What is a Contract for Difference?


Q.: What is a Contract for Difference?

A: CFD is an acronym for contract-for-difference. In a nutshell, CFD trading permits you to trade individual shares, treasury bonds, stock indices, and commodities just like you normally would. In a technical sense, though, you are not actually owning the underlying asset; you are simply speculating on its price.

A CFD are part of a wider group of trading products referred to as derivatives. A derivative at its core is a promise to pay upon the happening of a future event. These are so named because their value derives from the movement in price of an underlying asset or share. Apart from CFDs, which took off in the last decade, other derivatives products include futures and options which have existed for many centuries, and financial spread betting and warrants. 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.

But what exactly is a CFD? 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.

 

In quite a number of ways, CFDs look and feel like normal shares and the price of a CFD will simply mirror the underlying market. The attraction for speculators and brokers alike is that they do not have to actually own the shares - they only own the speculative contract. Because of this, traders can avoid the usual stamp 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 which means that investors can speculate on price movements without shelling out a lot of cash. Different CFD providers will demand different levels of margin deposits, however margins typically range 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.: The underlying market...what's that?

A: When you buy or sell a contract for difference, you are making an agreement to trade the difference in the value of an underlying asset (also referred to as the 'underlying security' or the 'reference asset') between now and the time the contract is closed. However, it is important to point out that you are not actually trading the underlying asset itself. CFD providers allow you to buy or sell CFDs on a wide number of underlying assets. Shares are the most common underlying asset although most CFD providers will also allow you to trade CFDs on other underlying assets, such as commodities and foreign exchange. So for instance, a Gold CFD means you are trading on the price movement in the actual Spot Gold market.

Winning trade - an example

Shares in The Big Company are trading at 100p each. You believe the firm is only likely to see its shares fall so purchase a short CFD against 10,000 shares in the firm. You are asked for 20 per cent of the value of the contract by a broker and pay £2,000. However, the contract is worth £10,000 and will result in a profit if shares rise. Soon after the company encounters problems that cause its shares to plummet to just 50p. This mean a difference in price of 50p on each of the 10,000 shares and will earn you £5,000, minus commission and interest charges.

Losing trade

However, it is also wise to be aware of the potential for loss. If you had opted to buy a long CFD against the 10,000 shares - handing over £2,000 in the belief shares would rise - it would have been a different story. The difference of £5,000 would now be in favour of the CFD broker. This would cause you to lose your initial stake of £2,000 and mean you owe an additional £3,000 on top. You could choose to close the CFDs and pay up or you could hold on and hope shares will go up. There is, of course, a risk further falls could happen and even more will be owed.

Q.: What does the term OTC mean?

A: OTC stands for 'over the counter'. The term 'OTC' refers to the fact that each CFD provider has their own CFD terms and conditions, and that the contracts for differences are traded directly between investors and the CFD broker, as opposed to an exchange such as the ASX. In practice, CFD providers may issue OTC CFDs either via the market maker or the direct market access route. This is because in both models you are still entering an agreement directly with the individual CFD provider to trade CFDs.


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