Contract for difference
Encyclopedia
In finance, a contract for difference (or CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the buyer will pay to the seller the difference between the current value of an asset
and its value at contract time. (If the difference is negative, then the seller pays instead to the buyer.) In effect CFDs are financial derivatives that allow traders to take advantage of prices moving up (long
positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate
on those markets.
For example, when applied to equities, such a contract is an equity derivative
that allows traders to speculate on share price
movements, without the need for ownership of the underlying shares.
CFDs are currently available in the United Kingdom, Hong Kong, The Netherlands, Poland, Portugal, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, Norway, France, Ireland, Japan and Spain. They are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on over-the-counter
(OTC) financial instruments.
, a UK tax.
The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, on their Trafalgar House
deal in the early 90s.
They were initially used by hedge fund
s and institutional traders to hedge their exposure to stocks on the London Stock Exchange
in a cost-effective way.
In the late 1990s CFDs were first introduced to retail traders. They were popularised by a number of UK companies, whose offerings were typically characterised by innovative online trading platforms that made it easy to see live prices and trade in real time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities); GNI touch is now owned by MF Global
. They were soon followed by IG Markets
and CMC Markets
who started to popularise the product in 2000.
It was around 2000 that retail traders realised that the real benefit of trading CFDs was not the exemption from stamp tax but the ability to trade on leverage on any underlying instrument. This was the start of the growth phase in the use of CFDs. The CFD providers quickly responded and expanded their product offering from just London Stock Exchange
(LSE) shares to include indices
, many global stocks
, commodities, bonds
, and currencies
. Trading index CFDs, such as the ones based on the major global indexes e.g. Dow Jones
, NASDAQ
, S&P 500
, FTSE
, DAX
, and CAC
, quickly became the most popular type of CFD that were traded.
Around 2001 a number of the CFD providers realised that CFDs have the same economic effect as financial spread betting except that the tax regime was different, making it in effect tax free for clients. Most CFD providers launched financial spread betting operations in parallel to their CFD offering. In the UK the CFD market mirrors the financial spread betting market and the products are in many ways the same. However unlike CFDs which have been exported to a number of different countries, spread betting relying on a country specific tax advantage has remained primarily a UK and Irish phenomenon.
The CFD providers started to expand to overseas markets with CFDs being first introduced to Australia in July 2002 by IG Markets, a subsidiary of IG Group
, and CMC Markets
. CFDs have since been introduced into a number of other countries; see list above.
Until 2007 CFDs had been traded exclusively over-the-counter
(OTC); however, on 5 November 2007 the Australian Securities Exchange
(ASX) listed exchange-traded CFDs on the top 50 Australian stocks, 8 FX pairs, key global indices and some commodities. There were originally 12 brokers offering ASX CFDs, but as of 2009 there are only five.
In June 2009, the UK regulator the Financial Services Authority
(FSA) implemented a general disclosure regime for CFDs to avoid them being used in insider information cases. This was after a number of high profile cases where positions in CFDs were used instead of physical underlying stock to hide them from the normal disclosure rules related to insider information.
The CFD is started by making an opening trade on a particular instrument with the CFD provider. This creates a ‘position’ in that instrument. There is no expiry date so the position is closed when a second reverse trade is done. At that point the difference between the opening trade and the closing trade is paid as profit or loss. The CFD provider may make a number of charges as part of the trading or the open position. These may include, bid-offer spread
, commission
, overnight financing and account management fees.
Even though the CFD does not expire, any positions that are left open overnight will be ‘rolled over’. This typically means that any profit and loss is realised and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. The industry norm is that this process is done at 10pm UK time.
CFDs are traded on margin
, and the trader must maintain the minimum margin level at all times. A typical feature of CFD trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on screen. If the amount of money deposited with CFD broker drops below minimum margin level, margin calls can be made. Traders may need to cover these margins quickly otherwise the CFD provider may liquidate their positions.
To see how CFDs work in practice see the examples of typical CFD trades. The ‘margin percentage’, and ‘charges’ shown may vary from provider to provider, but are typical of CFD providers.
In summary we have had to deposit $972.10 to cover margin on this trade and made a profit of $567.31. If the price of Apple shares had instead dropped by $6.15, we would have sustained a loss of $647.47 ($608 plus commissions).
In summary we have had to deposit $54.68 to cover margin on this trade and made a profit of $96.60. If the S&P 500 Index had risen instead by 10 points we would have sustained a loss of $95.40 ($96.00 + Costs). Note that the amount of gain or loss was bigger than the margin requirement. In other words, you would have gained or lost more money than you deposited.
benchmark e.g. Reserve Bank rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash
differential between the price of the opening and closing trades.
Traditionally, equity based CFDs are subject to a commission
that is a percentage
of the size of the position for each trade. Alternatively, a trader
can opt to trade with a market maker
, foregoing commissions at the expense of a larger bid/offer spread on the instrument.
or loss. On the other hand, a leveraged
position in a volatile CFD can expose the buyer to a margin call
in a downturn, which often leads to losing a substantial part of the assets.
CFDs allow a trader to go short or long
on any position using margin. There are always two types of margin with a CFD trade -
Initial margin is fixed at between 0.5% and 30% depending on the underlying product and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility
in the world
's stockmarkets.
Many refer to initial margin as a deposit
. For example, for large and highly liquid stocks such as Vodafone
the initial margin will be nearer 3%, and depending on the broker
and the client's relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher.
Variation margin is applied to positions if they move against a client. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £
100 in variation margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in running profits.
Variation margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.
. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. The margin requirements on CFDs are low meaning that only small amount of money is required to take large positions.
Market maker
s have the ability to manage the stop loss and when a stop loss order is triggered, they can close the position wherever they see that matching price and quantity are available. This increases your chances of getting out of a position that is going against you, albeit at a potentially inferior price to what you were expecting.
One of the problems with the price of a stop loss order is that it is only a target price. It depends if the market price actually trades at that level. If the underlying instrument price 'gaps' i.e. it moves past the stop price in one step, the stop will get executed at the next price that was traded or not at all depending on the CFD provider. This is normally not a problem on very actively traded products like indices and currencies, but can be an issue on equity prices, particularly for stocks that have low liquidity. It is also a problem when stock markets are closed, and the difference between the close on one day and the open on the next day is significant (for example: if there has been news about a stock overnight that impacts company profitability).
To mitigate this problem, some providers offer 'Guaranteed Stop Loss Orders' (GSLO) whereby the trader pays a premium for a price to be guaranteed should a stop loss price be triggered. As well as the additional charge, there are normally other restrictions. The closest a guaranteed stop loss order can be placed is typically 5% from the current price and providers usually have specific terms and conditions on the orders however they can be effective if exiting at a set price is important.
with a broker or market maker, known as a CFD provider. The CFD provider will define the contract terms, the margin rates and what underlying instruments it is willing to trade. They trade under two different models, which can have an impact on the price of the instrument traded:
s such as dividend
payments can have an impact on the share price and hence the price of an equity based CFD. However, a person who holds a CFD position has no ownership of the underlying instrument and so would not receive the dividend payment from the company that issued the shares.
In this case the CFD provider would pay the equivalent of the dividend to anyone holding a long
CFD position and deduct the equivalent from anyone holding a short position. This would be done on ex-div date as that is when the economic effect is felt on the underlying share price. The general rule is that any economic effect of a corporate action on the underlying must be reflected in the CFD. This includes dividends, stock splits, rights issues etc. However, a CFD holder will never have access to non economic corporate actions such as voting rights.
as the contract is designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, and the leveraging effect of this increases the risk significantly. Margin rates are typically small and therefore a small amount of money can be used to hold a large position. It is this very risk that drives the use of CFDs, either to speculate on movements in financial markets or to hedge existing positions elsewhere. One of the ways to mitigate this risk is the use of stop loss orders. Users typically deposit an amount of money with the CFD provider to cover the margin and can lose much more than this deposit if the market moves against them.
(OTC) traded derivatives
. Counterparty risk is associated with the financial stability or solvency
of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD trader could potentially incur severe losses, even if the underlying instrument moves in the desired direction. Although OTC CFD providers are required to segregate client funds protecting client balances in event of company default. Exchange-traded contracts traded through a clearing house
are generally believed to have less counterparty risk. Ultimately, the degree of counterparty risk is defined by the credit risk
of the counterparty, including the clearing house if applicable.
Although no firm figures are available as trading is off-exchange
, it is estimated that CFD related hedging accounts for somewhere between 20% and 40% the volume on the London Stock Exchange
(LSE). A number of people in the industry back the view that a third of all LSE volume is CFD related. The LSE does not monitor the numbers but the original 25% estimate as quoted by many people, appears to have come from a LSE spokesperson.
The CFD market most resembles the futures and options market, the major differences being:
are preferred by professionals for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to Futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent. Futures contracts tend to see price decay near to the expiry date compared to the price of the underlying instrument which does not occur on the CFD as it never expires and simply mirrors the underlying instrument.
Futures are often used by the CFD providers to hedge their own positions and many CFDs are written over futures as futures prices are easily obtainable. CFDs don't have expiry dates so when a CFD is written over a futures contract the CFD contract has to deal with the futures contract expiry date. The industry practice is for the CFD provider to 'roll' the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry, thus creating a rolling CFD contract.
, like futures are an established product, exchange traded and centrally cleared and used by professionals. Options like futures can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case, when options are used to speculate on markets. The main advantage of CFDs over options is the price simplicity and range of underlying instruments. Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument. CFDs cannot be used to reduce risk in the way that options can.
have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products. In markets like Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, which may have been partially responsible for the decline in volume of covered warrant there.
s (ETFs) like CFDs can be used for short-term speculation, and are available over a wide variety of underlying products. In particular, indices, commodities and overseas markets, which have been seen as one of the strengths of CFDs. Also in the same way as CFDs, there are ETFs on customised groups of instruments such as sectors or baskets and an increasing number of ETFs are set up to use leverage. Compared to CFDs, ETFs are exchange-traded products and have been around longer and are a more mature product. Like other exchange-traded products, the costs are higher and access is via a traditional broker.
(ASX) introduced exchange traded CFDs. As a result a small percentage of CFDs are now traded through the Australian exchange.
The advantages and disadvantages of having an exchange traded CFD are similar for most financial products and mean reducing counterparty risk and increasing transparency but costs are higher.
The current disadvantages of the ASX exchange traded CFDs and lack of liquidity means that most Australian traders still opt for over-the-counter CFD providers. As of 2010, no other exchange has followed the ASX in creating listed CFDs.
FSA
rules for CFD providers include that they must assess the suitability of CFDs for each new client based on their experience and must provide a risk warning document to all new clients, based on a general template devised by the FSA. The Australian financial regulator ASIC
on its trader information site suggests that trading CFDs is riskier than gambling on horses or going to a casino. It recommends that trading CFDs should be carried out by individuals who have extensive experience of trading, in particular during volatile markets and can afford losses that any trading system cannot avoid.
There has also been concern that CFDs are little more than gambling implying that most traders lose money trading CFDs. It is impossible to confirm what the average returns are from trading as no reliable statistics are available and CFD providers do not publish such information, however prices of CFDs are based on publicly available underlying instruments and odds are not stacked against traders as the CFD is simply the difference in underlying price.
There has also been some concern that CFD trading lacks transparency as it happens primarily over-the-counter
and that there is no standard contract. This has led some to suggest that CFD providers could exploit their clients. This topic appears regularly on trading forums, in particular when it comes to rules around executing stops, and liquidating positions in margin call. Although the incidence of these types of discussions may be due to traders' psychology where it is hard to internalise a losing trade and instead they try to find external source to blame. This is also something that the Australian Securities Exchange
, promoting their Australian exchange traded CFD and some of the CFD providers, promoting Direct Market Access
products, have used to support their particular offering. They argue that their offering reduces this particular risk in some way. The counter argument is that there are many CFD providers and the industry is very competitive with over twenty CFD providers in the UK alone. If there were issues with one provider, clients could easily switch to another.
Some of the criticism surrounding CFD trading is connected with the CFD brokers' unwillingness to inform their users about the psychology involved in this kind of high-risk trading. Factors such as the fear of losing that translates into neutral and even losing positions and becomes a reality when the users change from a demonstration account to the real one; a fact not documented by the majority of CFD brokers.
Criticism has also been expressed about the way that some CFD providers hedge their own exposure and the conflict of interest that this could cause when they define the terms under which the CFD is traded. One article suggested that some CFD providers had been running positions against their clients based on client profiles, in the expectation that those clients would lose, and that this created a conflict of interest for the providers.
, which flourished in the United States at the turn of the 20th century. These allowed speculators to place highly leveraged bets on stocks generally not backed or hedged by actual trades on an exchange, so the speculator was in effect betting against the house. Bucket shops, colorfully described in Jesse Livermore's semi-autobiographical "Reminiscences of a Stock Operator
", are illegal in the United States according to criminal as well as securites law.
:Category:Financial derivate trading companies
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
and its value at contract time. (If the difference is negative, then the seller pays instead to the buyer.) In effect CFDs are financial derivatives that allow traders to take advantage of prices moving up (long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
on those markets.
For example, when applied to equities, such a contract is an equity derivative
Equity derivative
In finance, an equity derivative is a class of derivatives whose value is at least partly derived from one or more underlying equity securities. Options and futures are by far the most common equity derivatives, however there are many other types of equity derivatives that are actively...
that allows traders to speculate on share price
Share price
A share price is the price of a single share of a number of saleable stocks of a company. Once the stock is purchased, the owner becomes a shareholder of the company that issued the share.-Behavior of share prices:...
movements, without the need for ownership of the underlying shares.
CFDs are currently available in the United Kingdom, Hong Kong, The Netherlands, Poland, Portugal, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, Norway, France, Ireland, Japan and Spain. They are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC) financial instruments.
History
CFDs were originally developed in the early 1990s in London. Based on equity swaps, they had the additional benefit of being traded on margin and being exempt of stamp dutyStamp duty
Stamp duty is a tax that is levied on documents. Historically, this included the majority of legal documents such as cheques, receipts, military commissions, marriage licences and land transactions. A physical stamp had to be attached to or impressed upon the document to denote that stamp duty...
, a UK tax.
The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, on their Trafalgar House
Trafalgar House (company)
Trafalgar House Public Limited Company was a British conglomerate with interests in property investment, property development, engineering, construction, shipping, hotels, energy and publishing...
deal in the early 90s.
They were initially used by hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s and institutional traders to hedge their exposure to stocks on the London Stock Exchange
London Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
in a cost-effective way.
In the late 1990s CFDs were first introduced to retail traders. They were popularised by a number of UK companies, whose offerings were typically characterised by innovative online trading platforms that made it easy to see live prices and trade in real time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities); GNI touch is now owned by MF Global
MF Global
MF Global , formerly known as Man Financial, was a major global financial derivatives broker. MF Global provided exchange-traded derivatives, such as futures and options as well as over-the-counter products such as contracts for difference , foreign exchange and spread betting. MF Global was...
. They were soon followed by IG Markets
IG Group
IG Group plc is a British-based company trading in financial derivatives. While the majority of the company's activities are based in the UK the company has also expanded internationally...
and CMC Markets
CMC Markets
CMC Markets is a UK based financial derivatives dealer. The company offers online trading in spread betting, Contract for difference and Foreign Exchange across world markets...
who started to popularise the product in 2000.
It was around 2000 that retail traders realised that the real benefit of trading CFDs was not the exemption from stamp tax but the ability to trade on leverage on any underlying instrument. This was the start of the growth phase in the use of CFDs. The CFD providers quickly responded and expanded their product offering from just London Stock Exchange
London Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
(LSE) shares to include indices
Stock market index
A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....
, many global stocks
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
, commodities, bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
, and currencies
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
. Trading index CFDs, such as the ones based on the major global indexes e.g. Dow Jones
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...
, NASDAQ
Nasdaq Composite
The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market, meaning that it has over 3,000 components. It is highly followed in the U.S. as an indicator of the performance of stocks of technology companies and growth companies. ...
, S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
, FTSE
FTSE 100 Index
The FTSE 100 Index, also called FTSE 100, FTSE, or, informally, the footsie , is a share index of the 100 most highly capitalised UK companies listed on the London Stock Exchange....
, DAX
DAX
The DAX is a blue chip stock market index consisting of the 30 major German companies trading on the Frankfurt Stock Exchange. Prices are taken from the electronic Xetra trading system...
, and CAC
CAC 40
The CAC 40 is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 most significant values among the 100 highest market caps on the Paris Bourse...
, quickly became the most popular type of CFD that were traded.
Around 2001 a number of the CFD providers realised that CFDs have the same economic effect as financial spread betting except that the tax regime was different, making it in effect tax free for clients. Most CFD providers launched financial spread betting operations in parallel to their CFD offering. In the UK the CFD market mirrors the financial spread betting market and the products are in many ways the same. However unlike CFDs which have been exported to a number of different countries, spread betting relying on a country specific tax advantage has remained primarily a UK and Irish phenomenon.
The CFD providers started to expand to overseas markets with CFDs being first introduced to Australia in July 2002 by IG Markets, a subsidiary of IG Group
IG Group
IG Group plc is a British-based company trading in financial derivatives. While the majority of the company's activities are based in the UK the company has also expanded internationally...
, and CMC Markets
CMC Markets
CMC Markets is a UK based financial derivatives dealer. The company offers online trading in spread betting, Contract for difference and Foreign Exchange across world markets...
. CFDs have since been introduced into a number of other countries; see list above.
Until 2007 CFDs had been traded exclusively over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC); however, on 5 November 2007 the Australian Securities Exchange
Australian Securities Exchange
The Australian Securities Exchange was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006. It is the primary stock exchange group in Australia....
(ASX) listed exchange-traded CFDs on the top 50 Australian stocks, 8 FX pairs, key global indices and some commodities. There were originally 12 brokers offering ASX CFDs, but as of 2009 there are only five.
In June 2009, the UK regulator the Financial Services Authority
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
(FSA) implemented a general disclosure regime for CFDs to avoid them being used in insider information cases. This was after a number of high profile cases where positions in CFDs were used instead of physical underlying stock to hide them from the normal disclosure rules related to insider information.
Trading
CFDs are traded between individual traders and CFD providers. There are no standard contract terms for CFDs, and each CFD provider can specify their own, but they tend to have a number of things in common.The CFD is started by making an opening trade on a particular instrument with the CFD provider. This creates a ‘position’ in that instrument. There is no expiry date so the position is closed when a second reverse trade is done. At that point the difference between the opening trade and the closing trade is paid as profit or loss. The CFD provider may make a number of charges as part of the trading or the open position. These may include, bid-offer spread
Bid-offer spread
The bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...
, commission
Commission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
, overnight financing and account management fees.
Even though the CFD does not expire, any positions that are left open overnight will be ‘rolled over’. This typically means that any profit and loss is realised and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. The industry norm is that this process is done at 10pm UK time.
CFDs are traded on margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
, and the trader must maintain the minimum margin level at all times. A typical feature of CFD trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on screen. If the amount of money deposited with CFD broker drops below minimum margin level, margin calls can be made. Traders may need to cover these margins quickly otherwise the CFD provider may liquidate their positions.
To see how CFDs work in practice see the examples of typical CFD trades. The ‘margin percentage’, and ‘charges’ shown may vary from provider to provider, but are typical of CFD providers.
Example 1 - an Equity based CFD trade
In this example we show an equity based CFD trade. The share price of Apple Inc is $194.38. We believe that the share price will rise and so decide to take a long CFD position. Our CFD Provider is quoting a price of $194.36 bid and $194.42 offer.| Step 1 Opening a position | |
| Buy 100 Apple CFDs at offer price | 100 x $194.42 = $19,442.00 |
| Margin requirement is open position x margin percentage. Typical margin for equities is 3%-15% depending on the liquidity of the underlying instrument. In our example Apple CFDs require margin of 5%. | $19,442.00 x 0.05 = $972.10 |
| You get charged commission of 0.1% on this transaction | $19,442.00 x 0.001 = $19.44 |
| Step 2 Overnight Financing | |
| To hold this position a financing charge is made each night. This is normally based on a benchmark rate per cent like LIBOR + broker margin per cent / 365. For simplicity we will assume the price of Apple shares stayed the same until the market close and so no P&L was generated on this day. | $19,442.00 x (0.0025 + 0.02) / 365 = $1.20 |
| Step 3 Closing the position | |
| The next day Apple share price has risen by $6.15. Our trade has moved in our favour and we decide close the position and take profit. | |
| Our CFD provider is quoting $200.50 bid and $200.58 offer. | |
| Sell 100 Apple CFDs at bid price | 100 x 200.50 = $20,050.00 |
| The position is now closed and so margin requirement is now zero | $0.00 |
| You get charged commission of 0.1% on this transaction | $20,050.00 x 0.001 = $20.05 |
| Gross profit is difference between opening position and closing the position | $20,050.00 - $19,442.00 = $608 |
| Net profit is gross profit less costs. The costs are commissions and overnight financing. In this example we have been charged commission twice, once to open the position and once to close it, and we have been charged one day overnight financing. | $19.44 + $20.05 + $1.20 = $40.69 |
| Profit & Loss shows a profit after costs | $608.00 – $40.69 = $567.31 |
In summary we have had to deposit $972.10 to cover margin on this trade and made a profit of $567.31. If the price of Apple shares had instead dropped by $6.15, we would have sustained a loss of $647.47 ($608 plus commissions).
Example 2 - An Index based CFD trade on the S&P 500 Index
In this example we show an index based CFD. The S&P500 Index is at 1093.9. We believe that the Index will go down and so decide to take a 'short' position. Our CFD broker is quoting 1093.7 bid and 1094.1 offer.| Step 1 Opening a position | |
| Sell 10 S&P500 CFDs at bid price | 10 x $1093.7 = $10,937 |
| Margin requirement is open position x margin percentage. Typical value for major indices is 0.5% | 10,937 x 0.005 = $54.68 |
| Commission – typically no commission is charged on index CFDs | |
| Step 2 Overnight Financing | |
| To hold a position a financing charge is made, however as we are holding a short position we will instead receive the financing. The rate is normally based on a benchmark rate per cent like LIBOR, from this we subtract the broker margin and divide by 365 to get the daily financing. For simplicity lets assume the US interest rate is 4% and the broker margin is 2%. | $10,937 x (0.04 - 0.02) / 365 = +$0.60 |
| Step 3 Closing the position | |
| The next day the S&P has dropped by 10 points to 1083.7 bid and 1084.1 offer | |
| Our trade has moved in our favour and we decide to take profit and close the position | |
| Buy back the position at the lower price | 10 x 1084.1 = $10,841 |
| The position is now closed and so margin requirement is now zero | |
| Gross profit is difference between opening position and closing the position | $10,937 - $10,841 = $96.00 |
| Net profit is gross profit less costs. In this example financing is actually positive and there are no other costs. So we get a credit of | $0.60 |
| Profit and Loss shows a Profit after costs | $96.00 + 0.60 = $96.60 |
In summary we have had to deposit $54.68 to cover margin on this trade and made a profit of $96.60. If the S&P 500 Index had risen instead by 10 points we would have sustained a loss of $95.40 ($96.00 + Costs). Note that the amount of gain or loss was bigger than the margin requirement. In other words, you would have gained or lost more money than you deposited.
Charges
The contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR or some other interest rateInterest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
benchmark e.g. Reserve Bank rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
differential between the price of the opening and closing trades.
Traditionally, equity based CFDs are subject to a commission
Commission (remuneration)
The payment of commission as remuneration for services rendered or products sold is a common way to reward sales people. Payments often will be calculated on the basis of a percentage of the goods sold...
that is a percentage
Percentage
In mathematics, a percentage is a way of expressing a number as a fraction of 100 . It is often denoted using the percent sign, “%”, or the abbreviation “pct”. For example, 45% is equal to 45/100, or 0.45.Percentages are used to express how large/small one quantity is, relative to another quantity...
of the size of the position for each trade. Alternatively, a trader
Trader
The term Trader can refer to:* Merchant, retailer or one who attempts to generally buy wholesale and sell later at a profit* Trader , someone who buys and sells financial instruments such as stocks, bonds, derivatives, etc....
can opt to trade with a market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
, foregoing commissions at the expense of a larger bid/offer spread on the instrument.
Margin
Traders in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (usually ranging from 0.5% to 30%). One advantage to traders of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profitProfit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
or loss. On the other hand, a leveraged
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
position in a volatile CFD can expose the buyer to a margin call
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
in a downturn, which often leads to losing a substantial part of the assets.
CFDs allow a trader to go short or long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
on any position using margin. There are always two types of margin with a CFD trade -
- Initial Margin - (normally between 3% and 30% for shares/stocks and 0.5% - 1% for indices, foreign exchange and commodities)
- Variation Margin - (which is then 'marked to market').
Initial margin is fixed at between 0.5% and 30% depending on the underlying product and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
in the world
World
World is a common name for the whole of human civilization, specifically human experience, history, or the human condition in general, worldwide, i.e. anywhere on Earth....
's stockmarkets.
Many refer to initial margin as a deposit
Down payment
Down payment is a payment used in the context of the purchase of expensive items such as a car and a house, whereby the payment is the initial upfront portion of the total amount due and it is usually given in cash at the time of finalizing the transaction.A loan is then required to make the full...
. For example, for large and highly liquid stocks such as Vodafone
Vodafone
Vodafone Group Plc is a global telecommunications company headquartered in London, United Kingdom. It is the world's largest mobile telecommunications company measured by revenues and the world's second-largest measured by subscribers , with around 341 million proportionate subscribers as of...
the initial margin will be nearer 3%, and depending on the broker
Broker
A broker is a party that arranges transactions between a buyer and a seller, and gets a commission when the deal is executed. A broker who also acts as a seller or as a buyer becomes a principal party to the deal...
and the client's relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher.
Variation margin is applied to positions if they move against a client. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £
Pound sterling
The pound sterling , commonly called the pound, is the official currency of the United Kingdom, its Crown Dependencies and the British Overseas Territories of South Georgia and the South Sandwich Islands, British Antarctic Territory and Tristan da Cunha. It is subdivided into 100 pence...
100 in variation margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in running profits.
Variation margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.
Leverage
One of the benefits (and risks) of trading CFDs is that they are traded on margin meaning that they provide the trader with leverageLeverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. The margin requirements on CFDs are low meaning that only small amount of money is required to take large positions.
Stop loss orders
A stop loss order can be set to trigger an exit point as pre-determined by the trader e.g. Buy at $3.00 with a stop loss at $2.60. Once the stop loss is triggered, a sell signal is activated to the CFD provider and actioned in accordance with their terms of business and taking into account available liquidity to action the request. DMA providers typically receive the stop loss value via the phone or online ordering and will place the order in the market to be actioned at the pre-determined price to a limited price range e.g. to a maximum 6c further,and providing there is matching liquidity. If the stop loss price is triggered and the price then rapidly moves outside the 6c range in this example, or there is insufficient liquidity for your order and considering other people that have orders at that price point, your stop loss sell order may not be triggered and you remain in the position.Market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s have the ability to manage the stop loss and when a stop loss order is triggered, they can close the position wherever they see that matching price and quantity are available. This increases your chances of getting out of a position that is going against you, albeit at a potentially inferior price to what you were expecting.
One of the problems with the price of a stop loss order is that it is only a target price. It depends if the market price actually trades at that level. If the underlying instrument price 'gaps' i.e. it moves past the stop price in one step, the stop will get executed at the next price that was traded or not at all depending on the CFD provider. This is normally not a problem on very actively traded products like indices and currencies, but can be an issue on equity prices, particularly for stocks that have low liquidity. It is also a problem when stock markets are closed, and the difference between the close on one day and the open on the next day is significant (for example: if there has been news about a stock overnight that impacts company profitability).
To mitigate this problem, some providers offer 'Guaranteed Stop Loss Orders' (GSLO) whereby the trader pays a premium for a price to be guaranteed should a stop loss price be triggered. As well as the additional charge, there are normally other restrictions. The closest a guaranteed stop loss order can be placed is typically 5% from the current price and providers usually have specific terms and conditions on the orders however they can be effective if exiting at a set price is important.
CFD providers
CFDs are typically traded over-the-counterOver-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
with a broker or market maker, known as a CFD provider. The CFD provider will define the contract terms, the margin rates and what underlying instruments it is willing to trade. They trade under two different models, which can have an impact on the price of the instrument traded:
- Market makerMarket makerA market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
(MM): this is the most common method, and is where the CFD provider makes the price for the CFD on underlying and takes all orders onto its own book. Most CFD providers will hedge these positions based on their own risk model, which may be as simple as buying or selling the underlying, but may also be via portfolio hedges or by consolidating client positions and offsetting one client long with another client short position. This does not affect the CFD trade as no matter what the CFD provider does with its own market risk, the contract is always between the trader and the CFD provider. The main impact is that price can be different to the underlying physical market as the CFD provider can for example take into account other client positions it is holding. This does allow the CFD provider to be very flexible in the products and trading times it offers as it allows them to easily create hybrids and hedge using alternative instruments for example to allow trading out of normal market hours. In practice, the market maker price usually matches the underlying instrument as the CFD provider would otherwise be exposed to arbitrageArbitrageIn economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
urs, but some CFD providers add an additional written guarantee in the contract that all CFD prices will match that of the underlying instrument. - Direct Market AccessDirect Market AccessDirect market access ' is a term used in financial markets to describe electronic trading facilities that give investors wishing to trade in financial instruments a way to interact with the order book of an exchange. Normally, trading on the order book is restricted to broker-dealers and market...
(DMA) was created in response to concerns that the price in the market-maker model may not match that of the underlying instrument. A DMA CFD provider guarantees that it will do a physical trade on the underlying market to match each CFD trade on a one-for-one basis. The contract is still between the traders and the CFD provider but through this method it is guaranteed that the CFD price is the same as the underlying price and that they will not be re-quoted. They will also be able to see their order in the underlying physical market order book. DMA only works where the underlying instrument can be readily bought and sold in the quantities that match the CFD and is most commonly used for shares CFDs. DMA CFDs can be more expensive as the CFD provider needs to cover the exchange transaction fees and may not be able get economies of scale by netting client orders together. The DMA model is much more like a traditional brokerInvestment brokerInvestment brokers are individuals who bring together buyers and sellers of investments. They need a license to operate. They act on behalf of buyers and sellers of stock...
model and is preferred by professional and institutional traders as it avoids conflicts of interest with the CFD provider.
Corporate Actions on Equity based CFDs
Corporate actionCorporate action
A corporate action is an event initiated by a public company that affects the securities issued by the company. Some corporate actions such as a dividend or coupon payment may have a direct financial impact on the shareholders or bondholders; another example is a call of a debt security...
s such as dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
payments can have an impact on the share price and hence the price of an equity based CFD. However, a person who holds a CFD position has no ownership of the underlying instrument and so would not receive the dividend payment from the company that issued the shares.
In this case the CFD provider would pay the equivalent of the dividend to anyone holding a long
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...
CFD position and deduct the equivalent from anyone holding a short position. This would be done on ex-div date as that is when the economic effect is felt on the underlying share price. The general rule is that any economic effect of a corporate action on the underlying must be reflected in the CFD. This includes dividends, stock splits, rights issues etc. However, a CFD holder will never have access to non economic corporate actions such as voting rights.
Market Risk
The main risk is market riskMarket risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
as the contract is designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, and the leveraging effect of this increases the risk significantly. Margin rates are typically small and therefore a small amount of money can be used to hold a large position. It is this very risk that drives the use of CFDs, either to speculate on movements in financial markets or to hedge existing positions elsewhere. One of the ways to mitigate this risk is the use of stop loss orders. Users typically deposit an amount of money with the CFD provider to cover the margin and can lose much more than this deposit if the market moves against them.
Liquidation Risk
If prices move against open CFD position additional variation margin is required to maintain the margin level. The CFD provider may call upon the party to deposit additional sums to cover this, and in fast moving markets this may be at short notice. If funds are not provided in time, the CFD provider may close/liquidate the positions at a loss for which the other party is liable.Counterparty Risk
Another dimension of CFD risk is counterparty risk, a factor in most over-the-counterOver-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
(OTC) traded derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
. Counterparty risk is associated with the financial stability or solvency
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD trader could potentially incur severe losses, even if the underlying instrument moves in the desired direction. Although OTC CFD providers are required to segregate client funds protecting client balances in event of company default. Exchange-traded contracts traded through a clearing house
Clearing house (finance)
A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
are generally believed to have less counterparty risk. Ultimately, the degree of counterparty risk is defined by the credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
of the counterparty, including the clearing house if applicable.
CFDs compared to other products
There are a number of different financial products that have been used in the past to speculate on financial markets. These range from trading in physical shares either direct or via margin lending, to using derivatives such as futures, options or covered warrants. A number of brokers have been actively promoting CFDs as alternatives to all of these products.Although no firm figures are available as trading is off-exchange
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
, it is estimated that CFD related hedging accounts for somewhere between 20% and 40% the volume on the London Stock Exchange
London Stock Exchange
The London Stock Exchange is a stock exchange located in the City of London within the United Kingdom. , the Exchange had a market capitalisation of US$3.7495 trillion, making it the fourth-largest stock exchange in the world by this measurement...
(LSE). A number of people in the industry back the view that a third of all LSE volume is CFD related. The LSE does not monitor the numbers but the original 25% estimate as quoted by many people, appears to have come from a LSE spokesperson.
The CFD market most resembles the futures and options market, the major differences being:
- There is no expiry date, so no price decay;
- Trading is done off-exchange with CFD brokers or market makers (note exception with ASX discussed below);
- CFD contract is normally one to one with the underlying instrument;
- CFDs are not available to US residents;
- Minimum contract sizes are small, so it’s possible to buy one share CFD, low entry threshold;
- Easy to create new instruments, not restricted to exchange definitions or jurisdictional boundaries, very wide selection of underlying instruments can be traded.
Futures
FuturesFutures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
are preferred by professionals for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to Futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent. Futures contracts tend to see price decay near to the expiry date compared to the price of the underlying instrument which does not occur on the CFD as it never expires and simply mirrors the underlying instrument.
Futures are often used by the CFD providers to hedge their own positions and many CFDs are written over futures as futures prices are easily obtainable. CFDs don't have expiry dates so when a CFD is written over a futures contract the CFD contract has to deal with the futures contract expiry date. The industry practice is for the CFD provider to 'roll' the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry, thus creating a rolling CFD contract.
Options
OptionsOption (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, like futures are an established product, exchange traded and centrally cleared and used by professionals. Options like futures can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case, when options are used to speculate on markets. The main advantage of CFDs over options is the price simplicity and range of underlying instruments. Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument. CFDs cannot be used to reduce risk in the way that options can.
Covered warrants
Similar to options trading, covered warrantCovered warrant
In finance a covered warrant is a type of warrant that has been issued without an accompanying bond or equity...
have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products. In markets like Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, which may have been partially responsible for the decline in volume of covered warrant there.
ETFs
Exchange-traded fundExchange-traded fund
An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
s (ETFs) like CFDs can be used for short-term speculation, and are available over a wide variety of underlying products. In particular, indices, commodities and overseas markets, which have been seen as one of the strengths of CFDs. Also in the same way as CFDs, there are ETFs on customised groups of instruments such as sectors or baskets and an increasing number of ETFs are set up to use leverage. Compared to CFDs, ETFs are exchange-traded products and have been around longer and are a more mature product. Like other exchange-traded products, the costs are higher and access is via a traditional broker.
Physical shares, commodities and FX
This is the traditional way to trade financial markets, this requires a relationship with a broker in each country, require paying broker fees and commissions and dealing with settlement process for that product. With the advent of discount brokers, this has become easier and cheaper, but can still be challenging for retail traders particularly if trading in overseas markets. Without leverage this is capital intensive as all positions have to be fully funded. CFDs make it much easier to access global markets for much lower costs and much easier to move in and out of a position quickly. All forms of margin trading involve financing costs, in effect the cost of borrowing the money for the whole position. This is charged daily for all open positions and makes CFDs convenient if used under around 10 weeks, an estimated point where CFD financing charge exceeds financing charge for stocks, but more expensive for long term positions.Margin lending
Margin lending also known as margin buying or leveraged equities have all the same attributes as physical shares discussed earlier, but with the addition of leverage, which means like CFDs, futures, and options much less capital is required, but risks are increased. Since the advent of CFDs, many traders have moved from margin lending to CFD trading. The main benefits of CFD versus margin lending are that there are more underlying products, the margin rates are lower, and it is easy to go short. It can be difficult and expensive to short sell using physical shares and may not be possible at all, however it is just as easy to go short as to go long with a CFD. Even with the recent bans on short selling, CFD providers who have been able to hedge their book in other ways have allowed clients to continue to short sell those stocks.Exchange traded CFDs in Australia
The majority of CFDs are traded OTC using the direct market access (DMA) or market maker model, but in 2007 the Australian Securities ExchangeAustralian Securities Exchange
The Australian Securities Exchange was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006. It is the primary stock exchange group in Australia....
(ASX) introduced exchange traded CFDs. As a result a small percentage of CFDs are now traded through the Australian exchange.
The advantages and disadvantages of having an exchange traded CFD are similar for most financial products and mean reducing counterparty risk and increasing transparency but costs are higher.
Advantages
- Market Independence; the exchange has to make sure markets are fair, orderly, and transparent. ASX is independent of the parties with whom a customer receives advice and deals through. This separation of responsibility between broker and exchange provides customers with choice as to whom they wish to execute their business through and also means there is one standard contract specification for all ASX CFDs.
- Transparency; ASX reports on all ASX CFDs transacted, open positions, bid, offers and their volumes and ASX CFDs are traded in the same way as other ASX traded contracts. ASX CFDs are offered on a separate market with a separate book to that of physical stock trading on the ASX. When trading ASX CFDs, the customer's order is entered directly via a Participant into the ASX CFD central market order book. This order book is available for the market to see. All orders are executed on a strict price/time priority.
- Counterparty risk; all settlement obligations are cleared and guaranteed by SFE Clearing Corporation (SFECC) which has a statutory obligation to operate "fair and efficient" facilities. These are monitored by both Australian Securities and Investments CommissionAustralian Securities and Investments CommissionThe Australian Securities & Investments Commission is an independent Australian government body that acts as Australia's corporate regulator...
(ASIC) and the Reserve Bank of AustraliaReserve Bank of AustraliaThe Reserve Bank of Australia came into being on 14 January 1960 as Australia's central bank and banknote issuing authority, when the Reserve Bank Act 1959 removed the central banking functions from the Commonwealth Bank to it....
(RBA). The ASX claims this reduces counterparty risk as the payment is guaranteed by the exchange central clearer which has much larger capital reserves than any individual broker. By comparison, all over-the-counter CFD providers in Australia are required by law to hold an Australian Financial Services Licence issued by ASICAustralian Securities and Investments CommissionThe Australian Securities & Investments Commission is an independent Australian government body that acts as Australia's corporate regulator...
. This license includes the requirement to hold client funds in segregated accounts so that a company failure will limit the loss for clients. However CFD providers may still be able to access this money to cover their own margin requirements, and if this resulted in overall company loss or foreclosure, a traders deposit could still be at risk.
Disadvantages
- Higher costs; the exchange and the clearing house need to earn money and so charge fees as well as the broker. In addition the broker’s administration costs tend to be higher to comply with exchange and clearing requirements.
- Limited products; Australian Securities ExchangeAustralian Securities ExchangeThe Australian Securities Exchange was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006. It is the primary stock exchange group in Australia....
only offers a small number of CFDs, does not cover all physical shares on its own exchange and does not offer CFDs on shares from any other country. It does offer a small number of global indices and some currencies. In contrast, CFD providers typically offer CFDs on thousands of underlying products from all over the world, including shares from all major markets as well as all major indices, commodities, currencies and treasuries. Unlike the ASX CFDS, the flexibility and ease of creating a new CFD on any underlying traded instrument as well as not being limited to exchange definitions has been seen as one of the strengths of CFDs.
- Pricing; one side effect of the separate order book for CFDs on the exchange is that prices and spreads are based on CFDs orders only. This means that the price and spread of an ASX CFD can be different from that of its underlying instrument. In some instances, while the underlying instrument is liquid and heavily traded with a tight spread the ASX CFD based on that instrument may have little or no liquidity and a wider spread. The viability of trading will depend on the ASX attracting enough participants to its CFD products to create a liquid market.
The current disadvantages of the ASX exchange traded CFDs and lack of liquidity means that most Australian traders still opt for over-the-counter CFD providers. As of 2010, no other exchange has followed the ASX in creating listed CFDs.
Criticism
Some financial commentators and regulators have expressed concern about the way that CFDs are marketed at new and inexperienced traders by the CFD providers. In particular the way that the potential gains are advertised in a way that may not fully explain the risks involved. In anticipation and response to this concern most financial regulators that cover CFDs specify that risk warnings must be prominently displayed on all advertising, web sites and when new accounts are opened. For example the UKUnited Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
FSA
Financial Services Authority
The Financial Services Authority is a quasi-judicial body responsible for the regulation of the financial services industry in the United Kingdom. Its board is appointed by the Treasury and the organisation is structured as a company limited by guarantee and owned by the UK government. Its main...
rules for CFD providers include that they must assess the suitability of CFDs for each new client based on their experience and must provide a risk warning document to all new clients, based on a general template devised by the FSA. The Australian financial regulator ASIC
Australian Securities and Investments Commission
The Australian Securities & Investments Commission is an independent Australian government body that acts as Australia's corporate regulator...
on its trader information site suggests that trading CFDs is riskier than gambling on horses or going to a casino. It recommends that trading CFDs should be carried out by individuals who have extensive experience of trading, in particular during volatile markets and can afford losses that any trading system cannot avoid.
There has also been concern that CFDs are little more than gambling implying that most traders lose money trading CFDs. It is impossible to confirm what the average returns are from trading as no reliable statistics are available and CFD providers do not publish such information, however prices of CFDs are based on publicly available underlying instruments and odds are not stacked against traders as the CFD is simply the difference in underlying price.
There has also been some concern that CFD trading lacks transparency as it happens primarily over-the-counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
and that there is no standard contract. This has led some to suggest that CFD providers could exploit their clients. This topic appears regularly on trading forums, in particular when it comes to rules around executing stops, and liquidating positions in margin call. Although the incidence of these types of discussions may be due to traders' psychology where it is hard to internalise a losing trade and instead they try to find external source to blame. This is also something that the Australian Securities Exchange
Australian Securities Exchange
The Australian Securities Exchange was created by the merger of the Australian Stock Exchange and the Sydney Futures Exchange in July 2006. It is the primary stock exchange group in Australia....
, promoting their Australian exchange traded CFD and some of the CFD providers, promoting Direct Market Access
Direct Market Access
Direct market access ' is a term used in financial markets to describe electronic trading facilities that give investors wishing to trade in financial instruments a way to interact with the order book of an exchange. Normally, trading on the order book is restricted to broker-dealers and market...
products, have used to support their particular offering. They argue that their offering reduces this particular risk in some way. The counter argument is that there are many CFD providers and the industry is very competitive with over twenty CFD providers in the UK alone. If there were issues with one provider, clients could easily switch to another.
Some of the criticism surrounding CFD trading is connected with the CFD brokers' unwillingness to inform their users about the psychology involved in this kind of high-risk trading. Factors such as the fear of losing that translates into neutral and even losing positions and becomes a reality when the users change from a demonstration account to the real one; a fact not documented by the majority of CFD brokers.
Criticism has also been expressed about the way that some CFD providers hedge their own exposure and the conflict of interest that this could cause when they define the terms under which the CFD is traded. One article suggested that some CFD providers had been running positions against their clients based on client profiles, in the expectation that those clients would lose, and that this created a conflict of interest for the providers.
Bucket shops
CFDs, when offered by providers under the market maker model, have been compared to the bets sold by bucket shopsBucket shop (stock market)
As defined by the U.S. Supreme Court a Bucket shop is "[a]n establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain,...
, which flourished in the United States at the turn of the 20th century. These allowed speculators to place highly leveraged bets on stocks generally not backed or hedged by actual trades on an exchange, so the speculator was in effect betting against the house. Bucket shops, colorfully described in Jesse Livermore's semi-autobiographical "Reminiscences of a Stock Operator
Reminiscences of a Stock Operator
Reminiscences of a Stock Operator is a 1923 novel by American author Edwin Lefèvre which is the thinly disguised biography of Jesse Lauriston Livermore...
", are illegal in the United States according to criminal as well as securites law.
See also
- Derivative (finance)Derivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
- Financial Spread betting
- Leverage (finance)Leverage (finance)In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...
- Technical analysisTechnical analysisIn finance, technical analysis is security analysis discipline for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis incorporate technical analysis, which being an aspect of active management stands...
- Trader (finance)Trader (finance)A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...
- Day traderDay traderA day trader is a trader who buys and sells financial instruments within the same trading day such that all positions will usually be closed before the market close of the trading day. This trading style is called day trading...
- Futures contractFutures contractIn finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
- Option (finance)Option (finance)In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
:Category:Financial derivate trading companies
External links
- November 2007, Financial Services Authority, CFD Trading Regulations http://www.fsa.gov.uk/pubs/cp/cp07_20.pdf