Where did CFDs come from, and why the Weird Name?

Dear Trader is my attempt to respond to the many users of this website who have been writing me with general questions about contracts for differences. Since I thought some of them might be of interest to our visitors I'm publishing the answers here:

Q.: Where did CFDs come from, and why the weird name?

A: A CFD is a 'Contract for Difference'. CFD's are a derivative product that were created in the UK. But who actually invented it? The answer is quite oddly - the Swiss. Respectively, the Investment Banking division of UBS in London. They were originally used by investment funds and major financial institutions as a way of escaping the British stamp duty tax but were introduced to the retail market in 1998 by Phil Adler and GNI touch. CFDs have only been available to private investors since the late 1990s but they're quickly becoming one of the most popular retail derivative products on the market!

The reason for the name is simple. A CFD is a contract which you buy at one price and sell at another. The purchaser of the contract will gain or loose from the difference of the buy and sell price. In other words you just own the right to the price difference - hence the name again - 'Contract, For Difference'.

Q.: Tell me more about the origins of CFDs?

A: CFDs have been around for over 30 years, with their first appearance tied to the volatile post-crash period of the late 1980's. At the time, fund managers and professional investors were trying to find a mechanism which would help them offset the risks in their portfolios and give them protection against protracted market declines. This led to the development of the so-called equity swap which empowered traders to short securities with gearing. However, while investment funds and major financial institutions were celebrating, it wasn't until the 2000s that contracts for difference started gaining a foothold amongst private investors. At last, retail traders were able to access markets and organise their investment portfolio with the same flexibility and efficiency as institutional investors. Thus, we can say that contracts for difference leveled the playing field for private investors.

Since then, CFDs have been rapidly gaining popularity amongst retail traders around the world. In the United Kingdom, for instance, the LSE estimates that CFDs accounts for more than a third of all stock trades that go through the exchange. The same trend is now happening throughout Europe, Australia, Japan and Singapore.

Q.: What is a Contract for Difference?

A: A contract for difference (CFD) is an agreement between an authorised, regulated provider and a trader to exchange the difference between the opening and closing price of a particular financial instrument.

A CFD is a hybrid of a futures contract and a parcel of shares. It is an agreement between a speculator and a broker to exchange the difference between the future market price of a stock and its price when the CFD is established. The agreement covers a predetermined number of shares but has no fixed duration unlike options and covered warrants. In other words a CFD consists of an agreement made between two parties, to exchange, at the closing of the contract, the difference between the opening and closing prices, multiplied by the number of shares in that contract. The deal is struck between you and the CFD broker - in most cases this is a direct contract, not traded on an exchange. If you want to close your position, you just have to make a reverse trade.

Unlike typical trading instruments, neither the speculator nor the broker actually own the financial product - they only own the speculative contract. Because of this, traders can avoid the usual duties and restrictions associated with most financial products. A CFD, or Contract for Difference can be considered as a more efficient way for the active or aggressive investor to trade stocks or other financial markets such as indices and commodities. A CFD is a derivative instrument that exactly follows the price of an individual stock or index, whether it's IBM, Yahoo, or the NASDAQ composite index. It is similar to a futures contract, but there is no expiration date on a CFD, also there is no standardised contract or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 25-30% of the notional value, depending on the underlying product and the broker.

Let's take an example: Suppose I believed the FTSE has been overbought and decided to take a short position (down bet) on the FTSE. I sell 1 CFD on the FTSE at 4600. Assuming that the margin requirement is 1% this would be equivalent to £46. I can also hold the position overnight and in this case I would pay (if long) or receive interest (if short) depending on my position. Since I'm short on the FTSE I would theoretically receive interest. My overnight margin requirement is the same: 1%. The next day, I buy the FTSE at 4550. I made 50 points, I had 1 contract open, hence I make 50 pounds. In this example margin is set at 1%, which is equivalent to 100X leverage.

Here's a good checklist for understanding CFDs: A CFD is a contract with a broker. You trade 'on margin', which means you do not pay the full purchase price of the share or index and do not physically own a share but make a deposit of about 10% to 25% of the value of the underlying share or index. If the margin deposit is 5% and you want to buy £1,000 worth of shares, your deposit is £50. If you want a whole portfolio of shares (maybe £10,000) you would only have to pay a £100 margin. Your leverage is increased by using CFDs and you are able to control up to 10 times (if not more) the stock compared with an ordinary share purchase. This higher gearing makes for greater profits if you correctly anticipate movements in the stock price. Conversely the risk of loss also increases at the same pace if the stock moves against you.

Q.: Show me some examples...

A: CFDs offer much more than equity derivatives, as you can also get CFDs on indices and forex pairs - so you could, for example, buy the FTSE, or sell the pound, using CFDs.

So this is how it works: Suppose you wanted to buy shares that currently stand at £3.00, you could buy 20,000 shares for £60,000 (plus commissions) or you could buy a CFD. If we assume that this is a blue-chip stock (i.e. highly liquid) your broker is prepared to offer you a contracts for difference at 10% margin, then you could get exposure to the same 20,000 shares for a margin outlay of only £6,000. If the shares then rise in price, say by 10p, you could close your CFD position for a gain of around £2,000 (10p x 20,000), less broker commissions or other costs.

Share CFD Example

Vodafone shares are trading 140 - 140.5p in the market, so a CFD issuer offers a CFD with the same pricing. If you think the price will rise, you can buy a CFD to trade 10,000 shares at 140.5p. The total value of the contract would be £14,050 but you only need 10 per cent initial margin of £1,405. If Vodafone shares rise to 145 - 145.5p, you can choose to close the CFD position by selling 10,000 Vodafone CFDs at 145p. You make 145p-140.5p=4.5p x 10,000 =£450, minus two commissions.

Index CFD Example

The FTSE 100 is trading at 5204 so a CFD issuer offers a CFD based on this price, by quoting a spread of 5201 - 5207. The price of the CFD is set in line with the spread at £5,207. If you think the index will rise, you buy as many CFDs as needed to give you the exposure you want - say 2 CFDs, giving a trade value of £10,414, but putting down 1 per cent initial margin of £104. If the FTSE 100 rises to 5255, you can close the poition and make 5252-5207=£45x2=£90, with commission in the spread.

Currency Trade Example

Crude oil is trading at $135 a barrel so a CFD issuer offers a CFD by adding a spread of $134.96-$135.04, with one CFD providing exposure to 100 barrels. If you think the price will fall, you sell as many CFDs as needed to give you the exposure you want - say 1 CFD, giving a trade value of 1 x 100 x $134.96 = $13,496 but putting down 5 per cent initial margin of £675. If the price falls to $130, you can close the poition and make $134.96-$130.04=$4.92x100=$492, with commission in the spread.

Q.: What markets are available to trade?

A: You can trade CFDs on anything ranging from local equity CFDs (i.e. individual stocks) to overseas shares, stock market indices, currency pairs and commodities on the same trading account.

In fact CFDs are now available in all shares in the FTSE 100, FTSE 250, and many popular UK small cap shares and some firms like IG Markets will even go down to companies with a market cap of around £10 million. Most issuers also offer CFDs on larger US, European, and international shares. This means that you can trade share CFDs on Google, Apple, Amazon, Microsoft, Yahoo, Honda, Toyota, BMW, BP and other sizable companies that aren't available on the London Stock Exchange.

CFDs are also available on all major shares indices, such as the FTSE 100 (UK), S&P 500 (USA), Dow Jones (USA), German Dax, French CAC 40 and other European indices, plus the Japanese Nikkei and other Asian indices. It is also generally possible to trade the major international stocks using cfds. In addition, you can also trade CFDs over changes in the relative values of currencies, such as the British Pound against the US dollar, or the US dollar against the euro as well as commodities, two of the most popular being gold and oil.

Points to note -:

• Individual equities are the most commonly traded types of CFDs. Some CFD providers also quote small-caps, although the coverage varies from broker to broker and market to market.
• Forex CFDs are also widely available. Unlike a regular forex trade, the position you take with your CFD is not subject to daily rollovers. The position remains open at the price you trade at until the position is closed and any profit/loss is immediately credited/debited to your account.
• Stock index CFDs enable you to speculate on the price movements of the stock market. With this type of CFD, however, you are trading a market segment (usually between 30 to 500 stocks), not just a share.
• Unlike some spread betting firms, issuers also provide CFDs on stock market sectors within international markets, such as banks, telecoms and household goods.
• Commodity CFDs are available on metals such gold, silver, platinum, oil and soft commodities, such as coffee and sugar and even exotic markets like pork bellies!
• ETFs (Exchange Traded Funds) are also offered as CFDs.
• Government bond CFDs are offered on UK gilts, US Treasury Bills and other issues.
• Currency CFDs are based on currency futures or indices of the exchange rates between various currencies and others.