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Are CFD Trading Costs Eating Your Profits?
According to research, the most common reasons for trading CFDs is that traders have limited funds to get into the direct equity market, followed by the greed factor of expecting to make large profits in a short space of time.
While such optimism works fine in a favourable market, a couple of consecutive unfavourable months has the ability to wipe out the entire investment amount and throw the trader out of the market.
When a trader has limited funds to invest, a more cautious approach is sensible for risk mitigation, capital protection and the sustainability of personal wealth in the face of a market downturn.
Along with leverage and high-risks, another key concern is the complicated fee structure of CFD trading. Most CFD traders focus on the speculative factors but can also be forced out of the market through capital loss in the accumulated cost of trading. It is highly advisable to do adequate research and clearly understand the fees and charges described in the PDS before trading CFDs and selecting a CFD provider.
The key charges involved in stock CFD trading are:
Commission – The commission is the cost a trader pays for buying or selling a position on the platform. The commission rate differs from broker to broker. The minimum commission rate for any AUS long trade can vary from AUD$10 to AUD$20. For US stocks it ranges from a US$9 to US$25. It is important for a trader to choose a provider wisely. CFDs are a high turnover instrument, and overall brokerage charges have a significant effect on portfolio performance.
Financing cost or holding fees – The fundamental difference between share and CFD trading is the finance cost. A finance charge is applicable whenever there is a margin loan – a feature that is built into CFD trading. The trader effectively takes out a loan whenever any open trade is held overnight. The finance charge is the interest the provider charges for a long (??) CFD position. It is crucial to note that interest is charged on the full exposure or face value of the trade, not on the borrowed amount. Each provider has its own method of calculating the holding fee. CFD brokers typically do not provide an exact amount charged as a holding fee for a position. They usually describe the method of calculating the interest in the Product Disclosure Statement.
The financing cost is normally calculated based on the LIBOR interest rate plus a mark-up, which is then applied to the number of actual holding days. In the case of short positions, however, the trader is paid an interest rate for overnight holdings. The short position fee is calculated based on the Inter-Bank Bid Rate (for the currency in which the underlying share is traded) minus a mark-down, applied to the number of holding days. The catch here is, in the current low interest-rate environment, the mark-down rate is higher than the cash rate, resulting in the trader's account getting debited with financing costs for short positions as well.
These financing costs are a key profit-maker for any CFD provider. The higher the face value of the investment, the higher the profit for the provider irrespective of the trader’s win or loss. The provider may not always act in the best interest of the clients. The trader may get advice from the CFD broker to increase their leverage or position sizing. The trader needs to understand the consequences of higher exposure and high leverage. It is sensible to select a broker offering low financing charges.
For example, a trader holds a long position of $50,000 with $10,000 initial investment. To hold it for 30 days, the trader will be charged approximately $185, and for a year around $2,220. The position needs to make a 4.44% return in a year to just breakeven on the holding cost. In a favourable market, it is not very difficult to achieve. If the market moves up 10% over a year, the trader will end up with approximately $2780 profit (after financing costs) or 27.8% return before taking into account other costs such as brokerage and spreads.
On the downside, a 10% unfavourable market movement results in a $7220 loss (plus brokerage etc.), leaving very little cash in the account for any future opportunity. It is important to identify the total capital risk a trader takes. CFD trading can be more profitable than trading shares in the shorter-term but holding costs can consume the profit in the longer term. In any market condition, the provider ends up making a decent profit from financing, brokerage and spread.
Spread – CFD brokers are market makers. The spreads and commission charges act concurrently in CFD trading. The traders can often find competitive commission rates offered by different brokers. If any provider claims that it does not charge a brokerage, the trader needs to be sceptical as typically the brokerage is hidden in their higher spread. Depending on the brokers, the spreads can widen at times, thereby reducing the trader’s profit. Traders need to consider the reliability of the trading platform verses the trading cost.
Exchange rate – CFD traders need to consider exchange rate risks and costs if trading CFDs on global markets. When trading globally, there are two transactions that occur every time an order is placed. First, transaction to buy/sell the position; second, the currency exchange transaction. The provider charges for both transactions, commission on the spread for the stock CFD and also on the spread for the currency exchange. It is advisable to do the necessary research and shop around to find a competitively priced broker, as all the costs add up and can make a big difference in the profitability of a trade.
Additional charges - The providers may charge for any additional information or service such as live data/prices or for accessing global markets. There are providers who may offer this information for free, with certain conditions (e.g. the trader needs to exceed a certain number of trades per month).
The CFD provider passes on the dividends to the trader (client) but retains the franking credits as a fee. However, in the case of any short positions held, the trader is bound to pay the dividend to the other party to the transaction.
Also, it is important to understand the margin requirement and the liquidation process of the provider. The provider may charge a penalty for inability to maintain the minimum margin requirement in the trading account.
The following table illustrates the approximate Net Return comparison for an outright purchase of Shares Vs a CFD long position:
As evident from the table above, the trading costs are an important aspect to consider in CFD trading.
A cautious approach to leverage, minimising trading costs and using a stop loss are the key elements of CFD trading.
A thorough understanding of CFD trading is highly recommended before getting into the market. It needs a high level of proficiency to estimate the risks and capitalise on them, to make a profit. Some of the fundamental variables to consider while building a CFD trading strategy are trading time frame, market volatility, risk profile and psychological profile. The objective should be to have a trading strategy that is suitable for that individual (specific) trader’s objectives.
CFD trading costs are not always transparent– there may be several aspects of the trading cost that may need to be factored in, depending on the particular broker. The traders should have proper knowledge of the underlying costs (outlined in the PDS) and how they can affect the profitability of the trade and the capital invested. This is even more important for the traders holding a CFD position for more than 4-6 weeks, as daily financing charges can accumulate rapidly and can become a substantial drag on the trade. Therefore, it is important to know all the relevant costs to make an informed CFD trading decision.
SQM Research's Top 5 SQM Rated Funds* for July 2019
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* Any Funds in this table that have international investments will have different hedging patterns, from hedged to unhedged or variable hedging. This may have an impact on fund returns. Please refer to the Fund's product disclosure statement for details.
SQM Research's Top 50 ETFs for July 2019
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