Contracts For Difference (CFDs)

A Contract For Difference (CFD) is a contract between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price. This difference is then multiplied by the number of CFDs specified within the contract.

CFDs work in a similar way to traditional share dealing. Although CFDs replicate the price movement of the underlying share, you do not own the share. You are using CFDs as a flexible and cost-effective way to speculate on whether that share or investment will go up or down. It has been estimated that up to 30% of the daily volume on the London Stock Exchange stems from CFDs. CFDs allow investors to take long or short positions, and have no fixed expiry date or contract size.

CFDs can be used to reduce the risk of unexpected market movements. For example, you may have a long-term share portfolio which you want to keep, but you are worried that it may lose value in the short-term because you think markets are heading down. You can take out a CFD that will help mitigate the short term loss, and might assist you to make a long-term gain.

If you get the market direction right, this can mean bigger profits. However, if you get the market direction wrong, it can mean bigger losses. You should understand the concept of what is known as ‘margin trading’, as you could lose more money than your original deposit on a trade. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities, although this percentage is normally lower for liquid markets such as foreign exchange.

CFDs are currently available in listed and/or over-the-counter (OTC) markets in the United Kingdom, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, France and Spain. 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, owing to restrictions by the US Securities and Exchange Commission on OTC financial instruments.

History

CFDs were originally developed in the early 1990s in London. Based on equity swaps, they had the additional benefits of being traded on a margin and being exempt of stamp duty. 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. CFDs were initially used by hedge fund managers and institutional investors to offset their exposure to stocks on the London Stock Exchange in a cost-effective way.

In the late 1990s CFDs were first introduced to retail investors. They were made popular by a number of UK companies, typically those companies with online trading platforms that made it easy to see live prices and to trade in real time. Investors quickly realised that the real benefit of trading CFDs was not the tax exemption, 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 offering from just London Stock Exchange (LSE) shares to include most global stock exchanges, indices, commodities, treasuries and currencies. Trading index CFDs quickly became the most popular individual CFD.

The CFD providers started to expand to overseas markets and CFDs were introduced to Australia in 2002. At about the same time, a number of the CFD providers also introduced financial spread betting to the UK. This has a very similar economic effect as CFD trading but is, in effect, tax-free. This is specific to the UK tax environment and has not been replicated in other countries.

Charges

The contracts are subject to a daily financing charge, usually applied at a previously agreed rate above or below the London Interbank Offered Rate (LIBOR). Traditionally, CFDs are subject to a commission charge that is a percentage of the size of the position, usually <0.25%, for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a (usually) larger bid/offer spread on the instrument.

Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (ranging from 1% to 30% usually). One advantage to investors of not having to put up the full notional value of the CFD as collateral is that a given quantity of capital can control a larger position, thereby amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to margin calls in a downturn, which often leads to losing a substantial part of the assets.

As with many leveraged products, maximum exposure is not limited to the initial investment. These risks are mitigated through use of stop orders and other risk reduction strategies. For the most risk averse, guaranteed stop loss orders are available at the cost of an additional one-point premium on the position and/or an inflated commission on the trade.

If you have a holding of physical shares, you can sell CFDs against this without crystallising a potentially taxable capital gain. This enables you to control the time at which you crystallise capital gains or losses and may help reduce your tax liability.

Risk

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, and
• variable (which is then 'marked to market').

Initial margin is fixed at between 5% and 30% depending on the stock 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 5%, and, depending on the broker and the client's relationship with the firm, the deposit may be even lower. This information is important for all CFD traders to consider before they actively look to take positions, long or short in stocks.

Variable margin is never set as a simple percentage because it reflects the underlying movement of a stock's price. 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 variable margin (1,000 shares x -10p) from the client's account. As this adjustment is made in real-time as the market moves lower, it is called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in positive variable margin.

Variable 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.

Exchange Traded CFDs

Exchange Traded CFDs are a new form of CFD that will be traded through an exchange based mechanism. Current CFD providers focus either on the direct market access CFD or on market maker models. This new development was launched in November 2007 on the Australian Stock Exchange (ASX).

The ASX claims that their Exchange Traded CFDs will enjoy the traditional benefits of leverage enjoyed by OTC CFDs but with reduced transaction costs from the central counter clearing model negating the financing charges traditionally imposed by third party CFD providers.

Only accredited brokers will offer exchange traded CFDs and multiple market makers have been appointed to facilitate liquidity. No guarantees are given that there will be liquidity available, instead liquidity is dependent upon the market utilising differences between the underlying physical market and the corresponding CFD (arbitrage).

Comparison of conventional share trading and CFD trading for ABC plc

The return on initial investment from trading conventional shares is 2.9%.

This can be compared to the return of 30.3% using CFDs.

For more information, please contact us.