Contracts for Difference
A CFD is an agreement between two parties to exchange the price difference of a financial instrument. The profit & loss is determined by the difference in the entry and exit price of the underlying instrument from when the contract is opened and closed. It allow the buyer or seller to gain market exposure while only outlaying part of the full notional value of the instrument.
I believe that trading a CFD is very similar to trading actual shares, except that you are trading with a margin, meaning that you only have to put up a certain percentage of your purchase.
What are CFDs?
The US Securities and Exchange Commission (SEC) don’t approve of contracts for difference (CFDs), so you cannot trade them in the US, but they are available in many other parts of the world, including England and Australia. The name is fairly descriptive, as contracts for difference allow you to take out a contract on a something, and profit from the difference in the value of the thing over time. The something, or the underlying, can be practically anything you can think of, shares, indices, commodities, currencies, etc.
CFDs are a very recent idea, having been invented in London less than 20 years ago. It seems that they sprang out of equity swaps, which is a financial tool used by hedge funds and institutional investors. The equity swap can create a payment for a difference in the future between two sources of cash flow, but is quite often used by the professionals just to get around taxes and legislation. In a few years, CFDs became used by ordinary traders, moving out of the institutional markets.
Two great points about CFDs, particularly for English traders. As the contract is only for the difference in price, you never actually own any shares and so escape any stamp duty or capital gains, while benefiting from the change in price of the shares. And your CFD dealer has a huge list of underliers that you can trade on, which means you can trade on international markets which would normally be restricted to you, or which you would have to have accounts at other brokers to access.
CFDs are always cash settled, regardless of the underlying security or commodity, so there is no confusion such as you may possibly have when trading futures. You leverage your investment, just as with futures, needing a margin of 5% or 10% depending on the underlying and your CFD dealer. They are marked to market every day, so you can the subject of a margin call, and as with other leveraged investments, it is possible to lose a lot quickly if you are not careful about what you are doing.
When holding a CFD overnight, you are paying interest. The interest charged is generally calculated on a daily basis, usually about 3% higher than the cash rate set by the reserve bank, Check with your broker.
In this respect, there is very little difference between long term investment in a CFD or investing in shares. Don’t forget, if you are purchasing equity by drawing money out of your capital trading account, you forgo interest received.
A CFD of course presents some degree of danger which we will explore a bit later. If you wish to trade a CFD, you have to make up your mind whether you wish to be a day trader or wish to hold the position for any length of time. If you wish to hold your position for anything else but to day trade, avoid taking much bigger CFD positions than what you would take with the actual stock. In this case, only use it to work with borrowed money. Always protect your trading capital. In other words, money management is of the essence. If you adhere to money management principles, trading a CFD is as safe as trading shares.
Remember: Leverage multiplies your investing power when you are right, but it also multiplies your losses when you are wrong.
Contracts for Difference are quite simply a great trading tool, and built specifically for traders to speculate. As with all derivatives that only need a margin to trade, you are in effect borrowing the rest of the cost of the underlying from your broker, so you must expect that your account will be charged interest for every day you are in the trade. If you are regularly trading, getting in and out of positions, this should not harm you too much. On the other hand, if you like the look of a share, but do not know if it will take off next week, next month or next year, then the interest could mount up, and you might be better off buying the shares directly, and not incurring the ongoing costs of a CFD.
Advantages of CFDs over Share Trading
- CFD trading like spread bets are not liable for stamp duty (although gains unlike spread betting are subject to tax).
- Stop orders and Trailing stop orders available to minimize risk.
- Only a percentage of the full contract value needs to be put up. CFDs are leveraged products (please note this also raises risk exposure).
- CFDs can be used to go ‘long’ or ‘short’. ‘Shorting’ is a term that refers to speculating that a financial instrument will fall in value
- CFD pricing is streamed directly to one’s desktop giving instant fills and often deeper liquidity
- Gain instant exposure to global stock markets using Index Tracking CFDs with a single click. Index-tracking CFDs, or Index trackers, are linked to the performance of a stock market index and can be traded both long and short.
- Get instant exposure to commodity markets like Oil, Copper or Gold.
You need to have a stop loss strategy to preserve your trading capital!
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