Understanding The Differences Between Cfds And Margin Lending

It was only until recently that investors wanting to gain additional exposure to

the share market had the choice of either borrowing money from the bank of applying for a margin loan.

It was in 2003 that traders in Australia we introduced to CFDs. The introduction of CFDs changed the industry. CFDs have become one of the fastest growing financial products in history, outstripping the growth seen in warrants in the 1990's.

No longer does a retail investor need to apply for a bank loan or deal with expensive full service brokers. CFDs have revolutionized the financial services industry, retail investors can now open a CFD account online in minutes and be up and trading before the end of the day, executing all of their orders in real-time, online.

Unlike margin lending CFDs are typically traded over the internet with the trader's portfolio being marked to market in real-time throughout the trading day, this is substantially different to the end of day portfolio revaluations used by traditional margin lenders. Real time portfolio margining means that traders can properly manage risk throughout the trading day rather than having to wait for statements to be generated at the end of the day.

CFDs offer the holder the ability to receive a dividend, this is much the same as shares bought using a margin loan, however an important difference is that the dividends received from owning shares include franking credits, whereas CFD dividends do not. The reason for this key difference is that when buying a CFD you own a derivative not the underlying share, as such you are not entitled to the franking credits or voting rights typically attached to share ownership. Most CFD traders are not concerned about franking credits or voting rights as they are short term holders looking to profit from much smaller price moves than long term investors.

One of the most significant advantages of CFDs is that traders are able to sell them just as easily as they can buy them, what this means is that going long is just as easy as going short, this allows traders to profit in falling markets. With traditional margin lending short selling is difficult and near impossible.

CFDs are relatively cheap when compared to margin lending, typical brokers offering margin loans will charge 0.50 percent whereas a typical CFD provider will charge 0.10 percent. One thing to be wary of is the interest rates charged by margin lenders and CFD providers. It is important to note that margin lenders will charge interest on the amount borrowed whereas CFD providers will charge interest on the full notional value of the position, however CFD financing rates tend to be lower. Financing rates are an important cost to consider when comparing both products however this less important for CFD traders that only hold their positions open for a short period of time.

CFD providers will generally offer significantly more leverage than margin lenders, this means that a lower capital outlay can result in significantly higher returns. It is important to note that higher leverage means higher risk and it is important to have in place a risk management strategy to control this. When trading CFDs often you can obtain leverage as high as 100 times whereas margin lenders will only offer around 10 time leverage or less. Leverage is often determined by the liquidity of the stock over which the CFD is quoted and its market capitalisation.

As CFDs are an over-the-counter derivative product it is important to note that you do not own the underlying share or instrument over which the CFD is based, this also means that you cannot transfer your position to another CFD provider or stock broker, you can only deal with the CFD provider that you opened up the position with. When you buy shares on a margin loan the shares are held in your name this means that you are able to move them freely from one stock broker to another.

CFDs suit short to medium term active traders looking to take advantage of market movements in both directions, however, margin lending is better suited to people who are looking for long-term investment opportunities and to take advantage of the tax benefits franking credits provide. It is important to remember that both products are leveraged and you should ensure that you adopt a proper money management plan.

by: Ben McGrath

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