CFD's or Contracts For Difference are fast becoming one of the most popular and lucrative ways of trading stocks on both the Australian and International share markets. In short, CFD's are a leveraged position which means that the money required to hold a large physical position is quite small. In Australia you can trade stocks in the top 200 with only 5% of the funds of your overall position. This means you can hold $20,000 of a stock for an outlay of only $1,000.

Because you are only putting in relatively small amounts and, for the moment ignoring 'spreads', you are trading the physical market your percentage returns on a 1% movement in the actual share price will translate to 20% return to you. Of course, the reverse is also true.

We wrote a lesson in November discussing CFD's, how they work and how they're calculated, but today we'll go more in depth on when you would trade, how to trade, and why you would trade a CFD rather than a physical share.

The CFD market allows traders to go short as easily as they would go long. So as a trader looking at the market, you may hold an opinion that XYZ is at the top of its uptrend and may be about to turn. If you were to 'short' in the physical market you would need a broker capable of handling your transaction, and would incur relatively high brokerage fees. Using a CFD provider is a simple and relatively cheap method to profit from a stock that is losing ground.

Please note that it is always good practice NOT to place a trade solely on good or bad press. Most of the time an announcement from a company that appears in the daily press is already known to the market and factored into the share price. We've all been caught up in the excitement of jumping into a stock that has just made a seemingly good announcement only to see the stock go backwards. Momentum is the key when you're reacting to this kind of news. Go with the flow. It's not a sure fire thing, but you'll win more than you lose.

Depending on which provider you place your CFD trade through; you will typically place your trade at a price which closely mirrors the current market price of the underlying share. If you hold an opinion that XYZ stock is likely to go up you would simply BUY as many shares in XYZ that you think appropriate. It is important at this juncture to have an idea of where your stop loss will be if the share price moves in the wrong direction. This is the time to set that stop loss. We typically run with a stop that represents 15% of your cash position ($150 on theoretical $1,000 or a price which reflects a technical stop). This level is entirely up to you as an individual trader, but it's worth remembering that greed and ego do not assist long-term success.

Now that you've got your entry and a safety barrier if your trade goes south, you should also consider an exit target. If you're very Bullish you may consider 40-50% gains as a minimum. But in reality a 20-30% return in quick time is much more than you could really expect from an equity position, so why be too greedy? It is possible to set one exit at 20% for half your position and one at 50% for the other half if you really want to get creative. Again, this is your personal choice as a trader.

With all of this quick, cheap and seemingly easy cash to be made from trading CFD's, why would you trade the physical market at all? It's very simple, physical shares are assets, they may go up in value slower than your CFD but they will also not hurt you to the same degree when they go in the wrong direction. You can hold your physical position for an indefinite period, and whilst this is technically true of the CFD market, there is an interest fee charged on a daily basis for the privilege. Both CFD's and shares return dividend payments, but as we all know, the day the dividend is paid, the share price drops dramatically.

There are arguments for both types of trading and clearly there are benefits to both. We have highlighted CFD's merely as a reference for those traders looking for a new way to benefit from the market. As traders we also recognise the benefits of being able to reverse an opinion and follow the trend in volatile times.