What Are Contracts For Difference (CFD's)?
CFD Trading – Contracts For Difference Explained
CFDs (Contracts For Difference) are one of the most widely traded instruments in the UK and European markets, increasing in popularity as traders worldwide become more familiar with what they are and how they can be used as part of a wider trading portfolio. Traded largely off-exchange, i.e. through a broker rather than on a stock exchange, CFDs provide inbuilt leverage for traders looking to ramp up earnings, and provide a more flexible tool for investing on the strength (or weakness) of long-term asset or index performance.
‘CFD’ stands for ‘contract for difference’, which means positions are effectively contracts with the broker instead of an acquisition of an asset. This is key as far as the tax treatment of contracts for difference is concerned, and gives rise to a number of the fundamental characteristics that make CFDs unique.
Unlike trading in shares, investing in contracts for difference doesn’t provide the trader with any direct, tangible asset, but rather is a contract similar in nature to futures which allows the trader to buy or sell an asset for the difference in spot price at some future point – the idea being that the trader opens the CFD when a security is likely to rise or fall in future, only to close the position at that future date and lock in a profit (or loss) accordingly.
The CFD can be closed at any point, and has a variable price relative to the underlying stock to which it pertains. In fact, depending on the exact type of broker you’re trading with, the price of the CFDs on offer may in fact directly track the underlying market price, with the broker effecting your contracts on the underlying market as a hedge against the risk of the broker’s liability for successful trades.
Example: How CFDs Work in Real World
So, where a CFD on Company X shares is priced at $1, it’s value might rise to $1.50 where projections take on a more favourable outlook for the future, and the trader can close his open position at any time to lock in any profit from the difference between the current price and the price of the contract for difference.
Detailed Trading Example
Here’s a full walkthrough of an example CFD transaction we’ve put together, to give you a flavour of the nature of the costs and considerations involved, along with a couple more worked examples below to help make planning your CFD investment strategy easier.
Say you identified an opportunity in XCorp shares and you want to take a long position. The shares are priced at 118p each and you have $5000 cash in your portfolio to invest. CFDs will be priced at the same rate as the price in the underlying cash market. In opening the trade you decide to invest $500 in XCorp CFDs, which is equal to a 5% margin (as an example, margin may vary) requirement for the transaction. The total size of the position would be, therefore $10,000 (when 95% of the transaction is leveraged funded).
At this stage, the broker will charge a commission portion on the transaction which covers the costs of their service. In our example, the commission rate applicable is 0.1%, although this figure naturally varies between different brokers, markets and CFDs. For your XCorp position, the commission payable would be $10 ($10,000 x 0.1%).
Your XCorp position is growing well, although the trading day is almost through. You decide to hold the position overnight, which incurs a financing charge to pay for the leverage sums tied up in the position. Assume XCorp shares closed up at 121p, and the rate of interest charged by the broker is 5%. The daily financing cost for the position is calculated by working out the total value of the position at market close ($10,254) and charging interest at the applicable annual rate then divided by 365. In this instance, the interest cost would amount to around $1.40.
At around lunchtime on day two, you decide XCorp shares have peaked in value, and it’s time for you to close out and bank a profit. Shares have risen to 124p, and your position is now worth $10,508. At the closing price, it is possible to work out the overall outcome of the trade by deducting the opening price and the leverage proportion along with any other costs to calculate profit.
Closing level – opening level =gross: $10,508-$10,000 = $508.
Less Commission + Interest = $508.00 – $11.40: = $496.60 profit.
Airlines look set to be affected by an announcement of a new environmental duty. Shares in FlyA, an already under performing company could be badly affected. You take a short position with shares valued at 82p worth $12,000 total transaction size.
The shares position closes at 81p on day 1 and 78p on day 2, at the end of which the position is closed.
Opening price: 82p
Total CFDs: 14634
Margin paid: $600
Commission: @0.1% = $12
Interest: Day 1 paid for short positions at 1% = ((14634 x 81p) x 1%)/365 = $0.32, Day 2 = ((14634 x 78p) x 1%)/365 = $0.31
Closing price: 78p
Closing position value: $11,414.52
Profit = Opening level less closing level less interest less commission = $12,000 – $11,414.52 – $12 – $0.63 = $572.85
This provides several key advantages over trading the underlying shares, including the ability to trade on margins which allows highly leveraged trading positions, and allows traders to see the benefits of dividend payments and company announcements without the tax drawbacks (not to mention the cash-flow implications) of actually buying the underlying securities.
CFDs are traditionally used by traders to capitalise on short term fluctuations, say over the course of a couple of days or weeks as most, where a trader can forecast either long or short positions as they deem appropriate. CFDs that tend to run longer very quickly become cost prohibitive as daily interest charges are applied, and the effect of this can be to render other profitable, far-sighted positions loss-making.
Key CFD Characteristics
Go Long or Short
Hedging with CFDs – Extra Advantage
But CFDs are also a particularly useful tool for traders looking to hedge against corresponding positions, and even have practical benefits for commodities traders looking to profit from a rise (or fall) in the price of a given market.
For example, a wheat supplier might take a long CFD position on wheat, in the knowledge that wheat prices will likely rise. Whereas the wheat supplier might be tempted to load up on wheat at today’s prices, this might not be feasible for reasons of freshness and cash flow – not to mention the costs of storing and monitoring excessive stock. As an alternative, taking out a CFD position allows the trader to capitalise on the rise in wheat prices on a leveraged basis, naturally amplifying the earnings potential of the transaction and providing a cleaner, more cost effective way of profiting from the growth in wheat prices.
As a result of this hedging potential, CFDs have found their way into some of the world’s largest institutional investment portfolios and hedge funds, providing a high-yielding investment vehicle through which other investment decisions can be offset.
Contracts for difference have a range of functions, and it is a particularly nuanced product that requires both prudence to minimise risk exposure and a solid working knowledge of the market for CFDs, not to mention the nature of the instrument. Nevertheless, as part of a diversified trading portfolio, CFDs can prove an excellent addition to other forms of trading, and can provide any portfolio with the flexibility to hedge, leverage and reap a tax advantage over trading the assets to which the contracts relate.
Contracts For Difference Summary
Contracts for difference have proven to be something of a boon for traders in recent years, providing an alternative leveraged product with a degree of flexibility and a preferential tax treatment to trading in shares. While contracts for difference are by no means an easy instrument to trade successfully, they do have a number of key benefits to bring to the table, and the possibilities with trading CFDs are limited only to the extent of your appetite for calculated risk and your ability to pick up on winning trends ahead of time.
But before we turn to the intricacies of CFD trading, and particular strategy options you can employ for greater consistency, it’s important to ensure a thorough understanding of CFDs at their most basic level – what they are, how they work, and how they piece-in to the overall trading picture.
How Are CFD’s Traded?
Contracts for difference are essentially contracts made between a trader and a broker that create an obligation to settle on the difference between the current price of an asset or index and the price stipulated on the contract at its point of formation. In more simple terms, a CFD is an agreement to pay or receive the difference in price from the point at which the agreement was made to the point at which you decide to close out – hopefully banking a profit in the middle-ground, providing markets move in your favour.
The contracts themselves are traded, rather than the instruments to which they relate. So, for example, a contract for difference on BP shares doesn’t actually involve the acquisition of any BP securities, and you receive none of the corresponding shareholder rights and responsibilities by entering the position – the contract is merely derived from the underlying security, responding in value to factors affecting the underlying asset price.
CFDs are generally traded off-exchange, and are fundamentally margined products. This means they allow traders to invest in positions more heavily than their available capital would allow, making up the difference in short-term financing provided by the broker. While this naturally incurs higher transaction costs, it gives the trader the opportunity to augment any winnings and ramp up the earnings potential of any given trade.
Sell or Buy
As a trader, you will be offered CFDs with both long and short positions, allowing the flexibility to either back a winner or piggyback a loser depending on market and economic indicators. You either buy a CFD in anticipation of a rising index level (“go long”), or sell a CFD if you expect markets to fall (“go short”), ideally closing out when you’re in a position to lock in a profit in either direction. With leverage on your side, the difference payable can often far outstrip the PIP (“percentage in points”) increase in value of your CFDs, thus even small price movements can create significant changes to the value of a holding.
Unlimited Range of Markets
CFDs trade on a wide variety of bases, and have grown to become increasingly widely utilised by more savvy traders. From securities to commodities, from forex to just about any index you can think of, contracts for difference are traded on the same basic principles, and you’re really only limited to trading on the bases offered by your CFD broker. While most brokers offer comprehensive coverage of the most commonly traded CFD bases, it is perhaps worthwhile to shop around before signing up to find a broker with the widest selection of contracts on offer.
Compared to dealing in shares, CFDs can be a great way to take advantage of more predictable market movements, and brings both profit and tax advantages to the table. Because CFDs are highly leveraged, the profit potential is often greater than 20 times more when trading CFDs, and for those looking to trade on indexes lower margin requirements make even greater multiples a realistic possibility. Furthermore, with no stamp duty applicable on CFD trades, there is a potentially significant saving to be had for larger scale investments.
Conclusion and Risk Warning
Of course, CFDs are not without their fair share of risks, and some would argue that CFDs present a greater risk profile than many other tradable instruments. By virtue of employing leverage, losses are multiplied in equal proportion to upside gains, and as a consequence traders are not automatically limited in liability to their investment. This often requires additional deposits to cover margin requirements and prevent early closures of otherwise profitable positions, and without due prudence and caution losses can become significant.
Having said that, CFDs nevertheless offer traders a flexible alternative to other trading instruments, and once the basics are understood, they can prove a valuable additional tool in building a sustainable, profitable trading portfolio.