Why CFD providers are knocking back at least one in 10 traders

Trading contracts for difference (CFDs) is undoubtedly risky.

And it's definitely not suitable for everyone.

Indeed, Australia's two biggest providers, IG and CMC, knock back, respectively, 20% and 10%-15% of people who apply for accounts but fail to satisfy the requirement that they have the knowledge, experience or financial resources to trade these securities.

"We are protecting ourselves and protecting them [the rejected applicants]" says Tom Roberts, head of premium client management at IG.

Anyone who trades CFDs needs to understand that because they are derivatives the gains and losses are magnified.

For example, the notional value of your trade may be $1000, you only outlay $50 - but if the price moves against you by 30 points, we will be asking you for a further $250 Roberts explains.

CFDs can seem attractive because, even if you don't have the money to buy the underlying asset, you can share in potential gains in that asset's value.

But the big danger is that because of the leverage you can end up losing much more than you put in when you share in the losses.

What are CFDs?

CFDs are leveraged derivative financial products, deriving their value from the value of another asset, such as a share, market index, commodity or currency. When you trade these securities, you take a position on the change in value of the underlying asset over time.

You can trade both long (buying one in the expectation that the underlying asset will increase in value) and short (selling one with the expectation that the underlying asset will decrease in value). In both instances you hope to gain the difference between the closing price and the opening value when you close the contract.

There are two types: ASX-listed CFDs, which are limited to the 60 most actively traded Australian shares and two indices, the S&P/ASX 200 and the Dow Jones Industrial average in the US; and over-the-counter (OTC) CFDs, which cover a much more comprehensive list of assets. This report is mainly about the OTC securities.

You do not buy or trade the underlying asset by buying a CFD; you are buying a contract between you and the provider. So, in effect, you are taking the risk that the provider is in a sound financial position and will be able to meet its obligations to you.

As clients of MF Global discovered, this is not a given. The global derivatives house collapsed in 2011 after drawing on customer funds to meet its liquidity requirements. Australian client funds totalling $313 million were frozen for several years.

Are they for you?

"CFDs are a trading vehicle, not the same as investing and involving different skills," says Ric Spooner, chief market analyst at CMC Markets. "For example, trading is often much more short term and traders usually need to be prepared to cut losses quickly. Whether they use CFDs or trade the underlying instrument, successful traders need to develop skills."

Dale Gillham, chief analyst at Wealth Within Institute (WWI), agrees: "Anyone wanting to trade CFDs needs to know how to trade first. Unless you can trade effectively in unleveraged markets like shares, then moving into a highly leveraged market is financial suicide."

To help people decide whether trading is really for them and to then choose the market they wish to trade, WWI has developed a free 10-lesson video course, called Trading Mentor, on trading for beginners. "Completing this course is a simple way to learn whether trading is the right fit," Gillham says.

To register for the course, you have to supply a phone number and email address.

"A general rule of thumb is the higher level of risk you take and the faster the market you trade, the more skill, knowledge and experience you need to manage the risk," says Gillham, adding that to trade CFDs you need to ensure you have:

• A written trading plan with tested and proven buy and sell rules.
• A solid understanding of risk and money management.
• A good understanding of stop-loss management.
• How to trade and how CFDs work.
• How to learn about CFD trading.

Where to learn about them

Before you even think about signing up with a provider, you should educate yourself about these derivatives. You can read books and articles and there are paid courses, such as those offered by WWI, which says it will teach you proven techniques for trading them and give you risk and money management rules. The cost is $3300 and WWI says it is suitable for traders who already understand how to trade shares.

The ASX provides free online courses and, although these place more emphasis on the ASX-listed product, they are a good place to start. Most providers also offer education to their clients, including demo accounts where you can practise your trading strategies without outlaying real money.

But while demo accounts can be useful, they can also be a little dangerous, warns Gillham. "Demo accounts allow you to test your knowledge and skill without risking the family home, and in this they can be a great thing.

"However, a demo account is like visiting a pet shop and taking a puppy home for the night. In most cases it's unlikely you'll hand the puppy back. Once you have used a free demo CFD or forex account, you will want to continue to use it once your free time has expired." He recommends that you do not trade with real cash until you have proved to yourself you can trade profitably.

But another school of thought says that trading with real money is very different as your emotions come into play. When you have skin in the game, "you need to get into the right mindset and understand the product you are trading", says IG's Roberts. To help clients adjust from demos to real trading, IG allows those starting out to trade with lower minimums for a few weeks.

CMC's Spooner advocates the strategy of "learning on the job by devoting some of your capital to your education and starting small to develop your skills".

Their positive features

One attraction for traders is the ability to get diversification with a low capital outlay and lower brokerage costs, Roberts says. For example, you can gain control over $10,000 worth of assets for a fraction of the cost.

Other pluses are minimal funding charges, unless you are a long-term holder, the ability to go long and short - a strategy you can employ to hedge your traditional portfolio - and the use of a platform where you can trade a range of asset classes.

You can also gain access to a lot of trading tools, charts and information, adds Spooner, singling out features available on the CMS site, such as analysts' posts when an important financial number is released, and chart forum, where both analysts and users post charts.

Risk management

Being able to set stop losses and working out your stop-loss strategy is very important for traders. Some providers, including IG, also offer guaranteed stop losses, which can add between 0.3% and 1% to the cost of a trade.

"Guaranteed stop losses eliminate the possibility of slippage [when the price you set as a stop loss is not achieved, maybe because the market is moving fast] and are very important tools," Roberts says. "Not only do they limit losses, they also give you more confidence and awareness of what you are doing.

"They are an important part of risk management, particularly for less experienced traders. No one likes to lose but you can establish upfront how much you are prepared to lose."

You also need to make sure you take your profits and to do this you set limits, says Roberts. "If the price gets to a certain level then it is sold. These can be daily limits or limits that are good until cancelled."

Spooner says he is a firm believer that "where you get out is at least as important as where you get in and that an exit strategy is crucial. Most good traders know where their exit will be when they get in, although they can move it as the market moves."

Does it take much time?

Can you trade CFDs and still hold down a regular job? "Absolutely," says Gillham. "A myth about trading CFDs is that you need to do it daily or all day long, which is simply not true. It does not matter what you trade - you should only trade when the time is right and not just for the sake of it."

Spooner says: "You need to ask yourself, 'How much time do I have? 'When am I available?' and fit your trading around that."

This is a particularly suitable strategy for those who take longer-term positions. Spooner notes there has been an increase in popularity of the German stockmarket (DAX), as the hours it trades are good for Australian workers - the main action is early in the night - and Germany's economy is large.

The ability to check prices on tablets and mobile phones also means traders no longer need to be glued to their computer screens, Roberts says. According to an Investment Trends survey of CFD traders in 2013, 70% use a phone or tablet in relation to trading.

How to choose a provider

Both Roberts and Spooner say it's important to choose a broker that does not use client money for hedging purposes: just look at the MF Global example.

A recent survey into forex (or FX) traders by Investment Trends found that 57% of frequent traders believe client fund segregation and not using client money for hedging purposes are key signs of a strong and secure FX provider.

Both IG and CMC belong to the CFD Forum, which was established by Tamas Szabo, head of IG Asia Pacific, where members have to agree to the segregation and protection of client funds.

You should look for a provider with experience and a strong track record. Both IG and CMC started in the UK and have been in business for 40 years and 25 years respectively.

Other desirable features are: stable and reliable platforms; client support through 24-hour, 51/2-day trading desks; and a range of tools, support, forums and new initiatives for traders.

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