A Contract for Difference (CFD) is a contract between two parties who speculate on the future price of some asset. These two parties are called “buyer” and “seller” – the buyer will pay to the seller the difference between the current price of the asset and its value at the time he entered the contract (if this difference is negative, the seller will pay the buyer).
Eric, Jill and John decided to watch the horse races taking place in their city. Before they reach the stadium they see a bookie.
CFDs are derivative contracts to exploit the difference between entry price and exit price of some underlying asset. If the price goes up after the trader (buyer) has taken a long position, he earns a profit (equal to the difference between exit and entry prices and minus transaction costs and overnight financing costs, if any). If the price of the underlying asset goes down, the trader will benefit if he had originally taken a short position.
CFDs are traded in the UK, Hong Kong, the Netherlands, Poland, Portugal, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, Norway, France, Ireland, Japan and Spain. They haven’t been permitted in the US, because of the restrictions implemented by the Securities and Exchange Commission (SEC) on over-the-counter (OTC) instruments.
Subjectively speaking, since in most cases CFDs are traded between individuals and CFD providers who are at the same time regulators of the trading platform, using large amounts of capital for these instruments is not advised. While the analogy is not perfect, you may imagine yourself in a court where the other side of the lawsuit also happens to be the judge. While this should not be a big issue under normal circumstances, if any wild moves take place (which is not that unlikely in the precious metals market given significant financial turmoil in the coming years), you may end up with a prematurely closed position due to some “unexpected technical difficulties” with a “we apologize for the inconvenience” message. Naturally, this does not have to happen and we’re not making any accusations here, but the point is – why risk a large amount of your capital in this way?
Brief History of CFDs
The first CFDs were developed in the early 1990s in London and were based on equity swaps. They were traded on margin and were exempt from a local UK tax – the stamp duty. At the beginning they were used only by hedge funds and large institutional traders wanting to hedge their exposure to stocks. A few years later, however, they were introduced to individual traders, who really appreciated the benefit of being able to trade on leverage. Responding to the surge in demand for CFDs, providers introduced products including not only stocks listed on the London Stock Exchange, but also indices, global stocks, commodities, bonds and currencies. In addition, they decided to expand their services overseas – in July 2002 CFDs were first introduced in Australia, and later in a number of other countries. Until 2007 Contracts for Difference were traded only OTC, but on November 5, 2007 the Australian Securities Exchange (ASX) listed exchange traded CFDs on the list of the top 50 Australian stocks.
CFDs are traded between individual traders and providers of CFDs. They are not standardized – every CFD provider can stipulate their contact terms, but nevertheless they have many things in common. Trading CFDs is like a long-term speculation. You “play” against the regulators, but while using their “toys”. You bet with the CFD provider on the future price, but they are the judge.
Buying a CFD doesn’t mean buying the underlying stock, but CFDs are directly linked to the share price. They mirror the movement and prices of the underlying asset.
There is no expiration date for Contracts for Difference – the position is closed when a reverse trade is made and at that moment profit or loss is calculated.
CFD providers can charge a number of fees, which may include bid-offer spread, commission (usually a percentage of the position size), overnight financing as well as account management fees. Contracts are also subject to daily financing charges, usually based on an agreed rate like LIBOR or another interest rate.
Margin Trading and Leverage
CFDs are instruments that are traded on margin. CFD traders must therefore always maintain a minimum margin level. In case the deposited amount of money falls below the stipulated minimum level, margin calls are made and traders have to either cover these margins, or their positions are liquidated.
The usual margin rate ranges from 0.5% to 30%. This enables traders to take advantage of leverage – their potential losses or profits can be substantially magnified. In the case of 0.5% margin, they will be magnified 200 times. On the other hand, in case of volatile markets margin calls may be so big, that the trader is pushed out of the market.
There are two types of margins:
- Initial Margin, also referred to as deposit (between 3% and 30% for stocks and 0.5% - 1% for indices, foreign exchange and commodities)
- Variation Margin (marking to market the results of price movements – they can have a negative or positive influence on a trader’s cash balance)
- Market Risk – CFDs are contracts to pay the difference between entry price and exit price. Since they are traded on margin, leverage increases this kind of risk substantially.
- Premature Liquidation Risk – in case of unfavorable price movements additional variation margin may be required to maintain margin level. CFD traders may be asked to deposit additional money on very short notice. If funds are not provided in time, the provider may close the position at a loss.
- Counterparty Risk – even if price moves in the desired direction, the trader may lose, if the other party doesn’t meet financial obligations or is insolvent. Exchange traded CFDs are considered to have less counterparty risk.
CFDs vs. Other Instruments
A number of financial products resemble CFDs, but futures and options are the closest to CFDs in character. There are, however, a few differences between them.
- CFDs have no expiration date.
- CFDs are usually traded over-the-counter.
- CFDs are usually one-to-one contracts.
- CFDs are not traded in the US
- Minimum contract sizes are very small; you can buy even one CFD share.
- It’s easy to create new instruments.
- There is a vast array of underlying instruments that can potentially be traded.
- In most cases, CFDs are traded between individual traders and CFD providers.