CFDs—The Next Generation?
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July 27, 2007
The majority of traders already know that some form of leverage must be used if you want to make short term trades and reap any benefit from small movements in price. Many traders will no doubt already be using CFDs to magnify potential profits in their equity, commodity or index positions as this instrument has been around for quite some time. If you are keen to learn more about CFDs there are a large number of articles in the Trading Tutor archive and some very good books about the subject (including CFDs – A Trader’s Guide, by yours truly!).
As with all useful products, the growing number of providers expands the product range and incites competition and innovation. This is true of CFDs, where we have seen a shift in the way ‘market price discovery’ has been calculated (the prices at which you inevitably buy and sell). Early CFD providers offered synthetic pricing models, however more recently direct market access models have become popular. Regardless of which system you are currently using, both these styles are OTC (over the counter) whereby you buy and sell your CFDs directly with your provider (who is acting as market maker) and not through a regulated exchange. Despite the misleading name, foreign exchange transactions have always been done OTC as have a large number of fixed income products.
For CFDs, the next stage in the continuing evolution has arrived in Australia – namely Exchange Traded CFDs. Although it remains to be seen whether this will be a popular alternative to established CFD providers, the ASX has listed several potential advantages regarding exchange traded CFDs. In our ongoing quest for the latest effective strategies we will do some investigation and take at least a cursory glance to see if this new product offers any extra benefits.
Exchange Traded CFDs were introduced in Australia by the Sydney Futures Exchange [SFE], however with the merger of the SFE and the ASX last year there was some confusion as to who would have jurisdiction over the product. It has now emerged that the SFE will be responsible for running the regulated CFD Exchange and access to the market (as with all exchanges) will be through a registered SFE broker. By incorporating the product onto the exchange, the high standards of the SFE must be met. A potential extra benefit of Exchange Traded CFDs, therefore, is the strict litigation and risk controls to which regulated exchanges are subject. The SFE is supervised by ASIC, and market operations are monitored by the Reserve Bank. This provides a level of comfort to the CFD trader in that there is stringent adherence to adequate capital and margin rules.
In addition to the benefits of regulation, Exchange Traded CFDs will offer an increased level of price transparency and market depth. This benefit will be reflected in order-price and time-execution priority. Simply put, you will be able to place an order and watch it ‘sit’ on the automatic order matching system as it waits for a matching opposite order. You can gauge the degree of priority your order receives with regard to filling it at the best price. You will also be able to see all other yet-to-be-matched orders, which will reveal the price at which investors are willing to buy or sell any of the listed CFDs. A large number of buyers at $10, for example, might influence you to short sell.
Although the transparency may be an extra benefit for those using synthetically priced CFDs, any trader who has DMA facilities can already access market depth and price transparency by scrutinizing the flow of the underlying assets in the physical market. Rather than seeing where the CFDs match, a DMA trader looks to see where the underlying shares are matching.
It is too soon to say whether the advantages of the new Exchange Traded CFDs will outweigh the increase in costs associated with exchange trading. As acceptance of this new way of CFD trading increases, so will the volume of Exchange Traded CFDs. Time will tell if this new approach to CFD trading is truly an advantage.
Stay Sharp,
John Jeffery
Trading Tutors
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