Contracts for Difference or CFD’s
What are CFD’s?
I had planned on doing a post on CFD’s in the near future as part of a series on the many products available to traders, however I have moved this forward in response to a comment made on this blog asking to explain what CFD’s are. Brian did give a response but asked me to expand on it for the benefit of all.
The term CFD stands for Contract for Difference, and it is essentially a contract between you and another party (the provider), where by you settle the difference between the purchase price and sale price of the contract. If your sale price happens to be higher than your purchase price you make money, likewise, if your sale price is lower than your purchase price, you will lose money.
CFD’s mirror the performance of an underlying asset such as shares, commodities, or an index, and so if the underlying asset does not exist, nor can the CFD, and thus they are referred to as derivatives. One of the benefits then of CFD’s is that you can control an asset without taking physical ownership of it (such as shares of a company).
CFD’s operate in a similar fashion to margin loans, i.e. they trade on margin. The trader pays an initial margin, which can vary typically from 5 - 20%, depending on the underlying asset and the provider, which enables them to gear their holdings and control more assets for less capital.
The other side of the contract, the CFD ‘provider’ is the counterparty to the trade. They provide the contract. If you carry a CFD long overnight, the provider will charge you a financing cost (normally 2% above overnight cash rate), and if you carry a short overnight you may receive a financing cost (normally 2% less than the overnight cash rate).
CFD’s are currently over-the-counter (OTC) products and therefore the details of the contract (such as margin requirement, financing rates) are specific to the providers and the clients (much like warrants), unlike exchange traded options which have a standardized and regulated system such as that provided by the ASX (the ASX controls the specifics of exchange traded options such as exercise price and so on).
CFD’s first appeared in Australia in 2002; however they have been widely used in the UK for many years. Currently, they are forbidden in the US and Canada.
Apart from being used to speculate on the markets through the use of gearing, they are also used as a hedging tool. For example, someone who owns a large portfolio of blue chip shares who believes the stock market is ripe for a large correction, will need to protect their capital, however to offload some or all of their portfolio, will incur large brokerage fees. To counter this, the investor may decide to short sell CFD’s in either the shares they own, or even the major ASX index. The cost of doing this is far less than selling their current portfolio. If indeed the stock market does correct and the investor feels the correction is over, they can close their CFD’s for a profit, offsetting the capital loss to their blue chip shares.
Other benefits to CFD’s are that they do not suffer from time decay, nor are they as complex as other derivatives such as options and futures. Going short is extremely easy and you will receive interest on shorts held overnight. You will also receive dividends and stock splits just as you would if you owned the underlying shares (however you are not entitled to voting rights).
Risks involved in CFD’s are that they are highly geared, and unlike options where the most you can lose is the initial outlay, you can lose far more than this with CFD’s. They are similar to a home loan, where if you owed a bank a $200,000 mortgage and had to sell your house for say $150,000 (for whatever reason, such as a market downturn, or the house has been run down), then you will still owe the bank $50,000. CFD’s are the same; if you are holding a losing position and the difference between the purchase price of your contract, and the current value exceeds your initial outlay, then you will need to find this difference from somewhere (although providers normally have systems in place to alert you to such possibilities before they get dangerously out of hand by not allowing you to leverage out your whole account balance).
Other risks involved can be with the provider themselves, such as they may have poor financials and can not meet their obligations; this could result in significant losses to the investor. There can also be timing issues, such as delays in responding to your requests or trades, and also pricing issues which we’ll discuss next.
There are two models offered by CFD providers, and they are the market-maker model, and the direct market access model.
The direct market access model is where the provider uses the ASX trading platform, and as such give you the exact prices as those quoted in the market place. They hold the positions in the market place and you hold the CFD. The process is: Client makes an order with the provider to purchase a CFD, the CFD provider holds the position in the underlying asset through the ASX.
The market-maker model is where the provider creates their own bid and ask price, and as such, make the market. The idea is that the prices quoted are supposed to mirror the underlying market, but this is not always the case. If you purchase a CFD through a market maker, you are accepting their quoted prices and not those quoted on the ASX. Providers using this method will either take on the risk of a position themselves, or hedge by taking a position in the underlying market.
CFD’s are an extremely handy tool and as such should be a part of all traders knowledge base at least, even if you do not plan to trade them right now. CFD’s are becoming so common now that trading such things as Gold, Oil and other commodities are all too easy. The biggest risk in my view is not being aware of the inherent dangers that CFD’s possess, and like any financial product, they require respect. Used wisely, they can serve you well.
Note: Readers of posts will vary in trading experience. For example, some will understand the term ’shorting’ and other’s will not. Rather than explaining every term as if every reader is a complete novice, it is better to explain things as we understand them and then answer questions should they arise. If you don’t understand something that is posted, please ask, as it is guaranteed other’s may have similar questions.
Happy Trading
Dean Whittingham
Elite Insiders Group - Trading Systems
Financial Market Fisherman © 2004 - 2007
