Tag: Misc

Contracts for difference come in a variety of different types, broadly classified into three categories: unlisted, listed and exchange traded. Each has its own distinct properties, and depending on your trading preferences will be more or less suited to your requirements. We’ve broken down the three most significant classifications below to give you an idea of what each has to offer, to help better inform your trading decisions.

Unlisted CFDs

By far and a way the most common type of contracts for difference, unlisted CFDs are those of which we traditionally know as CFDs – that is, broker traded, off-exchange instruments exchangeable for the difference in price between the point the contract is formed and the point at which the position is closed. Unlisted CFDs are facilitated by the broker, and are essentially agreements with the broker, providing both unlimited upside gains and unlimited losses (without the interplay of stops). As the name suggests, unlisted CFDs are not listed on any stock exchange or openly traded market, with different brokers offering different products accordingly.

Listed CFDs

By contrast, it is also possible to trade listed CFDs, which differ in a number of key points. Primarily, listed CFDs are listed on a public market and thereby supervised by the relevant stock exchange. Listed CFDs are tradable by the public on both a primary and secondary basis, and are therefore distinct from unlisted, broker-trader CFDs. In practice, this means that while transactions are still conducted through a broker, and there is very little in the way of noticeable difference from trade to trade, deals are actually being facilitated by the broker rather than being made with the broker.

This function provides a further benefit for traders, in the form of a limited downside exposure. Unlike unlisted CFDs, which traders are required to fund to the extent to which positions are negative, listed CFDs are purchased in the same way as shares, with an automatic and free guaranteed stop which puts a cap on the liability of the position at the total initial investment. This effectively removes the major disadvantage of trading unlisted CFDs, whilst still providing the leverage and the same style of trading instrument.

Exchange Traded CFDs

A third type of contract for difference, albeit less widely available than the preceding two, is the exchange traded CFD. Exchange traded CFDs are traded publicly like listed CFDs, but benefit from a greater degree of transparency and enhanced accountability that comes with the oversight of a regulated stock exchange. Additionally, because exchanges are more sizeable than most third party CFD brokers and regulated with far more scrutiny than any broker on the planet, the chances of encountering an illegitimate trader or unfair terms of business are far slimmer.

Every different type of contract for difference has its own advantages, and depending on your specific trading level, appetite for risk and price-sensitivity, you may be more suited to one particular type. As a result, it is advisable that you look into the different options when deciding how to invest, and potentially consider diversifying your trading as you start to become more experienced to account for a wider cross-section of trading instruments.

Introduction of Contracts For Difference – How Did CFD Trading Start?

Like most derivative instruments, CFDs are a comparatively recent innovation that was brought into life to fill a custom gap in the trading market, and to better meet the needs of particular given investment clients.

Since its inception as an instrument, the humble Contract For Difference has become a staple trading product for investors and traders across the world and of all different levels, scaling the full spectrum from single, private investors to hedge funds and institutions managing billions. The characteristics of CFDs are distinctive, and their uses well defined, but how exactly did they come into being, and what is the back-story to this now globally popular instrument?

CFDs are a product of City investment houses, and are generally considered to be the creation of employees of one of the City’s most recognisable derivative brokers at the time. The contract for difference was conceived in the 90s, designed by a latter-day subsidiary of Merrill Lynch to provide a more feasible means of leveraged shorting – i.e. selling shares on credit which would later be bought back to be sold at the entry price of the trade, with the advantage of a highly leveraged framework to amplify gains from incremental market movements.

Key Characteristic of CFDs

After their creation, CFDs then became a component of a number of investment banking deals, providing a means of avoiding the stamp duty liability of share transactions whilst still creating effectually the same outcome. The hostile takeover bid for Trafalgar House plc launched by financiers Brian Keelan and Jon Wood was credited as one of the first to apply the contract for difference to those situations, paving the way for many more similarly constructed deals over the coming twenty years.

The launch of CFDs to a retail investor audience came just a few years later, to limited initial success as investors got to grips with the function and the role of this altogether new instrument. While bearing some resemblance to futures contracts, CFDs presented traders with a range of new functionality they could apply, and the practical blueprints provided by City finance houses in funding high profile deals paved the way towards a greater understanding of the role of CFDs in the average investment portfolio.

As the decade progressed, the contract for difference lent itself to a number of other commercial situations, with a clear tax advantage making it an essential tool for the hedge fund era of hedged, leveraged, derivative investment. But it was only at the turn of the 21st century that CFDs really took off as a private instrument, with the Internet permitting greater and easier access to the markets, knowledge and brokeriing platforms and the wider realisation that leverage could prove the key to successful trading.

Growth of CFD Trading

As derivatives became a more fashionable choice for investors, CFDs rode the wave to become one of the largest instrument classes traded today, with many tens of thousands of traders around the world holding open positions at any one time.

While CFDs may not have had a long and distinguished history, they have come a long way in a short time. Initially conceived as a financing tool to M&A; and takeover activity, CFDs gradually moved into the retail investment space to give traders an alternative instrument with a high margin component to optimise the profits from any single position.

As CFDs continue to develop and brokers introduce new innovations in the marketplace, CFDs as an instrument look set only to play a more crucial role than at present in the future of private and institutional trading.

One of the advantages of CFDs over regular share trading is the comparatively favourable tax treatment of the former, providing traders with a more cost-effective way to invest. While the tax treatment of contracts for difference is naturally variable from jurisdiction to jurisdiction, the UK makes special provisions for CFDs as a result of certain of their characteristics, ensuring the trading model falls outwith the parameters of certain otherwise chargeable taxes.

Just like trading in shares, disposal of contracts for difference will attract capital gains tax liability to the extent to which any profits exceed the annual exemption. Bear in mind that capital gains tax is a complicated tax, with a variety of reliefs that may come in to play beyond the annual exemption amount, and so for more significant disposals it may be well worth seeking professional advice on the tax treatment, and any means by which capital gains tax liability can be minimised.

Avoid Stamp Duty with Contracts For Difference

Where contracts for difference differ from the trading of shares is in stamp duty liability. Stamp duty is charged on share transactions at a rate of 0.5%, and unless you’ve got a keen eye you won’t even be aware it’s being deducted when trading through an online broker until you notice the corresponding dent in your trading account. When trading in CFDs, stamp duty is not applicable, given that is only related to the buying and selling of land and shares – CFDs being derivative, intangible instruments do not attract liability to this form of tax.

While this does present a saving of 0.5%, it doesn’t necessarily mean CFDs are always destined to be the most profitable way to invest. For example, if you were looking to establish a long position in Company X over a number of years, you might be tempted to think that CFDs are the way to go to avoid paying stamp duty – in actuality, paying the 0.5% duty and investing pound-for-pound will circumvent the need for high interest and financing costs, which will in this case more often than not prove prohibitive for the investor.

CFD Trading Tax Flexibilities

Another key benefit of trading CFDs which makes them a vital tool to have in your locker is their flexibility, which presents a variety of options for legitimately managing your exposure to taxation. One of the most commonly witnessed examples of this pertains to so-called ‘bed and breakfasting’ – the illegal process of offloading assets at the end of one tax year only to instantly buy them back the next with a view to capitalising on allowances and exemptions on both sides of the financial year.

Provisions put in place to stop bed and breakfasting require that any shares reacquired in the 30 days following their disposal be treated as having never been disposed for tax purposes – however, clever management of CFDs can create the same tax saving effect without contravening the law.

When the positions are offloaded, simply opening positions to tie in the current market price with contracts for difference will guarantee you the ability to regain your shares at a future point outside of the 30-day period, thus allowing you to circumvent the tax liability you would otherwise face.

While these represent but a few brief examples of the taxation angle to CFDs, it is hoped that the flexibility and malleability of CFDs as a trading tool can be applied in creative ways to minimise tax exposure and reduce the likelihood of significant tax liability on any particular trade.

Whenever you are engaging in transactional activity, it’s important to have a think about the tax consequences of your actions. While a trade might look juicy in prospect, understanding the impact of tax is critical to accurate forecasting and remaining in compliance with the law. Fortunately, the savvy trader is able to take advantage of provisions in the tax statutes that allow for certain reliefs and discounts to be factored in to the annual trading tax bill. But firstly, it’s important to understand exactly how CFDs are taxed and what liability you may be opening yourself up to face.

Holding positions in CFDs relative to the shares in an underlying company are preferred by many traders as a cleaner, more tax-friendly way of backing a company that shows signs of promise. Because CFDs trade on the basis of shares, but transfer no rights and responsibilities to the holder, they are less involved than shares, and fundamentally more straightforward instruments. One of the drawbacks of non-entitlement to shareholder rights is the situation regarding dividends, and without some specific treatment by CFD brokers this can lead to an obvious imbalance in the pricing of the contracts they offer.

A dividend is a payment made to shareholders from a declared dividend fund, paid out on a per-share basis from a portion of the net profits after tax and retained sums.

As a shareholder, dividends are declared and paid to you by the company, offering a residual yield and building in some value in actually owning shares. But for holders of contracts for difference, which may very well pertain to the shares of the very same company declaring a dividend, how is this apparent anomaly rectified?

Dividend Payments and Contracts For Difference

It would seem particularly harsh on traders if dividend payments made no impact on the value of their contracts, and at any rate that wouldn’t be a true reflection of the value of their positions. The inherent value of an asset increases when it has a proven and demonstrable yield, and any company that finds itself in a position to declare a dividend is usually doing so off the back of a highly profitable, strong trading year. Therefore the very presence of a declared dividend is sufficient to increase the value of the shares in the relevant company, and all instruments and trading assets derived from those shares.

For traders holding long CFD positions at the time of a dividend declaration, the situation is rectified by the broker factoring in the additional value of the dividend into the value of the CFDs, often at a rate less than 100% of the declared dividend value. This effectively ensures CFD holders benefit from the declaration of the dividend as they should, without any recourse to claim the dividend from the company.

It is important also to note that dividend declarations are also paid on short positions, and (unsurprisingly) brokers tend to do so at no less than 100% of the dividend amount. When taken into consideration, a paid dividend on a short position is actually a subtraction in value, given that you’re anticipating a fall in value, and so it pays to be on top of when dividends are likely to be announced to ensure you don’t get caught up as a result of a hefty payout.

Other Corporate Action Effects

Likewise, with other corporate actions (such as, for example, a rights issue), the trader is open to receiving the benefits and drawbacks of the decision where otherwise without ownership they might expect to be cut out of the loop. In order to consistently reflect the true value of the underlying assets to which they relate, CFD brokers take steps to ensure every corporate action that bears on shareholders also bears on CFD traders, so it’s important to make sure you’re on the ball when it comes to leaving open positions ahead of corporate announcements.