In the early days traders wanting to borrow money to trade had little choice, either borrow capital belonging to the bank to buy share or phone their stockbroker and submit an application for a margin loan. Contracts for Difference changed all this. But what separates CFDs from a margin loan? – after all both instruments involve borrowing money from a third party.
The fact is that when you get right down to it, there are significant differences between contracts for difference (CFDs) and conventional shares trading or margin lending. Many of these are advantages, but you should also know about the disadvantages so that you can make a balanced decision on the type of financial instrument you want to use.
Stocks represent ownership in a company. As a stockholder, you are interested in the companys performance, the companys management, and the dividends that are paid. In fact, as a part owner you have some control over the running of the company, can speak to the Annual General Meeting, and vote on motions made at that meeting. Of course, unless you are Warren Buffett or a similar self-made financier, you will have to convince many others of your point of view in order to make any changes.
How does Margin Lending Work?
For instance, let’s assume you have deposited $20,000 and borrowed $80,000 so you now own $100,000 worth of securities. If the stock price goes up then you have few problems, however, if the $100,000 goes down by 20% to $80,000, then the ratio of loan to stock value becomes 100%. A margin call might follow to bring the ratio back to the 80% level, which in this case would amount to $16,000. If you are not able to provide the extra funds, the financial institution you have borrowed the initial money from will sell a part of your shareholdings to bring the percentage back to the 80% level.
If the value of the shares goes down, then in the same way as with CFDs you may receive a margin call from your broker or bank telling you to put more money in your account. You generally have to respond within 24 hours, or the broker will start selling your assets to cover his risk.
Short Selling via a Stockbroker Compared to Short Selling via a CFD Provider
When you buy or trade contracts for difference, even if they are for individual stocks, you never have any ownership in the company. All you have is a contract which states money will change hands, the amount depending on the change in value of the stocks. One point with CFDs it is as easy for you to short the stock, gaining from a loss in value, as it is for you to go long and profit from the stock price increase. When you trade in stocks, in order to short your broker must find a matching position to borrow from so that the trade can be placed.
Short selling with a full service stockbroker can be difficult as traders are required to enter into complex stock borrow agreements and abide by stock exchange short selling rules. Moreover, brokerage commissions and margin rates for margin loans aren’t that attractive either. Normally, short-selling is charged at full-service rates and a trade to enter a short position with a conventional stockbroker could easily cost $80. In addition, short selling stocks via stockbroker usually comes at a higher margin rate (requiring at least 25%-30% of the value of the underlying exposure to go short as opposed to 5%-10% with a contracts for difference provider) and is also contingent on there being sufficient stock to borrow. Margin loans will typically charge 0.50% of the value of a position whereas a typical CFD provider may charge only 0.10% making CFDs much more cost-effective. If the shares cannot be borrowed the position cannot be taken. If the company decides to recall the shares for any reason, then the short position will be winded down. Short selling a traditional stock may also be constrained by the downtick rule which states that a short sale transaction cannot be entered at a price that is lower than the price of the previous trade.
Forex Trading and Margin Forex
Originally, under margin forex trading the provider would open a position directly into the market on the client’s behalf. With CFD FX, you are simply agreeing a contract with the CFD provider to pay the difference between the levels at which you opened and closed the contract. In this perspective, the CFD route is likely to turn out cheaper although the margin forex route might be seen to be more transparent, as you are dealing directly in the market. Today, margin FX is more likely to replicate the processes of FX markets and because of this the trader is assumed to have bought at the spot price while the contract is designed to consistently roll over each day. With a number of margin FX providers, after a period (say, a month) this contract may expire and the trader would then have to re-open their forex trade. CFDs, on the other hand don’t have a pre-determined expiry date and are inherently designed to allow easy speculation on prices. Also, see Forex CFDs versus Forex Spot Trading.
Leveraged Trading and Financing Requirements
Moreover, with contracts for difference, you are able to profit from a much larger number of stocks than you could normally afford to buy. As CFDs are derivatives, it is not necessary to put up the total amount for the value of the stocks. Typically, you will be asked to pay about 10% as an initial margin payment so gaining an exposure of £100,000 would really only require a deposit of £10,000. Any running profits that you make can actually be used as margin to esablish new positions but any losses would have to be made good by reducing your position or by providing extra funds. This flexibility is one of the major advantages of trading CFDs.
Because you are making use of this facility, there is a slight disadvantage that you are charged interest on a daily basis for the money that you have effectively borrowing to control the total value of shares traded. If you want to buy stocks and hold them for years in anticipation of steady growth, then this aspect of CFDs means that they would not work for you. On the other hand, if you are a regular trader in the market and actively watching your investments, then the interest is just another trading charge. One thing to be wary of are the interest rates charges and how these are treated by margin lenders and CFD providers. This is because margin lenders will charge interest on the amount borrowed whereas CFD brokers will charge interest on the full notional value of the open position, although CFD financing rates are often lower. Financing rates are an important cost factor to consider when comparing CFDs and margin loans although this is of course less important for CFD traders that only hold their positions for a short period of time.
One neutral feature of CFDs is that they are ‘marked to market’ every day. This means your account is revalued to the current worth, unlike stocks where you only realize your profit or loss when you sell. Whether this is an advantage or a disadvantage depends on how good your selection is. If your choice increases in value, then your account will go up, but if your trade isn’t working out, then you can even get a situation where the CFD dealer asks you to put more money in.
Dividend Payments and Franking Credits
Both contracts for difference and shares qualify for dividend payments, however one notable difference is that the dividends received from owning the actual stocks include franking credits whereas CFD dividends do not. This is because when you buy a CFD, you do not own the underlying shares and as such you are not eligible to the franking credits or voting rights generally associated to share ownership. This shouldn’t make much difference to most CFD traders as they are typically short term holders looking to gain from much smaller price fluctuations than longer term investors. Margin loans may be more appropriate to longer term investors who want to take advantage of both dividends and franking credits while CFDs are better suited to frequent traders who want to dip in and out of the markets to take advantage of small price movements whichever way the market moves.
A big advantage that CFDs have over UK share dealings is that whereas in the UK you have to pay stamp duty of 0.5% on all UK share purchases (which has somewhat reduced the cost effectiveness of ‘day-trading’ traditional stocks and shares), CFDs are exempt from stamp duty and this has added to their appeal.
CFDs are liable to capital gains tax but CFD losses can also be offset against any future profits for the purpose of tax calculation. When you actually trade in CFDs you purchase those contracts in nearly the same way you buy shares. So if you wanted the same equivalanet exposure to 1,000 shares in a company trading at 450p, you’d have to buy 1,000 contracts at, 450p per contract.
So, if you are active in the markets, there are quite a number of advantages to using CFDs instead of stock purchases. It’s worth looking into them more, so that you are familiar with them and can use them in the right circumstances, however beware that both CFDs and margin loans are traded on margin and it is important that you use leverage sensibly and have an appropriate risk management plan to limit your downside should the market move against your position.