Why Trade CFDs: Comparison to Shares Trading

What is a CFD (Contract for Difference)?

Contracts for difference (CFDs) are one of the world's fastest-growing trading instruments. A CFD - which stands for "contract for difference" - is an agreement to exchange the difference in value of a particular share or index between the time at which a contract is opened and the time at which it is closed. There is no restriction on the entry or exit price of a CFD, no time limit is placed on when this exchange happens and no restriction is placed on buying first or selling first.

A CFD is an agreement to exchange the difference between the entry price and exit price of an underlying asset. For instance, if you buy a contracts for difference at $14 and sell at $16 then you will receive the $2 difference. If you buy a CFD at $10 and sell at $8 then you pay the $2 difference. When you enter a CFD contract you are not buying the underlying share, even though the movement of the CFD is directly linked to the share price. Since you do not own the share, you are only required to provide a deposit to your CFD provider which could be as low as 5% for blue chip shares. This means you can trade up to 20 times your initial capital.

Contracts for differences (sometimes referred as swaps or waves) allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date or contract size. CFDs mirror the movement and pricing of the underlying share. A CFD allows a trader to gain access to the movement in the share price by putting down a small amount of cash known as a margin. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 80% of the face value of the financial instrument. For indices or currencies, these margin requirements can be as low as 1 percent of the underlying value of the security.

As opposed to an expiry date a CFD is effectively renewed at the close of each trading day and rolled forward if desired - you can keep your position open indefinitely, providing there is enough margin in your account to support the position. In this stance contracts for differences are very similar to futures without an expiration date.

While the contract remains open, your account with the provider will be debited or credited to reflect interest and dividend adjustments. You can choose to "long" or "short" a position - if you are long, you receive dividends and pay interest, if you are short you do the reverse. Commission is paid on either side of the contract and you can close a contract at any time. In practice there is no minimum contract value though, normally, the smallest contract value will be £10,000.

What are they similar to?

CFD trading is similar to trading shares but with several important differences. One such difference is that when you trade a CFD you don't own the actual share. When you trade a CFD on Google or BHP Billiton, you are trading the price difference between your entry point and your exit point. You don't own the Google or BHP Billiton shares - you are only counting on their price going up or down.

In terms of the derivative's family tree, CFDs sprout from the futures and options branch. The closest cousin to CFDs is spread betting, which works on similar principles in that you are trading on margin and you can go long or short on a position. However, in monetary and experience terms, there is a higher level of barrier to entry for CFDs.

They say...

"A CFD is a virtual investment on margin," is the way iDealing sums it up. That is, it is a "contract between the provider and its customer to simulate the cashflows an investor would receive or pay if they were buying or selling an actual financial security."

They have been a staple of the institutional market for some years but now they are available to private investors they are one of the fastest growing financial areas, as more and more individual investors make use of their flexibility. CFDs are undoubtedly one of the most exciting products available to the retail investor in recent years," adds City Index rather breathlessly.

There are three primary cashflows related to an equity investment - the difference between the purchase and sell price, the dividend (if any) paid while the investment is held, and the interest on the cash required to pay for the stock. The CFD contractually passes these cashflows to or from the client.

"Like other derivatives," says IFX Markets, "they were designed for those investors who wanted to benefit from movements in an underlying asset, but did not need any rights of ownership." As such, you are not entitled to any voting rights - but because you don't own the actual share, it also means you are not liable to pay stamp duty.

According to IG Markets, investing via CFDs gives you access to "thousands of UK, US and world shares on margin with transparent pricing direct from stock exchanges around the world". The standard rate of commission on all this is 0.10%.

But what is margin? Well, as CMC Markets says, it is a "more efficient use of capital because you only have to allocate a small proportion of the value of your position to secure a trade, while still maintaining full exposure on the market". The company summarises this by saying that "in effect, you are able to magnify your return on investment". As Hargreaves Lansdown goes on to explain, "this is called gearing".

Or, as IG Markets puts it, you can open a position without having to put up the full underlying value. "Instead you put up a deposit or margin from just 10% of the contract value (or 5% for limited risk trades)."

Always remember, however, that the obvious corollary to such a leveraged position is that your losses are likewise magnified. As Blue Index says: "CFDs utilise leverage and can be very high risk, so they are only available to clients who have the experience and resources to deal in these type of investments.

"CFD trading is inherently risky and is not appropriate for all investors. You should know how much you potentially can lose and honestly evaluate if you can afford to lose it in view of your financial resources and investment goals."

Hence also the risk protection on offer in the form of stop-loss mechanisms. "If the market moves sharply against you, we guarantee that your position will be closed at your chosen stop level," says IG Markets.

But what of the other benefits? Well, first there is the possibility of going short on a share. "Trading a CFD short is a convenient and cost-effective way of mirroring a potential fall in the underlying share," says Cantor CFDs.

The chance to "pairs trade" is also opened up. "Trading a CFD pair makes it possible for an investor to establish a balanced collateral position while maintaining market sensitivity," says Cantor. "By buying a monetary value of one share, the investor can sell short exactly the same value of another. Being from the same market sector, both shares will typically have a high correlation, which should substantially reduce market risk. The performance of a pairs trade is generally monitored in terms of the ratio of the two stock prices."

CFDs can be extremely rewarding when a trader has knowledge, skill, discipline and time, and when they are used in the appropriate market. But I must stress that you take the time to train, to develop your discipline and to plan...

CFD Trading Example

To place a long trade you need to place an order to buy the CFD. Each broker will use a slightly different method to place orders but if you have bought a share before, it will be very easy to adapt to buying CFDs. To trade short, you need to place an order to sell the CFD. The mechanics of placing the order will depend on the CFD provider that you are using.

Opening the position

Say WXY Ltd is quoted in the market at $3.71/3.72. You think the price is due to rise, and decide to buy 10,000 shares as a CFD at $3.72, the offer price. Your initial outlay (supposing WXY Ltd is an S&P/ASX 20 stock) is just 10% x 10,000 shares x $3.72 = $3,720. The same outlay with a regular stockbroker would only give you exposure to the performance of 1000 shares. The usual commission rate on this transaction is just 0.1% or $37 (10,000 shares x $3.72 x 0.1%).

Closing the position

A month later WXY Ltd has climbed to $4.06/4.07 in the market & you decide to take your profit. You sell 10,000 shares at $4.06, the bid price. The commission payable is $41 (10,000 shares x $4.06 x 0.1%). Your gross profit on the trade is calculated as follows:

Closing level $4.06

Opening level $3.72

Difference 0.34

Gross profit on trade $0.34 x 10,000 shares = $3,400

Note: To determine the overall profit on the transaction you would also have to take into account the commission you have paid & interest and dividend adjustments.

Comparison: Shares Trading versus CFD

Which to use: CFDs, Shares or Futures?

Contracts for Difference suit most trading strategies and can complement your existing trading plan. They are especially convenient for the stock market (if used under around 10 weeks, an estimated point where CFD financing charge exceeds financing charge for stocks) while futures are preferred by professionals for indexes and interest rates trading (but CFDs for indices are used too and futures for stocks also). In addition to avoiding stamp duty in the UK, increased flexibility and leverage are other advantages of CFDs over more conventional forms of margin trading (like stocks), although with futures there is usually sufficient leverage available (typically 20:1, but can be as high as 70:1). All forms of margin trading involve financing charges (with the exception of the Spot Foreign Exchange market), although in the case of futures contracts these are already embedded in the price of the instrument.

Conclusion

As you will by now have gathered, CFDs are not for the faint-hearted. In fact, all providers are obliged by the Financial Services Authority to ascertain from prospective clients that they are well-versed in the arts of trading the markets and have the appropriate experience to enter into the field.

On this basis, it is clear that CFDs are not a product suited to everyone's needs. That they can be a useful weapon in the private investor's armoury is undeniable - they do open up the benefits of ideas such as shorting and gearing and they also come without the cost of the spread.

However, only experienced private investors need apply - as with any form of short-term trading on margin, while the benefits can be huge, so can the losses. Bags of experience and a disciplined trading strategy are essential. As a rough guide, if you are considering using such instruments for the first time, it might be better to look first at using spread betting as the nursery slopes. Alternatively, you can find a plethora of guides and online training programmes on the sites listed opposite.

 Small Moves, Large Stakes

 Advisory Services

 CFDS - The Emerging Investment of Choice