Q:How are CFDs issued?A: CFD providers allow speculators to take long or short positions on CFD positions by hedging their liability under the contracts in the market.
So if a trader was, for example, to submit an order to buy 10,000 CFDs in BP, the provider would buy 10,000 shares in BP as a hedge, and write a CFD at the same price.
In this way, the trader receives the CFD position, in this case long 10,000 Vodafone CFDs, while the provider has hedged its side of the contract, which is going short on BP by buying shares in the market.
But that ties up the issuer’s capital – so the issuer will want to be compensated for that. So if the trader wants to hold the position overnight, or over a period of days, the issuer will charge a daily interest rate on the full value of the CFD position. This is known as the financing charge.
Most CFD brokers specify their interest rates as a set number of points over the London Overnight Interbank Rate (Libor).
The minimum contract size is typically one share and the trading hours are generally the same as the underlying exchange.
Q:What is a contract value?A: The number of shares in the contract multiplied by the price of that underlying share. The contract value will change in line with the movements in the price of that underlying share. A contract for difference is marked to market – that is, it is valued daily at the close of business mid-price of the underlying share.
Q:What is an equity CFD?A: Equity CFDs (also referred to as share CFDs) are contracts that mirror the performance of the underlying market security with the profit or loss calculated as the difference between the purchase price and the selling price. The only difference is that you don’t physically own the underlying shares.
The spread of share CFDs are often the same as the spread of the underlying security on which the CFD is based however when trading shares this is often referred to as the bid and ask price. In fact, most brokers take their equity CFD prices directly from the underlying with the only costs consisting of the market spread, a flat rate or percentage-based commission and a small daily interest charge on long positions held open overnight. The most common pricing structure is the percentage based one where providers add a small percentage commission (from 0.1% to 0.5%) on the transaction. Share CFDs are traded on margin so you only need a small proportion of the total value of a position to trade. Equity CFDs also mirror all the rights in the underlying shares; thereby the owner of a share contract for difference will receive cash dividends and participate in stock splits, rights issues or takeover corporate action.
Let’s take an example of Marks & Spencer Group Plc (MKS – London Stock Exchange). The stock is currently trading at 237p so an investor could buy 5000 CFDs for an exposure of £11,850. This would usually require a margin deposit of around 10% or £1150. If MKS in the following days rallied to 265p, the position would be closed by selling the contract back for a gain of £1400 (excluding broker commissions). As you can see a relatively small move in MKS has resulted in a gain of 121.74% on the initial margin outlay deposit (of course leverage cuts both ways and you would have made a loss for this amount should the market have moved against you…)
Equity CFDs are now possible on most main global equities including USA equities. The most liquid companies require a 5% initial margin, smaller stocks may require a deposit of 10% to 20% and the margin required can even go up to 50% for particularly illiquid shares to reflect the higher risk. The minimum contract size can be as low as one share and the trading hours are generally the same as the underlying exchange.
Q:If I buy Share CFDs does that mean I own the shares?A: No, with contracts for differences you never own or have ownership rights in respect of the underlying asset. The agreement between you and the CFD provider for a share CFD is to exchange the profit or loss on a stated transaction. Through holding a CFD you don’t own the underlying share and, as such, you don’t have any voting rights.
Q:What stocks are available?A: Consult your CFD broker for updates, but currently the guide is: You can trade equity CFDs on UK, US and European markets and index CFDs on any of the following: FTSE 100, WALL STREET, S&P 500, NASDAQ 100, DAX 30, CAC 40, SWISS MARKET, IBEX 35, MIB 30, EURO STOXX 50, NIKKEI DOW 225, HANG SENG.
There are several important differences between trading UK and overseas equity CFDs. First, the trades are always executed in the base currency with the prices quoted as seen in the underlying market. In other words UK equity CFDs are quoted in pence while CFDs on US stocks are in cents. This means that currency risk becomes a factor with the profit or loss from CFD transactions on foreign markets being affected by fluctuations in FX rates. Second, the financing charge or credit will be based on the interest rate of the relevant market. Finally, the margin requirements reflect the risk and will generally be 10% or more with the trading hours typically the same as on the underlying exchanges.
Q:Ok, but how is commission calculated for a CFD?A: Most CFD brokers offer a percentage based commission structure with 0.10% being considered the industry standard.
CFD commission is calculated based on the full market value of the position:
Full Market Value x Commission rate = Commission charged
With a typical CFD provider, the below transaction will occur:
$100,000 x 0.10% = $100
Your commission charge would be $100 for a $100,000 trade.
Assuming the $100,000 market value on the position was generated by transacting 15 trades within the one share, the CFD broker would charge you a fee per trade, applying a minimum charge for each trade. Assuming the minimum charge is $10 (some CFD providers charge between $15-$20), the cost of the trades would amount to $150 ($10 x 15).
Note: A number of CFD providers may widen the spread of share CFDs when there is insufficient liquidity in the underlying market over which the CFD is derived, whilst others may include their commission rate into the spread. When choosing a CFD provider it is very important that you ensure the spreads of the share CFDs offered mirrors the spread within the underlying stock on which the CFD is based. CFD brokers that widen the spread of CFDs over liquid shares as well as charging a fee are earning extra revenue by taking advantage of their client’s lack of awareness of the price of the underlying instrument on which the CFD is derived.
Q: What is the Spread?A: The spread amounts to the difference between the price that you can sell or buy an asset. This consists of the ‘Bid’ and ‘Offer’ prices, for instance the difference between the Bid and Ask price of a stock. As with buying a share using a normal stockbroker, there is a bid price and an ask price involved with CFDs.
Example: How prices are quoted -:
Say a stockbroker is quoting the stocks of a company at Bid 98.75 – Ask 99.25.
This implies that if a trader wanted to buy the stock of this company via this stock broker, then he would have to pay 99.25 per share. If the trader wanted to sell some of his existing shares then the stock broker would be willing to take them off his hands at 99.75 per share.
Note that spreads are applicable across just about all exchange traded and over the counter financial products however it isn’t a term often utilized by share traders but more frequently referenced when discussing index and forex contracts for differences.