPTER 2:
CFD TRADING COSTS & RISKS

 

 

Brokerage Fees
   On-Line Trading
   Over The Phone Trading
   Full Service Firms

Beware Of Promises About Commission Free Trading!
Paying The Spread
CFD Financing
Foreign Currency Exposure
How Corporate Actions Affect You
  What About Dividends?
  What About Stock Splits?
  What If A Company Goes Bankrupt?
The Tax Implications of CFDs
Chapter 2 – Key Points To Remember 


Having covered the basics, now it’s time to start digging a bit deeper, and in this section, we’re going to be taking a closer look at one very important aspect of CFDs that doesn’t get a lot of press.  It’s not sexy or glamorous, and it’s not terribly exciting to think about, but it really matters in terms of your overall level of success.

We're talking about costs.

Remember in the last section where we talked about the importance of treating your investment portfolio like a business?  Well, this is the first of many times we’ll be going back to this.

No business can find long term success unless it keeps a watchful eye on its overhead costs.  In terms of your investment portfolio, keeping your costs low is every bit as important as formulating a winning strategy, and can sometimes mean the difference between making money on a given trade, and losing money.

Therefore, it’s extremely important to thoroughly understand what your costs are, and what kinds of things are driving them.  That’s what this section is all about!

 

Brokerage Fees

We mentioned in the last section that the fees CFD brokers charge tend to be about half what a traditional stock broker charges, but there’s some variance here, depending on exactly how you trade.

There are three basic ways you can do that:  Online, over the phone, or with a full-service brokerage firm that includes professional advice and assistance.  We’ll look at each of those three just below. 

For the moment, the most important points to remember is that brokerage fees are the most visible costs you’ll  have to bear as an investor, but they’re not the only ones, and that they tend to be significantly less when using a CFD Broker.


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On-Line-Trading

This is far and away the simplest and easiest way to trade.  It’s super convenient, and there are some really great online brokerage services that offer an amazingly robust set of features.

You can expect to pay between $7 to $12.50 per side, or 0.1%, whichever is greater, and you should be aware that most online brokers offer volume discounts.  That’s probably not going to matter to you right away, but once your turnover hits a million bucks a month, you’ll see your fees reduced further still.

If a million dollars a month sounds like a lot of money to you, consider this:  If you make 10 trades (both sides) at $50,000 each, you’re done, which means you can hit that volume a lot quicker than you might think!


 

Over the Phone Trading

The internet has existed longer than CFDs have, so this is kind of a holdover, imported by CFD brokers because it was the way stocks were traded before there was an internet.  It’s a little old school, but it’s the method some people simply prefer to do business.

Your fees will be a bit higher if you choose to trade in this manner, ranging from $12.50 to $35 per side, or 0.125% to 0.35%, depending on how complex your order is. 

Note that you can find some brokers who will accept phone orders at no extra charge, but this is becoming increasingly rare.  Most brokers encourage their clients to place orders online, and the extra fees are an important part of that.


 

Full Service Firms 

Full-Service brokerage firms have been around almost as long as the stock market itself.  They are high-end service offerings that involve lots of hand holding and professional advice, but of course, they’re also the most expensive way you can trade, charging as much as 1% per side.

Think about that for a second.  If you use the least expensive, online trading option, then compared to that, the full-service broker is ten times more expensive.  Unless the professional advice you’re getting provides returns ten times better than you can get on your own, you’re not getting a great deal.

In practice, this would be quite rare, and because of that, you’re almost always better off to do your own research and reap bigger profits as a result.

 

Beware Of Promises About Commission Free Trading!

There are a number of brokers who promise commission free trading, and with good reason.  It is an irresistible lure.  Unfortunately, if something sounds too good to be true, then it almost always is.

Mostly, this is used as a marketing gimmick.  The reality is that commission free brokers simply raise their costs in other areas in You’ll need to research specific brokers to get a feel for their cost structures.

 

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Paying the Spread

While we’re on the topic of the spread, this is a good time to acknowledge it as a very real cost you’re going to have to pay.

A bit earlier, we made mention of the fact that CFDs were ill-suited investments to make if you want to capture micro-profits, holding positions for a very short timeframe (measured in minutes or hours).  The reason for this is the fact that you have to pay the spread.

Here's an example of how that works:

Let’s say you’re buying a Share CFD for a company, priced at $50.  The price you pay might be $51.  The difference is the spread.

Let’s say you bought 50 shares.  If you turned around and sold them as soon as you completed your purchase, you’d lose fifty bucks, because you’d be selling at $50, but you bought at $51.  In other words, the stock price needs to rise by at least a dollar in order for you to break even. 

Anything after that, less the selling commission, is money in your pocket, but as you can see, the spread can really impact your bottom line and is something you should always be mindful of when conducting trades.

 

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CFD Financing

Most investors use CFDs for day trading, but you can hold your positions as long as you like.  If you hold them past 5pm New York time (7am Australian Eastern Time), then you’ll most often be charged a small financing charge for maintaining your position overnight.

Having the option to do this gives you more investment opportunities, but again, this is not something you should do lightly.  So how much are we talking about here?

The exact rates vary from one broker to the next, and you’ll want to carefully read your broker’s PDS (Product Disclosure Statement) to understand the full cost, but in general, brokers charge 2-3 percent above the cash rate.

So for instance, if you’re trading in Australia, and have taken a $5000 position, and the Reserve Bank of Australia’s rate is 3%, and your broker charges 2% above that, then you’re looking at a charge of:

·       Position size ($5000) * (RBA Rate (0.03) + broker’s fee (0.02) = $250

·       Divide this number by 365 to get the one day rate = $0.69

As you can see, this is a very modest fee, and it’s not something that should dissuade you from holding a position for longer than one business day.

Having said that, you should only do so if you are extremely confident that the price will continue to rise the following day (long position).

Again, this fee is small enough that it should not often dissuade you, but you do need to be mindful of the fee, because it’s part of the cost of doing business, and will have some impact on your final Return on Investment.

Here’s something interesting:  It works in reverse if you’re holding a short position!  In other words, instead of being charged a small fee, you get a small credit if you’re holding a short position.  The same math applies.

Note:  Markets aren’t open on the weekend, so if you hold your position over the weekend, then you’ll be charged (or credited) for Saturday and Sunday as well.

 

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Foreign Currency Exposure

A lot of people get addicted to the fast pace and extreme volatility of the currency (forex) markets, but there is a small wrinkle you should be aware of that a lot of people overlook.

Most brokers hold your profits in US Dollars.  That’s true regardless of what currency pair you’re trading (even if you’re trading Crosses, which don’t involve US Dollars on either side). 

What that means from a practical standpoint is that your country’s exchange rate as compared to the US Dollar matters a great deal, and can impact your total Return on Investment.

 

How Corporate Actions Affect You

Corporations are always in motion.  Always busy, and their actions can impact your trading positions in a variety of ways.

We’ll go over some of the basic things you can expect to see happening as you begin investing.  Some of these will serve to enhance your positions and their profitability, while others will have to be counted as expenses against you.

 

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What about Dividends?

At first glance, you might not think that dividends will play any role in your CFD trades.  After all, you’re trading a derivative, not the actual shares of stock.  The reality though, is that they can, and do have an impact on your CFD positions.

A dividend is essentially a reward paid to investors for the profits that the company has paid.  They are paid twice a year, with the first annual payment being referred to as the “interim dividend,” and the second being called the “final dividend.”

From the perspective of a CFD investor, the most important date to remember is the “ex-dividend” date, often called the Ex-Div date for short.  If you buy before this date, and are still holding it when the dividend date rolls around, you’re entitled to a dividend if one is paid.  If you buy after the Ex-Div date, you’re not.  It’s as simple as that.

When the dividend is paid varies from one broker to the next, but in general, the payment will be made either the day before the ex-div date, or the day of.

Important Note!  If you’re holding a short position, then you don’t get a dividend.  Instead, your account will be debited by the dividend amount. 

For instance, if you hold a short position of 1000 share CFDs on a given company, and that company pays a ten-cent dividend, then you’re going to see a hundred bucks debited from your account on the day the dividend is paid.  This is the kind of thing that can (and should) influence your buying and selling, short/long position strategy!

It’s also important to mention that in the overwhelming majority of cases, a company’s share price will fall by an amount equal to the dividend payment when it occurs.  In rare cases, this doesn’t happen, but it happens often enough that you can rely on it.

Yet another point is the fact that actual shareholders receive Franking credits, which are tax credits for the taxes the company has paid on its profits before the dividend is paid.  CFD investors do NOT get these credits, which does have some tax implications at the end of the year, but certainly shouldn’t often dissuade you from holding a given position.

What About Index CFDs and Dividends?

This is yet another dividend-related wrinkle.

If you’re holding an Index CFD position, and one or more of the companies that make up the index pay a dividend, then your account will be credited or debited, based on the company’s position contributes to the index in question.

This seldom makes a huge difference, but can either be a nasty surprise or an unexpected boon, depending on the shape of your position (short or long). 

Say, for instance, you’re holding a short Index CFD position and are anticipating a nice profit, but you failed to take the dividend payments into account.  This can easily wipe out any profits you were expecting!

The reason for all of this is simply that because CFDs are priced according to the underlying asset, anything the corporation does has to be reflected in the CFD market, or the pricing picture would become skewed over time and not track perfectly, like it’s supposed to.

 

What about Stock Splits

Once in a while, a company will implement a stock split.  If you’re holding 10,000 shares of that company’s stock at a $100 share price, then after the split, you’ll be holding 20,000 shares at $50.

When this happens, it will be reflected in the CFD market as well.  Again, any action the corporation takes is reflected in the CFD market.  If that weren’t so, then the pricing would not, and could not be accurately reflected.

 

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What if a Company Goes Bankrupt

It’s a sad fact, but corporations often do go bankrupt.  Here’s the thing though; that never happens overnight.  There are signs and forewarnings, and if you’re paying attention, you can see it coming well in advance.

If you’re holding a long position in such a company, then as the stock price continues to deteriorate, it will inevitably trigger your exit strategy and you’ll mitigate your losses before they become catastrophic, but there’s another way of looking at it.

A company that’s swirling the drain represents a profit opportunity in the form of taking short positions – provided that you exit the position before the bankruptcy is finalized.

Note that everyone else (your broker included) is going to see the bankruptcy coming, and when a company is in distress, the rules for investing begin to change.  You may be required to put up up to a 100% margin on your position, and close the position out at the last available trade price as determined by your broker.

This is a key point.  In certain exceptional cases like these, your broker can and will change the normal rules of trading as they deem appropriate.  This isn’t done as a means of punishing you, but to keep the market functioning smoothly.  Sometimes it works in your favor, and sometimes it doesn’t, so don’t take it personally.

 

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The Tax Implications of CFDs

There are a couple of important points here.

For the purposes of this section, we’re going to assume you’re living in Australia.  If you live in some other country, you’ll want to study that nation’s tax code carefully, and it might be best to get the help of a professional tax preparer for at least your first year, so you can get an in-depth look at how your investing profits and losses impact your tax situation.

The first point worth mentioning is this:  Profits and losses are treated differently if you’re running your investment portfolio as a business, versus if you’re making trades as a form of gambling.

This goes back to something we talked about earlier, and our recommendation is that from day one, you treat your investment enterprise as a business, because of the discipline it helps instill in you.

From a tax perspective, the difference is this:  If you’re treating your enterprise as a business, then your losses will count as an allowable deduction.  If you’re not, they won’t.

 

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Chapter 2: Key Points To Remember

  1. Your investment costs really matter.  Keeping them low will help improve your ROI (Return on Investment).  Also, having a firm understanding of your costs is key to your long-term success because it keeps you from paying for crap you don’t need, or paying too much for services in general
  2. Corporate actions can and will have an impact on your CFD positions.  It pays to be aware of them.  This comes down to doing your due diligence, and understanding the companies or products you’re investing in
  3. If you’re investing in CFDs, then the major costs you should be aware of are:
    + Brokerage fees
    + Paying the spread
    + Paying Dividends(or having them credited to your account, depending on what kind of position you’re holding)
    + CFD Finance (if you’re holding a position overnight)
  4. It pays to consult a tax professional for at least your first year of investing so you can learn how to properly handle your profits and losses from a tax perspective
  5. We recommend running your investment portfolio like a business from day one.  Not only can you count any losses you incur as an allowable deduction, but it also helps to foster greater investing discipline.

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CHAPTER 3: How to Get Started Trading CFDs