CFD Overview
From 123CFD
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[edit] Introduction
A contract for difference (or CFD) is a contract between two parties, buyer and seller, stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.) Such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares
Contracts for differences allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.
CFDs are currently available in listed and/or over-the-counter markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand and most recently Sweden. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future. CFDs are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments.
[edit] History
[edit] In the beginning
Contracts for Difference originated in the 1980s within the institutional environment. The term back then was 'equity swap' and was created for large financial institution's and banks to hedge their share positions. These trades were costly and required a high level of administration, making them unattractive to retail traders.
Since 1999, CFD trading has been available to retail investors, first spawning in the UK then flowing across the rest of Europe, and now, the world.
[edit] Popularity
There are a few different takes on 'why' the popularity of CFDs has dramatically increased over the past decade, while I am not sure which of the following have the greatest weight in this growth, I know they were all key contributors.
The UK Financial Services Act which came into effect in 1988 was the beginning. This encouraged individuals to take up private ownership of shares and drew a large number of people to the financial markets. Suddenly everyone had the ability to own a piece of the pie. The constantly moving numbers of the companies and indices on the exchange gave birth to a whole new breed of speculative traders and then, full blown gamblers. The complexity of the stock market meant it was not suited to all types of gamblers, thus spread betting firms started to specialize. Some of these firms converted into the CFD brokers we have today and they brought their customer base with them.
Since the first CFD brokers birth in 1999 their popularity has skyrocketed. Initial interest grew in the UK as traders buzzing with excitement of the stock boom looking to avoid stamp duty turned to CFDs. CFDs continued to grow with the introduction of short positions allowing users to make money on the falling markets and/or hedge their existing portfolios for a margin of the cost.
But possibly the largest key contributer to CFDs has been technology, namely the internet. With the introduction of live remote prices and online brokers, CFD trading became possible from home. Due to the short term positions of CFDs and the high margins, speed to market, accurate prices and systems are vital for successful CFD trading. The internet was the platform to deliver these.
[edit] The present
Now CFDs are used world wide by all levels of traders and are growing at an exponential rate! While they are still illegal in the US, many US investors are turning to the European and Australian brokers as they still allow trading on US stocks.
[edit] Leverage
One of the most attractive aspects of trading CFDs is the easily available access to leverage. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. CFDs use the power of leverage to trade which is one of the key reason they are such a powerful tool. CFDs are collateral financed, meaning you only need an initial margin of 1-30% of the total value of the trade to enter the position.
[edit] Examples
This means if you wish to enter a position of 1000 BHP Shares at $35 each, usually you would need to front $35,000. Using CFDs, trading on a 5% margin, you would only need an initial deposit of $1,750.
An example is the easiest way to show the power of leverage.
If you had $1,750 to invest, and wished to purchase BHP at $35 and sell at $37, a standard trade would look as follows:
BUY: 50 x $35 = $1,750
SELL: 50 x $37 = $1,850
PROFIT = $100 or 5.7%
Using the power of leverage the above example reads as follows:
BUY: 1000 x $35 = $1,750 (5% deposit) + $33,250 (95% borrowed funds)
SELL: 1000 x $37 = $37,000
PROFIT = $2000 or 114%
As you can see the profit received after using leverage was far greater than without. It is important to note, that losses are also magnified when using leverage.
[edit] CFD Providers
While the price of a CFD mimics the undying asset it follows, transactions using CFDs can be VERY different to purchasing the asset itself.
[edit] CFD Broker as the Market Maker
A market maker is a person or a firm who quotes both a buy and a sell price in a financial instrument or commodity, hoping to make a profit on the turn or the bid/offer spread.
In foreign exchange trading, where most deals are conducted OTC, and are therefore completely virtual, the market maker sells to and buys from its clients. Hence, the client's loss is the company's profit and vice versa. Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets.
Most stock exchanges operate on a matched bargain or order driven basis. In such a system there are no designated or official market makers but market makers nevertheless exist. When a buyer's bid meets a seller's offer (or vice versa) the stock exchange's matching system will decide that a deal has been executed.
Most CFD Brokers are Market Makers, but some just provide a portal or access point to these Market Makers making them plain old CFD Brokers.
When trading CFDs your broker becomes the market maker by creating a Synthetic Market. This ensures that all of your Buy/Sell orders are guaranteed at the requested price, theoretically creating infinite liquidity. Sounds pretty sweet right? While high liquidity is one of the large benefits of CFDs it does come at a price, The Spread. Since CFDs trade on a Synthetic Market, that has minimal regulation and costs they are defined as an Over The Counter product. You cannot move CFDs between brokers, transfer them from funds to trusts or even to other people as they are a contract between you and your broker and that contract says that you can only sell that CFD back to the broker you purchased it from.
This gives brokers the enormous power of spread control, something that they can use to create large profits for themselves (by offering larger spreads than the underlying market). In the nature of turning a profit (in the long run) this is however a financially unsound move for the brokers as smaller (tighter) spreads attract more customers, which in turn earn the broker more dollars. You will usually find that the most prominent brokers will offer a tight bid/ask spread in order to retain their customers.
[edit] Synthetic Pricing
Synthetic Pricing relates to how your CFD broker creates the bid/ask spread for any particular CFD. This will usually start with the broker examining the underlying asset then placing the policies or rules it has determined and pricing them into the spread (see below for Costs of the Spread).
[edit] Direct Market Access
Direct Market Access (DMA) pricing is quickly becoming the most popular form of CFD pricing (if it isn't already). With traders seeking fairer pricing the the form of tighter bid/ask spreads and the increasing competition between CFD brokers, DMA pricing has prevailed among most CFD Brokers.
When using DMA pricing, a broker promises to deliver a bid/ask spread identical to that of the underlying market. This gives many advantages including the ability to participate within a real electronic order-driven market and gain access to the grey market. The largest limiting factor of DMA trading is the liquidity provided (which also mimics that of the underlying market).
The other advantage of DMA trading is that it ensures a delta of 1. A phenomena rarely experience with other derivatives (and synthetically priced CFDs).
DMA Trading is usually more costly to the trader in terms of commission and monthly access fees, but the savings that can be made from the controlled spreads usually makes up for the additional fees.
[edit] Exchange Traded CFDs
While not operational yet, the ASX is looking to launch the first Exchange Traded CFD Market in the world in late September. See the future(below) for full details.
[edit] Costs of Trading
I am sure most of you are aware that rarely do you receive 'something for nothing' and CFD brokers are a prime example of the invalidity of this phrase.
[edit] Platform Fees
Some brokers will charge a monthly fee to use their CFD Platform. Some will only charge for use of their research information, while some will provide free access to their platform. Differences in the volume, type and size of your trades, will determine what broker to choose. Usually free brokers will have looser bid/ask spreads, so a comparison between brokers is essential before choosing a platform.
[edit] Commission
Most CFD Providers will charge a commission on trades, this usually ranges from 0.1%-0.5% plus a minimum fee for smaller trades ($5 or $10). This is considerably cheaper than most securities brokers and is well deserved to. With minimal regulation and only one transaction (between you and your provided) costs are minimal as opposed to trading a stock where it must pass through a large electronic exchange and audit stream in order to change hands.
Some brokers offer 'commission free' trades, but there are usually hidden costs as can be seen below.
[edit] The Spread
The Spread can become costly when trading on a Synthetic Market with Synthetically priced CFDs. Synthetic Pricing relates to how your CFD broker creates the bid/ask spread for any particular CFD. This will usually start with the broker examining the underlying asset then running it through a predetermined system of policies and rules to output an inflated spread. For instance, if the underlying ask price of a stock is $20.00 (on the securities exchange) your broker may choose to sell it to you at a price of $20.05. This is a fairly simple concept to understand but it is easy to see the costs that can add up over time. If the broker makes $0.05 on every CFD you purchase, a position of 1000 shares will equate to $50. If you add commission of 0.01% on top you are looking at $60 in costs as opposed to $10. Most brokers aim to provide a tight bid/ask spread and DMA providers provide a perfect spread increasing the fairness to traders.
Be warned, this is how the 'commission free' brokers make their money. They provide a loose bid/ask spread, charging you every time you enter or exit a position (relative to the underlying market) which can equate to much higher fees than the commission charging brokers.
[edit] Financing
Since CFDs trade on a margin, you are borrowing money to complete the trade. Now we all know borrowing money isn't free, as is the case with CFDs.
The difference with CFDs is that you can avoid financing by getting out of the trade in the same day as finance charges only occur on positions held over night. Since CFDs usually trade on 100% borrowed money (as the margin is merely a deposit on the loan) positions held over night are charged accordingly. Financing on CFDs is usually calculated at a few percentage points above (for long positions) or below (for short positions) as the countries underlying cash rate. Thus if the cash rate is 5.5%pa you will usually be paying 7.5%pa for long positions and earning 3.5%pa for short positions.
Going long will incur a financing charge calculated at the 'discount rate/365 days' (0.075/365) which is charged daily in cash.
If you short sell a position, you earn interest over night which uses the same calculation bar a cheaper rate (0.035).
[edit] Dividends
Dividends are payments made by a company to its shareholders. When a company earns a profit, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders of the company as a dividend. Paying dividends is not an expense; rather, it is the division of an asset among shareholders. Many companies retain a portion of their earnings and pay the remainder as a dividend. Publicly-traded companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one.
Dividends are usually settled on a cash basis, as a payment from the company to the customer. They can also take the form of shares in the company (either newly-created shares or existing shares bought in the market), and many companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.
Since owning a CFD is practically identical to owning the actual share, you are also entitled to dividends as per the share holders above. The major difference is that all dividends are cleared in cash, there are no reinvestment schemes or any other sort of substitute available.
- Dividends are paid in cash into your CFD account if holding a long position.
- In short selling, the opposite happens, and you are required to pay the dividends. These are taken out of your account in cash.
[edit] Types
Since a CFD is basically a punt on the future value of an asset, it can (theoretically) be created on the underlying price of any asset. However there are many assets that are too hard or costly to price and/or don’t move quickly enough to be financially viable which is why most CFD providers will provide a standard set of instruments to trade. This standard can vary greatly or slightly depending on the broker you choose and their trading policies but there is slight standardization between the different brokers. Please see the CFD Types page for a full overview on the different types of CFDs provided by most brokers.
[edit] CFDs vs other Derivatives
[edit] CFDs VS Futures
Futures are another form of derivative, while inconsistent in specifics across the world’s exchanges they are still a highly traded product and hold many similarities to CFDs. In layman’s terms a future is typically a contract set in place to purchase an asset, in the future, at a set price. Futures can be created on almost any asset, just like a CFD. The most commonly found form of Futures are Equity (Share) Futures. There are 3 main differences between futures and CFDs these being, liquidity, expiry dates and financing costs.
Liquidity is an issue for almost all futures markets bar OneChicargo (the largest US based futures exchange). They have become infamous for slippages on price and bad execution. This is a direct result of the poor liquidity found in their underlying market (eg the SFE). Since futures are an exchange traded product, they require a buyer and seller for every transaction, if there is no counter partner to fill the order it is up to the market maker to step in and fill the order. Since market makers cannot easily accumulate or dispose of their net positions (due to the small amount of transactions on the exchange) they have to offer wider spreads to traders in order to stay in business. The larger spread causes more volatile movements in the price of the derivative thus more slippage and lower profits.
CFDs on the other hand have an almost infinite amount of liquidity. Since they are not an exchange traded product, you are guaranteed to fill your order at the requested price by your provider. Not to say slippage doesn’t occur, it can be a big problem, but this is usually due to the synthetic price determination of the market maker (see above), not due to the lack of participants. And since providers are pressured by customers to provider tighter spreads, this is becoming less of an issue for CFD traders.
Expiry Dates are another big difference CFDs have to futures. Expiry dates exist on futures because in the traditional sense, this is the date that the asset has to be delivered and the agreed price. Since most futures contracts are closed out before the expiry date occurs, the asset doesn’t physically get delivered but technically there is still one in place. This supports the financial markets and allows people who actually want to own the share (or other asset) the ability to obtain it.
CFDs are priced as daily contracts that roll over every night. So if the decision to hold the CFD over night is made, the position is closed, financing, dividends and other charges/distributions are paid out and the position is rolled into the next day as a new holding
Financing is the third differentiator to of Futures and CFDs. CFD financing has been covered above and as discussed is paid in cash on all holdings held over night. Since futures are leveraged product, financing costs are inevitable. The difference with futures is that the financing cost is calculated into the price of the future and is represented in the difference in the price of the future against its underlying asset; this cost is referred to as the ‘cost of carry’. This cost of carry is usually determined by a premium or discount rate of 1 or 2 percent above or below the central banks underlying cash rate.
[edit] CFDs VS Options
There are two similarities between options and CFDs. The first is they both provide leverage to the trader. Secondly, both derivatives allow the trader to participate in the downside of the falling markets by taking a short position. This is where the similarities end.
Option prices are derived from different components, many more than a CFD. The most important being the price of the underlying share (as with CFDs), but also by volatility, time to expiry, prevalent interest rate and supply and demand factors. The number and complexity of price indicators that options can demonstrate creates a lack of transparency in their pricing. The formula for correctly pricing options was awarded with a Nobel Price! No easy feat, adding credibility to the complexity of the instrument. With this noted, it is easy to see that the price of an option can significantly vary to that of its underlying asset.
CFDs have a much closer relationship with the price of their underlying asset. This means that analysis and valuation of your CFD portfolio can be done through examining the market of its underlying asset (eg stock). Information on listed shares is more widely available and analysis is plentiful and thorough.
Simply put, the complexity of options pricing means they are priced as their own instrument and trading them means learning many new indicators. Since CFDs mimic the stock they are following, there is little information beyond standard stock market analysis that is required to trade them.
[edit] CFDs VS Warrants
Warrants are simply long dated options issued by a market maker. There is limitations surrounding short selling and the price is very unpredictable.
Warrants are similar to CFDs in that they are not transferable between providers. If you bought a Macquarie Bank Warrant, you have to sell it back to Macquarie bank. Otherwise their pricing complexity is similar to that of options.
[edit] CFDs VS Shares
Owning a CFD is very similar to owning a share. Its like owning the share without actually owning the share. You get most of the benefits such as capital gains and dividends besides a few such as voting rights. CFDs however give you access to a long list of options that shares do not such as the ability to go short, trade on a margin, to sell on a down-tick, low commissions, no stamp duty or GST plus other tax exemptions and the ability to trade all types of securities.
[edit] The Future
The fastest-growing financial sector at the moment is leveraged share trading. There have been a multitude of products introduced in recent times including some of the above. Other products include Margin and/or Trading Loans. CFDs have however been the driving product behind this statistic for the last 5 odd years.
[edit] Exchange Traded CFDs
The SFE (Sydney Futures Exchange), now owned by the ASX is at the back end of a new instrument named Exchange Traded CFDs. This idea is so good that there is speculation many other exchanges around the globe are seeking to implement a similar system. The SFE is set to launch the worlds first CFD market of this kind in late September and already has most of Australia’s largest market participants lining up for a piece of the action.
Basically the goal is to create a regulated market for trading CFDs, where individual trades are monitored by an authorized government body. The ultimate purpose for this type of market is perfect transparency. The simple workings of exchange traded CFDs are that the broker or provider is required to hedge every CFD transaction by actually purchasing the shares on the market its self. This will give perfect synchronization between the CFD traders and the price movements of the underlying exchange. Essentially, Exchange Traded CFDs aim to include all the desirable components we associate with stock exchanges along with all the desirable components associated with trading CFDs.
