Contract for difference
From Wikipedia, the free encyclopedia
A contract for difference (or CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.) For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares
Contracts for difference allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 30% of the notional value for CFDs on leading equities.
CFDs are currently available either unlisted or listed [i.e. mini-warrants and ASX CFDs listed on the Australian Securities Exchange] and/or over-the-counter markets in the United Kingdom, The Netherlands, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, France, Ireland, Japan and Spain. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future. CFDs are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on OTC financial instruments.
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[edit] History
CFDs were originally developed in the early 1990s in London. Based on equity swaps, they had the additional benefit of being traded on margin and being exempt of stamp duty, a UK tax. The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, on their Trafalgar House deal in the early 90s. [1] [2]
They were initially used by hedge funds and institutional investors to hedge their exposure to stocks on the London Stock Exchange in a cost-effective way.
In the late 1990s CFDs were first introduced to retail investors. They were popularised by a number of UK companies, whose offerings were typically characterised by innovative online trading platforms that made it easy to see live prices and trade in real time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities); GNI touch is now owned by MF Global UK Limited. They were followed by IG Markets and CMC Markets.
The CFD providers started to expand to overseas markets with CFDs being first introduced to Australia in July 2002 by IG Markets a subsidiary of IG Group. CFDs have since been introduced into a number of other countries, see list above.
Up until this point CFDs have always been traded Over the Counter (OTC); however, on 5 November 2007 the Australian Securities Exchange (ASX) listed exchange-traded CFDs on the top 50 Australian stocks, 8 FX pairs, key global indices and some commodities.
[edit] Charges
The contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR or some other interest rate benchmark e.g. Reserve bank Rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.
Traditionally, CFDs are subject to a commission charge on equities that is a percentage of the size of the position for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument.
Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (usually ranging from 1% to 30%). One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a substantial part of the assets.
As with many leveraged products, maximum exposure is not limited to the initial investment; it is possible to lose more than one put in. These risks are typically mitigated through use of stop orders and other risk reduction strategies (for the most risk averse, guaranteed stop loss orders are available at the cost of an additional one-point premium on the position and/or an inflated commission on the trade).
[edit] CFDs versus futures
CFDs are convenient (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. In addition to avoiding stamp duty, increased flexibility and leverage other advantages of CFDs over more conventional forms of margin trading (like stocks). All forms of margin trading involve financing charges, although in the case of futures contracts these are already embedded in the price of the instrument. On the one hand, futures are more transparent (for instance: a group of hedge funds linked to BAE Systems managed to gain effective exposure to more than 15% of Alvis plc through CFDs without having to warn the British regulator, see more in the "virtual positions" section of this IFLR article on virtual positions through CFDS). On the other hand, CFD-related hedging is estimated to account for more than 25% of the volume on the London Stock Exchange.
[edit] Exchange Traded CFDs - ASX CFDs
Exchange Traded CFDS are a new form of contract for difference that are traded through an exchange based mechanism. Current CFD providers focus on either the direct market access CFD or market maker models]. This new development was launched in November 2007 on the Australian Securities Exchange (ASX). There were originally 12 brokers offering ASX CFDs, which has now been reduced to the following four brokers - Morrisons, Bell Potter, Commonwealth Securities and Sentinel.
[edit] Difference between ASX CFDs and OTC
Disadvantages of ASX CFDs
ASX CFDs are generally offered on a limited number of shares rather than all shares on the exchange. The costs associated with trading ASX CFDs are typically higher than trading with OTC providers. Broker commissions, wider market spreads and ASX fees are some of the extra charges.
Market Independence. ASX is required under the Corporations Act to ensure that its markets are fair, orderly and transparent. As the central market operator, ASX is independent of the parties with whom a customer receives advice and deals through. This separation of responsibility between broker and exchange also provides customers with choice as to whom they wish to execute their business through.
Having a central market also means there is one standard contract specification for all ASX CFDs.
Transparency. ASX reports on all ASX CFDs transacted, open positions, bid, offers and their volumes. ASX CFDs are traded in the same way as other ASX traded contracts. It is important to note that ASX CFDs are offered on a separate market with a separate book to that of physical stock trading on the ASX.
This means that the ASX CFD order book is priced by market makers along with orders submitted by listed CFD traders. Therefore the market spreads and liquidity will be different to that of the physical ASX share market.
Risk Management. In the ASX CFD market all settlement obligations are guaranteed by SFE Clearing Corporation (SFECC).
All ASX CFD margins are calculated by SPAN, recognized globally as the leading margin calculation system.
SFECC has a statutory obligation to operate "fair and efficient" clearing and settlement facilities. These facilities are monitored by both ASIC and the Reserve Bank of Australia (RBA).
Trading in the ASX CFD Market.
When trading ASX CFDs, the customer's order is entered directly via a Participant into the ASX CFD central market order book. This order book is available for the market to see. All orders are executed on a strict price/time priority. This means that the first order with the best bid or offer price is always executed first.
OTC Providers
All OTC CFD providers in Australia are required by law to hold an Australian Financial Services Licence issued by Australian Securities and Investments Commission (ASIC). This licence requires providers to comply with all relevant sections of the Corporations Act 2001. For example providers are required to offer an independent dispute resolution service to hear and determine complaints of clients.
Counterparty risk. Client funds are held in segregated accounts, however some CFD providers can access this money to cover their own margin requirements, and if this resulted in overall company loss or foreclosure, a traders float could be at risk with some providers.
Pricing. OTC CFD providers essentially offer 3 different models, STP - Straight Through Processing with guaranteed market prices, DMA - Direct Market Access where all trades are entered into the ASX physical stock order book. Finally there is MM - Market Maker model where the OTC CFD provider makes the price in the underlying instrument which can be different to the ASX physical stock order book. Customers executing 'MM' or 'STP' OTC CFDs may not have their orders in the ASX central market order book. These orders are transacted with the OTC CFD counterparty (typically described as a CFD Provider).
[edit] Stop loss orders
A stop loss can be set to trigger an exit point as pre-determined by the trader eg Buy at $3.00 with a stop loss at $2.60. Once the stop loss is triggered, a sell signal is activated to the CFD provider and actioned in accordance with their terms of business and taking into account available liquidity to action the request. DMA providers typically receive the stop loss value via the phone or online ordering and will place the order in the market to be actioned at the pre-determined price to a limited price range eg to a maximum 6c further,and providing there is matching liquidity. If the stop loss price is triggered and the price then rapidly moves outside the 6c range in this example, or there is insufficient liquidity for your order and considering other people that have orders at that price point, your stop loss sell order may not be triggered and you remain in the position.
Market makers have the ability to manage the stop loss and when a stop loss order is triggered, they can close the position wherever they see that matching price and quantity are available. This increases your chances of getting out of a position that is going against you, albeit at a potentially inferior price to what you were expecting.
Some providers offer Guaranteed Stop Loss Orders (GSLO) whereby the trader pays a premium for a price to be guaranteed should a stop loss price be triggered. The closest a stop loss order can be placed is typically 5% from the current price and providers usually have specific terms and conditions on the orders however they can be effective if exiting at a set price is important.
[edit] Leverage
One of the most attractive aspects of trading CFDs is the easily available access to leverage. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. CFDs use the power of leverage to trade which is one of the key reason they are such a powerful tool. CFDs are collateral financed, meaning you only need an initial margin of 1-30% of the total value of the trade to enter the position.
[edit] Examples
This means if you wish to enter a position of 1000 BHP Shares at $35 each, usually you would need to front $35,000. Using CFDs, trading on a 5% margin, you would only need an initial deposit of $1,750.
An example is the easiest way to show the use of leverage.
If you had $1,750 to invest, and wished to purchase BHP at $35 and sell at $37, a standard trade would look as follows:
BUY: 50 x $35 = $1,750
SELL: 50 x $37 = $1,850
PROFIT = $100 or 5.7%
Using leverage the above example reads as follows:
BUY: 1000 x $35 = $1,750 (5% deposit) + $33,250 (95% borrowed funds)
SELL: 1000 x $37 = $37,000
PROFIT = $2000 or 114%
As you can see the profit received after using leverage was far greater than without. It is important to note, that losses are also magnified when using leverage.[3]
[edit] CFD Calculation
Due to the dynamic nature of the stock markets and increased leveraged possible with CFDs (up to 100 fold) it is important that traders regularly calculate their risk, position sizes, the return required to cover CFD loss and overnight financing costs to manage their moving portfolio and changing risk. With the leveraging of CFDs it is possible to lose a lot more money than your account size should positions go against you. Some CFD providers offer CFD calculators while websites like CFD Calculator cover a range and are therefore less likely to be biased.
[edit] Risk
CFDs allow a trader to go short or long on any position using margin. There are always two types of margin with a CFD trade -
1) Initial (normally between 5% and 30% for shares/ stocks and 1% for indices and foreign exchange), and 2) Variable (which is then 'marked to market').
Initial margin is fixed at between 1% and 30% depending on the underlying product and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility in the world's stockmarkets.
Many refer to initial margin as a deposit. For example, for large and highly liquid stocks such as Vodafone the initial margin will be nearer 5%, and depending on the broker and the client's relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher. This information is important for all CFD traders to consider before they actively look to take positions, long or short in stocks.
Variation margin is applied to positions if they move against a client. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £100 in variation margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in running profits.
Variation margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.
Another dimension of CFD risk is counterparty risk, a factor in most over-the-counter (OTC) traded derivatives. Counterparty risk is associated with the financial stability or solvency of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD investor could potentially incur severe losses, even if the underlying instrument moves in the desired direction. Although OTC CFD providers are required to segregate client funds protecting client balances in event of company default. Exchange-traded contracts traded through a clearing house are generally believed to have less counterparty risk. Ultimately, the degree of counterparty risk is defined by the credit risk of the counterparty, including the clearing house if applicable.
