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How to pick a CFD broker

Created:

25 April 2008

Updated:

19 November 2008

Written by:

Dominic Picarda and Rakesh Shah

You can't pick up a financial publication without seeing advertising for CFDs these days. There is a huge number of firms trying to sign up new punters, but all the different offers and rates can be bewildering.

There are two main ways to approach contracts for difference (CFDs): come up with your own trading ideas or get advice from a professional. The method you choose will depend on how experienced you are and how confident you are in your own abilities. Each can be profitable in the right circumstances, so neither is automatically preferable to the other.

With an execution-only account, you decide what to trade and process the order yourself. Typically, you will open and close trades via the internet. This approach is most suitable for those who have a decent track record of trading for themselves, either through work as a City trader or as an individual with a spread betting or other derivatives account.

If you want inspiration for your trading and help putting it all into practice, an advisory account can make sense. Here, the broker will ring you up or e-mail you with trading ideas. The final say is always yours: if you’re persuaded by their research, you instruct them to make the trade on your behalf.

An advisory service is not simply about getting opportunities pointed out to you, though – the broker can also help you manage your risk. Controlling your exposure and getting out of trades at the right time is just as important as what to buy and sell. A good advisory broker can provide guidance on the size of your positions and where to place stop-losses, for example.

Of course, you need to be sure that the advice you're getting comes from a reliable source. It is worth asking who's generating the ideas and what their record is. Some firms employ trained analysts in this area, whereas others rely on research bought in from elsewhere.

"We send text messages to our CFD account holders and some others alerting them to a new trade idea," says Kareem Khouri, a director at Killick Capital. "Our own fundamental and technical analysts come up with the ideas."

The best way to establish the credibility of a company's trading research is to try before you buy. Any good advisory broker should allow you a free trial of its research before you start trading. This will require you to open an account with the firm, but not to deposit any money in it.

Margin

The margin – or deposit that the broker requires you to lodge in order to trade – can make or break a trader if the terms change while they are in a losing position. An increased margin requirement can force the closure of a position against the wishes of a punter. Some CFD brokerage firms raise margin rates with just an hour's notice.

As a result, you should speak to your account handler to ascertain the firm’s margin policy and do some asking around to find out how it has behaved in the past. Remember, every broker retains the right to change margins at short notice and funding your account adequately is always your responsibility.

Direct Market Access

Under the new Markets in Financial Instruments Directive (MiFID) rules for European financial markets, best execution in equity trading for clients has become a top priority for brokers. But this is still not as good as trading CFDs via Direct Market Access (DMA).

With DMA, you enter buy and sell orders directly into the London Stock Exchange's central order book, without a middleman processing your order. The instant that you click the mouse, your order flashes up on the screens along with those of institutional traders.

The beauty of this is that you can become a price maker, rather than a price taker. That is to say that, when you trade, you get to state the price at which you are willing to deal, rather than simply having to accept whatever the market is saying at that moment. So, if your price is keen enough, it will flash up first in the order book, ensuring that it gets filled.

Many CFD brokers offer DMA and Level 2 data in some form. If you are an active day trader, GNI markets, IG Markets, Saxo Bank, E*Trade and CMC Markets allow you to set up 'pre-populated' trade tickets, where you can place orders with one click for extra speed, rather than confirming your instructions. Naturally, you have to be especially careful when using this option.

Commission & borrowing costs

Execution-only CFDs incur lower commission than an advisory service. With an advisory firm, you're paying extra for the privilege of getting research ideas, risk management advice and the facility of talking to a trader about your positions.

The commission you pay can be explicit or implied. For example, for an execution-only CFD trade on UK shares you might pay 0.1 per cent on each part of the transaction: when you open a position and when you close it. However, with equity indices, foreign exchange, commodities, interest rates and bonds you’ll pay no commission. Instead, the broker makes money on the spread – the difference between the prices at which you enter and exit your trade.

For execution-only trades on individual equities, you can pay as little as 0.08 per cent (0.16 per cent in total). For an advisory service, you might well pay 0.5 per cent (1 per cent in total).

For traders that are taking large position sizes on a regular basis, it’s definitely worth asking the broker for a lower commission rate to be applied.

Funding is the other major cost of trading CFDs. But it doesn’t get all the attention it should from traders, especially compared with the subject of commission. Financing costs can add up quickly on CFD positions and even outweigh the commission charges. So, it's absolutely key to be aware of exactly what your broker will be charging you to finance your long positions and paying you on your short positions.

The standard way of calculating financing costs involves a premium or discount to the London interbank offered rate (Libor) – the interest rate used by financial institutions for loans between each other. You might expect to pay Libor plus 2.25 per cent on long positions or receive Libor minus 2.25 on short positions. You obviously need to establish this with your provider in advance of doing any trades.

Earning cash on your deposit

It's important to know whether you will earn interest on your cash deposit when it is not being used for trading – especially if you have a substantial amount. The table below summarises what's on offer.

ABN Amro's market index product offers a novel approach to payment of interest on CFD account balances. It credits customers with interest on a second-by-second basis. For example, if you open a short Market Index Gold CFD at $942 at 9am and buy it back for the same price at 4pm – ie, you hold it for seven hours – your profit-and-loss account will be zero, but you will then receive credit interest for seven hours. All other CFD providers calculate financing rates on an overnight basis.

Limited-risk accounts

It is possible to amass huge losses on CFD trades if you're not careful. Because a lot of borrowed money is involved in taking a position, you can easily see your deposit wiped out and end up owing the broker large sums on top of that. If you want to learn the ropes without being on the hook for potentially unlimited losses, then a limited-risk account may be the solution for you.

A limited-risk account won't allow you to lose more than you've deposited in your account. And all your trades have guaranteed stop-losses built in. So, even if the markets suddenly jump to a price beyond your stop-loss order, your position is automatically closed at a pre-determined price. Your maximum loss is therefore known in advance.

Figure 1: ODL Securities

Other typical restrictions on a limited-risk account include caps on the size of positions that you are allowed to enter and a narrower range of assets and markets to trade than with a full CFD account.

Europe-wide financial-industry rules introduced last year allow anyone to have a limited-risk CFD account. However, if a broker will not let you open a full CFD account, you should think twice about whether you’re ready to trade CFDs at all.

Orders, execution methods and using a platform to manage risk

CFD trading can be complex and, in today's competitive market, trading systems have more functionality than ever. Unfortunately there is a downside to this. With the increase in complexity there are more things that can go wrong – and they inevitably do. For an active trader, it would be prudent to have at least two accounts with different brokers and a back-up telephone service if your internet connection fails.

Figure 2: ABN Amro Bank

Other risks can be mitigated by using stop-loss orders and other contingent orders. CMC Markets, Saxo Bank, ODL Securities and E*Trade all allow you to put stops, trailing stops and take profit orders into the market, allowing you to walk away from the screen.

Figure 3: CMC Markets

It is important to link your orders with 'one cancels other' (OCO) orders or to set up an alert system to ensure you delete any stop-losses after you've taken your profits. If you don’t, you could end up with unwanted positions, with the stop-order being filled at a later time as it has not been cancelled. Other brokers including IG Markets and ABN Amro offer you guaranteed stops for a premium.

Trading CFDs on indices, currencies and commodities

If you’re looking for tight spreads and need consistent pricing for intraday trading, ABN Amro is offering CFDs on indices, foreign exchange, bonds and commodities. ABN Amro Market Index allows you to execute your trade automatically with liquidity provided by the bank itself. The pricing is taken directly from the market and there is no dealer intervention or delays. You can trade anything from £1 to £5m with auto pricing with no re-quotes or delays. Most brokers offer CFDs on indices and commodities, but each sets different levels of margin that change frequently.

Charting software

As we show in our article on technical analysis is key to the CFD trader's decision-making. CFD firms are responding to this with ever-improving charting packages.

CMC and IG Markets offer a back-testing service where you can enter conditions based on charting parameters and see how a system would have performed in the past. This is a powerful feature, but is also complex and requires a few hours of homework to get going. To get the most out of it, a technical background is necessary.

Technical analysis involves a lot more perspiration than inspiration. It is predominantly about spending time looking at charts in search of opportunities, rather than coming up with bright ideas. However, some CFD firms' charting tools help you filter for patterns. For example, GNI Touch's software automatically identifies 22 Japanese candlestick formations, such as Dojis and morning stars.

Figure 4: GNI Touch Charting

If you scan a large number of stocks for patterns, IG Index offers an advanced template feature where you can scroll through a list by single keyboard clicks. This is restricted to the FTSE 100 in the UK – any other lists will need to be created from scratch. A number of charts can be customised with different indicators and set for different time frames. These are all linked and will update with the master chart. You may find that multiple monitors allow you to work more efficiently.

Figure 5: IG Markets

E*Trade and Saxo Bank's platforms tackle the problem from a different angle, allowing you to set up multiple tabs with different charts in each one. You could have a tab for mining stocks, one for indices and one for banking stocks, for example.

Figure 6: E*Trade

Education

Even if you're already used to trading in some capacity, it is worth getting some education in CFDs. Many companies offer in-house seminars, which can be a good way of learning about their particular offering, as well as getting some tips on how to trade. It's also a great opportunity for advisory customers to meet and assess the people who will be generating their trading ideas and executing them.

Good character and stability

Like any other business, there are a few unscrupulous operators in the CFDs business. The relationship between advisory CFD brokers and their customers in particular can be open to abuse. There have been some cases where inexperienced punters have lost crippling sums of money as a result of making too many trades on the urging of their advisory broker.

Watch out for 'bucket shop' CFD brokerages that make money by using boiler-room tactics. Their traders are ordered to pressurise their clients into as many trades as possible in order to rack up commission.

"The acid test should be whether you feel your broker is acting in your best interests," says Steven Mayne, head of CFDs at Montague Pitman. "The frequency of trading is a critical issue here. Is your broker pushing you towards trades much more often than you would feel comfortable with otherwise? If he is pressurising you into trades, you've got the wrong broker."

"A good broker will tell you the rationale for a trade. He should always explain what the risk-reward ratio is and what the timeframe is. There should be no sales patter, such as telling you that you’re going to 'miss the boat' if you don't act immediately."

It is also important to feel comfortable that your trader is financially stable. Global Trader – a spread-betting and CFD firm – was recently closed down by the Financial Services Authority after it was left with a black hole in its finances after a big customer suffered heavy losses.

But most customers would be eligible for compensation if the firm fails. And, in all but the worst situations, customers would be given the opportunity to make arrangements to close their positions with a troubled company.

"You definitely need to feel confident about the broker you're trading with," says Richard Cunningham of City Index Advisory. "This could mean looking at their balance sheet and asking them whether they take a lot of proprietary risk."

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