Tax Implications of Gains from Trading in CFDs

If you are trading CFDs in Australia, you obviously want to know the tax implications in regard to gains or losses that you make in the process because there is a confusion whether trading CFDs is a gambling activity or not.   

Any gains arising from gambling contracts do not qualify as assessable income/loss nor shall they be considered under capital gain or loss. The ATO holds the view that trading CFDs is not a gambling activity.

The Australian Tax Office (ATO) considers any profit made or loss incurred during the process of trading CFDs is assessable income or tax deductible as the case may be. However, the profits obtained and losses incurred must be a result of a business operation or transaction and the transaction/s must have been entered into as an ordinary part of carrying on a business. Gains from trading CFDs that do not meet these conditions qualify for tax as capital gain or loss.

This also means that while calculating capital gains arising from trading CFDs, the tax office will give due consideration to cost of acquisition and factors that apply to buying and selling assets. In the case of trading CFDs, the cost of acquisition includes the price plus charges, fees, interest or any other expense that you may incur for acquiring and holding the CFD. Similarly, the cost that you may incur for disposing of the CFD will also be considered. Similarly, any benefits such as interest, dividends or any other adjustment made to your account during the course of business of trading CFDs shall form a part of net gain.  

The above provisions apply to resident Australians. If you are a non-resident, you may want to consult a professional to know your status as well as the tax implications of trading CFDs. 

The Adjustments That Might Be Made On Your Short Positions in Australian CFDs

An efficient internal risk management policy is one of the most important issues that CFD providers, including product providers that offer Australian CFDs, have to attend on daily basis. Known as hedging, this is a technique designed to reduce or eliminate financial risk. This amounts to taking two opposite positions in Australian CFDs that will offset each other if prices change.

One of the ways that they hedge their risks associated with short positions in Australian share CFDs is to borrow Australian shares from non-residents for Australian tax purposes.

When you buy or sell Australian CFDs you are actually entering into a contract in which the CFD provider is the counterparty, who is also exposed to a risk. Only, in this case the CFD provider has to take into account its entire exposure based on all positions that clients have opened in Australian CFDs. In many cases the short positions may be offset by long positions but there may be instances where short positions in Australian CFDs far outnumber long positions. To cover its risk, a provider of Australian CFDs prefers to borrow the underlying Australian shares from non-residents for tax purposes.

However, if it has to borrow shares to cover your short position in Australian CFDs from Australian residents, it has to take into account the adjustments that it might have to make in the accounts holding Australian CFDs.  

To this purpose, a CFD provider will make adjustments on AustralianCFDs held in your account to the tune of cash dividends as well as any attached franking credits. However, this may not be necessary in all cases and may be done with or without any prior notice in this regard. 

Adjustments Due to Corporate Actions on Share CFDs

The CFD account maintained for recording transactions made by you is an ongoing account and many adjustments are made in it on daily basis. While some adjustments pertaining to ‘marked to market’ amounts or ongoing margins are made on all types of CFDs, there are some that are specific to share CFDs.

As a general rule, all corporate actions including dividends, rights issue and stock splits must be reflected in share CFDs as well. Announcement of corporate actions that benefit shareholders are likely to have a positive effect on share price of the company as well as on CFDs related to it. For example, when a company announces a dividend, other things being the same, the share price and consequently the price of its CFD, is likely to increase. 

This is done because of the basic nature of CFDs, which are contracts that allow you to make a profit (or loss) without actually owning the underlying asset, the share of a company in this case. Since you hold CFDs and not shares, you are not entitled to receive the dividend the company pays. To compensate those who hold long positions in shares CFDs, the CFD provider pays an equivalent amount in their accounts. On the contrary, it deducts a similar amount from the accounts of those who are short in share CFDs.

All adjustments on share CFDs are made at the end of the trading day and only if you hold positions till the close of business on the date prior to the record date of the corporate action.

All That You Would Want To Know About Margin Requirement in CFDs

One of the advantages of CFD trading is that of not having to put up as collateral the full notional value of the CFD. This means that a given amount of capital can control a larger position, which amplifies the potential for profit. At the same time, you stand to lose a substantial part of the margin money in the event of a downturn in a volatile CFD.

A CFD provider allows you to create long or short positions in any CFD. There are normally two types of margin requirements: Initial Margin and Variation or ongoing margins.

Initial margin is the amount you are required to maintain in your account for as long as the position is open. This may vary from 3 to 30 percent on shares and commodities and 0.5 to 1 percent on indices and foreign exchange. Initial margin is fixed on the basis of the underlying reference instrument of each CFD and the perceived risk in the underlying market.

Variation margins or margin on ongoing basis is applied to CFD positions if they move against you. If you were to buy 1000 shares using a CFD at 1 dollar and the price dropped to 90 cents, the CFD provider with deduct 100 dollars as ongoing margin. On the other hand, if the price were to group by 10 cents, your account will be credited by the same amount as running profit. Ongoing margin is also known as ‘marked to market’ as it is deducted or paid in your CFD account on real time basis.

On the other hand, the initial margin is deducted from your account when you open a CFD position and is replaced only after you close the position. 

Spreads: The Cost of Trading in CFDs

Spreads offered in CFDs is one of the major consideration, besides credibility, while choosing a CFD provider. Spread in CFDs is basically an indirect cost that you pay for trading. 

Spreads are reflected in the two prices —one higher and one lower — that you get when you request a quote for CFDs. The higher price or the Offer is the price at which the CFD provider is ready to sell CFDs to you. The lower price or the Bid is the price at which it will buy CFDs.

Spreads in CFDs should be viewed as a measure of transaction cost and the liquidity of the relevant market. When you want to initiate a trade in CFDs you are actually demanding liquidity. The counterparty, a market maker or CFD provider supplies liquidity. When the transaction is completed, you as a demander of liquidity pay the spread while the other party earns the spread. Along with brokerage fees, the bid/offer spread comprises the total cost of trading in CFDs.

This is how you pay the transaction inasmuch as it relates to spreads. Suppose the bid/offer price that you get is 5/6 AUD and you open a position by buying CFDs at 6 dollars. Let us assume that the price does not change during the course of the day and also that you are constrained to close the position by the end of the trading session. You will have to close it at 5 dollars and the transaction (open and close) has cost you 1 dollar multiplied by lot size. If you want to make a profit, you will have to wait for the price to cross 6 dollars.

How to Buy and Sell in CFD and Shield CFD Accounts with Market to Limit Orders

Most CFD providers have different types of trading orders for your convenience and risk management. The simplest way to trade is to use market orders, which is a buy or sell order at the best current market price. The other way is to use a limit order, which is to set a limit at which you will buy or are ready to sell.

Some brokerages allow you to place a market to limit order in your CFD account/s. A CFD provider may set conditions and define market to limit order differently for various types of CFD accounts.

Market to Limit Order: CFD and Shield CFD Accounts

 Shield CFD account is an account where your liability is limited and you cannot lose more than the amount in your account. In these accounts, market to limit order means that you place and order within a price range. If the product provider does not want to trade within this price range, the order will not be executed.

There may be, at times, situations when there is a lack of liquidity in the underlying reference instrument (the asset that a CFD refers to) in the underlying market. Liquidity in this case implies the number of underlying reference instruments available for buying or selling at a given price. If you are trading on an electronic trading platform, the CFD provider will execute your order within your requested price range in a way that it reflects this lack of liquidity.

Market to Limit Orders: DMA CFD Accounts  

The definition is slightly different in these accounts, which are Direct Market Access CFD accounts. Here it is an order where you want to buy or sell at the current bid or offer price. A buy order is executed at the lowest offer price at the time of the order and a sell order is executed at the highest bid price. 

Limited Liability in Shield CFD Account

CFD providers offer different types of accounts to their clients to suit individual needs. One of the more popular accounts is a limited liability account, which is often known as a Shield CFD Account.

A Shield CFD Account is a limited liability account, which means that the account holder cannot lose more than the total equity in his/her account. Total equity in this context is the account balance plus any benefits and/or interest accruing on the account and less any charges, adjustments and fees that may be payable in respect of a CFD.

To ensure that the account holder does not lose more than what is in the Shield CFD Account, the product provider places one or more liquidation orders that are executed the moment the total equity is equal or less than the liquidation level.

Limited liability CFD accounts often have provisions for placing relevant stop loss orders for closing or reducing existing position/s created in the account but guaranteed stop loss orders are not allowed. Still, a Shield CFD account stop loss order is more or less like a guaranteed stop loss order inasmuch as that it is executed at the agreed price. But in the event of gapping due to sharp movement in the price of the underlying reference instrument and the CFD price gaps through the stop loss level, a limited liability CFD account stop loss order is executed at the agreed price regardless of the next available CFD price. However, such stop losses can be placed at a minimum distance constraint set by the product provider.

Regardless of the fact whether a Shield CFD Account stop loss order is placed or not, the underlying condition of limited liability under which the account was initially opened still applies to the account. 

Stock Index Futures and Index Future CFDs

Index futures and/or index futures CFDs refer to a basket of top stocks traded in an exchange. Similarly, sector index CFDs refer to top stocks within a specific industry. A bank index, for example, has top banks as its constituents.

An index or sector futures contract is an agreement to buy or sell an index at a specified future date at an agreed price and a cash settlement occurs on expiry of the contract. Index futures CFDs on the other hand are not settled for cash but automatically carried over to a new date by the product provider.  

CFDs are contracts for difference and you trade in the underlying reference instrument (in the present context, an index futures contract) without actually owning it. Your trade for the price fluctuations and your profit or loss is the difference between the price when you enter and exit a position. The counterparty in CFDs is the CFD provider with whom you must complete all transactions in relation with the position you open. All closing positions must necessarily be equal and opposite of the open positions.

Index futures CFDs are derivative products just like index futures contracts but the problem with trading directly on a futures exchange is that there are standardised contracts that specify position size and expiry date. In contrast, CFDs are customised derivative products without a standard form. CFDs are also simpler to understand as they trade at the spot price with a small commission or the providers spread reflected as the difference between bid and offer quotes.

However, there is a risk involved in CFDs because they are offered over-the-counter and not regulated products. Much depends upon the credibility of the broker you choose to trade with.

Information Relevant to Treasury CFDs

CFDs are tradable instruments that mirror price movements of an underlying asset. The profit or loss you make is the difference between the price at which to open a position and the price at which you close it.  In case of treasury CFDs, the underlying reference asset is fixed income securities issued by the government and/or other bonds. A major advantage of trading treasury CFDs is that you can benefit from even extremely small price movements.

The price of most CFDs is influenced by multiple factors. These include the regular demand and supply factors and performances, corporate actions (for example in share and index CFDs) and other finer points that make markets move in the way they move. However, when you trade in treasury CFDs the major and some sometimes the only factor that you need to be aware of is the underlying profit (interest) associated with the treasury instrument related to the CFD. That means that your view of the market depends upon the direction in which you expect interest rates to move in future. 

Normally, treasury instruments and related CFDs trade at a premium if the prevailing interest rate in the country is less than the rate at which the bonds were issued at. That means that you would go long on treasury CFDs if in your view interest rates are likely to fall.

The other factor that influences treasury CFDs is the interest amount paid or payable on the bond. As time passes the face value of a bond increases in line with the interest accrued on it unless it is a bond that actually pays out monthly/quarterly/annual interest. In that case, the price of related CFDs will increase gradually in the run up to the record date for interest payment and revert back after the record date.   

Are Commodity CFDs a Better Option to Futures?

If you want to trade in commodities like oils, metals, grains and some agricultural or ‘soft’ commodities, a simpler way to trade them is through commodity CFDs. Access to commodity CFDs is much easier and more convenient than futures exchanges. However, just how many of these commodities are available to you depends largely on the CFD provider you choose.

It is crucial that you understand the way commodity prices are shown because it may lead to a bit of confusion at times. Commodity prices are reported as spot price (the current market price at which a commodity can be bought) as well as futures price, the price at which it will be available in future and reflects market sentiment. A regulated exchange shows the price of futures contracts and this is the underlying reference instrument of commodity CFDs. 

The price of commodity CFDs depends upon the futures of the underlying commodity. A CFD provider endeavours to match the bid and offer prices of commodity CFDs with prices in futures exchange but there is no guarantee.

Commodity CFDs enjoy a distinct advantage in that they provide easy access to commodity futures and lend well to trading flexibility due to smaller manageable lot sizes. However, all good things have a flip side. You may have to manage between futures and CFDs because the provider that you choose may not allow trading in all commodities that you want to. Moreover, it is not uncommon to see providers to increase their spreads to increase profits or manage their risks in volatile market conditions.

Bullion CFDs and Forex CFDs: The Connection

If you are an Australian and in any way connected with the financial markets you cannot afford to ignore gold. And if you are a forex trader, bullion CFDs provide you an excellent hedging opportunity.

Australia is one of the biggest producers and exporters of gold and its financial markets are greatly affected by the price of gold. For many years now, the currency pair AUD/USD has been moving in tandem with the price of gold, which is also the underlying reference asset for bullion (gold) CFDs.

CFDs refer to contract for difference that allows investors to take advantage of fluctuations in price without actually owning an asset. As such, when you create positions in bullion CFDs, you do not actually own physical gold or silver but only the right to make a profit or loss when the price gold or silver moves favourably. As an investor you must know certain basic aspects that relate to the positions you take in bullion CFDs.

Gold and silver bullion CFDs have a strong connection with Forex CFDs because the trading position you take reflects your view on the price of the metal in relation to currency value. While most CFDs are related to the underlying reference instrument or asset, gold CFD mean that you are taking a view on the price of gold as well as the currency it deals against. If you create a long position in gold you are expecting the price of gold to go up. It automatically means that you are short on the US dollar. Similarly, short positions in gold CFDs mean that you are going long on USD.  

Basic Guidelines for Forex CFDs

Trading in Forex CFDs involves taking a position on currency exchange rates. Since a Forex CFD is associated with a currency pair (for example, AUD/USD), it means that its price as well as the price of the underlying reference instrument is associated with the factors that affect these two specific currencies (AUD/USD). Your position in Forex CFDs reflects your views on each of the currencies involved.

Before you even think of trading Forex CFDs you will do well to understand the system because the Forex market is a different from other markets. When you trade in CFDs, your position is leveraged, which means you are controlling a much bigger amount that you paid for opening a position. The amounts involved in Forex CFDs can be huge and while there is a great potential of profit there is a corresponding potential of loss as well. 

There are many positives to trading Forex CFDs but there are also some hidden risks that you should be aware of. The Forex market is a typical market that requires a good understanding of the factors that affect currency movements. Your understanding of these factors will go a long way in understanding how to take positions in Forex CFDs pertaining to various currency pairs.

There is money to be made trading Forex CFDs provided you are careful. One of the biggest mistakes that you can make in trading Forex CFDs is to get carried away and indulge in overtrading after a series of profitable trades.

Also, be careful in choosing a trading platform. The platform you choose for Forex CFDs should allow 24x7 access to the market and ensure that orders, including stop loss and limit orders are put up as soon as you place them. 

Reasons Why You Should Trade Index CFDs

Trading in CFDs gives you considerable advantages over conventional share trading. It is flexible as you can profit from price fluctuation of an underlying assets no matter which way the price moves. Moreover, CFDs are leveraged products and you can take positions on paying only a small percentage of the contract value as margin money. At the same time, trading in CFDs is risky business and one wrong move can result in losing the entire amount in your account.  

One way of managing risks associated with CFDs is to place a stop loss order for every trade you open; the other is to trade in index CFDs. An index CFD provides a distinct advantage over other CFDs.

First up, most CFD providers do not charge brokerage on index CFDs and even if they do, it is a very nominal amount.

Investors with a portfolio of blue chip stocks are usually wary of selling them but often relent not having taken advantage of the sharp price movements. Indices are baskets of benchmark shares and trading in index CFDs is an excellent way of hedging a blue chip portfolio.

Index CFDs provide an unbelievable access to leverage. The margin money that a CFD provider requires you to pay on index CFDs can be as low as 0.5%.

No matter which way the markets move, the price of an index can never go to zero as the underlying reference of index CFD comprises a basket of top performing shares in an exchange.

Nevertheless, there is still a fair amount of risk involved in index CFDs. It is wise to use stop loss orders and also trade for small profits and avoid getting lured by promises of huge profits.   

All That You Wanted To Know About Share CFDs

Contracts for difference, commonly known as CFDs, are financial derivative products representing a trading contract between you and a CFD provider as the counterparty. A CFD has an underlying reference instrument and in the case of share CFDs, it is a share listed on an exchange.Trading in CFDs is similar to trading in shares and there is a huge potential for profits. As with any other high profit financial instrument, trading in CFDs is associated with an equally high potential for loss.

When you trade in share CFDs, you get a quote from the entity you are trading with. This quote will most often be the same as the price at which the underlying share is trading in an exchange. You are charged a commission on the full value of the contract that is number of CFDs traded multiplied by price. However, you do not pay the full contract value but only a percentage as margin money, which is meant to cover the risk exposure of the counterparty.

One of the biggest reasons why trading in CFDs is becoming increasingly popular in Australia is that it allows investors to trade long or short to take advantage from whichever direction you expect the price of the underlying reference instrument to move. You trade long in CFDs that you expect will show an upward movement and you go short if you expect the price to fall. 

At the same time, since CFDs are traded on margins and are leveraged products, trading in CFDs is considered to be riskier than normal share trading. Trading in CFDs without placing stop loss orders against each trade can result in a substantial loss. 

Types of CFDs and the Three Major Order Types

Different types of CFDs are classified on the basis of the underlying financial instrument they relate to. For example, share CFDs have shares as the underlying reference instrument. Similarly, commodity CFDs are related to commodities, Forex CFDs to currency exchange rates and Treasury CFDs to government securities. CFDs may also refer to futures contracts and exchange traded indices.

Basically, there are three basic types of orders in CFDs. 

–        A market order is order for creating positions in CFDs at the best available market price. Some CFD providers allow you to place market orders even when the markets are closed so that you get in as soon as the market opens.

–        A stop loss order is for restricting the amount of potential loss that you are ready to take. A stop loss order for buying a CFD means that you will buy if and when it trades at or above a specified price. A stop loss order for selling a CFD means you will sell if and when it trades at or below the specified price.

–        A limit order is an order that you use to open or close existing positions in CFDs at a price that is more favourable to you than the current market price.

Providers of CFDs tend to make different combinations and permutations of these basic order types to allow traders to select the one that suits them the most under the circumstances. These order types include but not limited to orders to accept a price within a specified range, contingent orders to control potential profits or loss on open positions in CFDs and one-cancels-the-other-order. This is of particular importance for traders who cannot, due to whatever reasons, afford to be in front of their computers to trade in CFDs all through the open hours of markets.

Salient Features of a CFD

A CFD, short for Contract for Difference, is an agreement between an account holder and an issuer of CFD. The price of a CFD depends on an Underlying Reference Instrument, which is normally a share, commodity, index, index futures or any other financial instrument traded in a stock, commodity or currency exchange.

A CFD issuing company may offer different types of accounts but the features that govern CFD trades are the same for all types of accounts.

Salient Features of a CFD

-CFD is primarily a speculative product.

-A CFD is not ownership of the Underlying Reference Instrument.

-A CFD cannot be traded in an exchange.

-The profit or loss that an account holder makes is the difference between the CFD price at the time of opening and closing of positions multiplied by the number of CFDs traded. This is regardless of whether a single or multiple positions were created in a CFD. However, in the end, the opening and closing positions must be equal and opposite of the opening order.

-All transactions (opening and closing of positions) relating to a CFD can be made only with the same issuer and not with any third party.

-The issuer may charge a pre-agreed commission and finance and rollover charges on each CFD entered into with the account holder.

CFDs are speculative products and offered over-the-counter. Since it is an unregulated market, it is of utmost importance that people interested in CFDs educate themselves. Of particular importance is the risk involved, regardless of the fact whether you are buying or selling a CFD.

CFD Position: Vital Information

Just as in any other form of trading, you open a CFD position on the basis of whether you expect the price to move up or fall. Whereas in other forms of trading you buy when you have the capacity to pay the full price and sell only if you already own a product, you can open a buy or sell CFD position simply by meeting the margin requirement applicable to the CFD position. 

A CFD position may be opened with a buy order or a sell order. However, if you close a CFD position, it must be equal and opposite of the open order. Multiple open CFD positions can be closed with one single order.

The most important aspect of opening a CFD position is margin money that you are required to pay. Since you do not pay full contract value, the CFD provider requires you to pay a percentage as security to its exposure to the risk as the counterparty to the contract.

Margin requirements tend to vary and depend upon two major factors:

-          Market volatility: There can be extremely sharp price movements in times of volatility, which increases the product provider’s risk to a CFD position.

-          Internal risk management: Every CFD provider has a risk management policy. The basis of such policies is usually its overall risk exposure taking into account the sum of all CFD positions opened with it.

Margin requirements are at the sole discretion of the product provider and tend to vary. Regardless of the margin money you pay on the CFD position you open, you need to be always prepared to pay the total contract value of your CFD position/s. Failure to meet margin requirements or full contract value in periods of very high volatility may mean termination of your CFD position/s.

Trading CFDs on the long and short

Have you ever wondered how a seasoned trader trading in CFDs makes money even when the market is going down? The reason is that you can make money trading CFDs in a rising as well as a falling market. 

Trading CFDs means that you take a position on the basis of how you expect the price of the underlying reference instrument of the CFD to move.   

Trading CFDs on the long and short is a technique where you go long when you are expecting the market to rise and go short when you expect it to go down.  

A long position is set up by initiating a buy order as your opening position and sell order when you close the trade. Similarly, a short position is created when you initiate a trade with a sell order and close by placing a buy order. 

The next crucial aspect of trading CFDs is that opening and closing trades must be equal and opposite of each other. When trading CFDs if you open with a buy order, you close it with a sell order and the other way round. If you have created multiple positions while trading CFDs, you can close them with a single closing trade. 

Whichever way you do it, the profit that you make or the loss you book in trading CFDs is the difference between the value of the opening and closing positions, net of any charges that you must pay or the benefits that accrue to you in relation to the CFD.