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The A to Z of CFDs

Created:
25 April 2008
Written by:
Dominic Picarda

Acontract for difference (CFD) is an agreement between two parties over the price of a particular asset. The two commit to take opposite sides of the agreement. So, when the price of the asset goes up or down, the one who correctly predicted the direction of the movement receives from the other the difference between the starting price and the ending price.

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Here's a simplified example. Say that you and I agree a contract for difference on Vodafone. You think Vodafone will go up from its current price of 150p. I take the other side of this deal. Three weeks later, it has risen to 160p. You decide to end the contract and I pay you the difference between 160p and 150p, or 10p. Had it fallen from 150p to 140p and you’d ended the contract, you'd have paid me the difference.

Why not just buy the asset itself rather than faffing around with a CFD?

If you're only interested in profiting from short-term movements in an asset's price, a CFD will make more sense than buying it outright.

When buying a share, you have to pay stamp duty because a change of ownership is taking place. You don't pay stamp duty with a CFD, because it's only an agreement over a price – no transfer of ownership is involved.

More important, you can make much bigger returns with a CFD than you can by owning shares outright. Because you only have to stump up a small fraction of the total value of your position, you can make big profits from a small move in the share price. This is called 'gearing' or 'leverage'.

What can I speculate on with a CFD?

CFDs let you bet on a wide array of different assets, all from one single account. You can bet on whole indices, domestic and foreign, such as our own FTSE 100 or something as far-flung as New Zealand's NZX 50. Likewise, you can punt on individual shares in many markets. Some firms offer the facility to bet on entire industry groups, such as UK banks or German technology shares.

Away from equities, you can also bet on the prices of government bonds and other interest rates, foreign-exchange pairs and commodities. If you wanted to trade all these assets individually, you'd need several different brokerage accounts, perhaps in more than one country.

What if I think something is going to fall instead of rise?

With a CFD, you can make money from something going down as easily as easily as you can from it going up. You simply start out by placing a sell order for Vodafone contracts instead of a buy order. So, if Vodafone's share price then falls from 150p to 140p, you get paid the difference, multiplied by the number of contracts you sold.

This is a key advantage of CFD trading over dealing in actual shares. For private investors, it is very difficult to sell shares short.

How does 'gearing' actually work?

Let's say you want to take a £100,000 position in Vodafone because you think the shares are going up from 150p. You therefore buy 66,667 contracts, with a total value of £100,000. However, the CFD provider only asks you for £8,000 – they will put up the rest.

Over the next couple of weeks, Vodafone shares rise as expected to 160p. Your position is now worth £106,667 and you sell the contract for a profit of £6,667 (£106,667-£100,000). But your investment was just £8,000, so you've made a return of £6,667/£8,000 = 83.3 per cent, even though Vodafone only went up 6.6 per cent.

Of course, the broker will want some interest for lending you £92,000. But even after you've paid that, you'll still be handsomely in the black.

Isn't it all very risky?

Because of gearing, CFDs can be extremely dangerous in the wrong hands. If you take inappropriately large positions, you can end up losing much more than your initial stake. Inexperienced or irresponsible traders have frequently ended up losing not only their shirts but their entire wardrobes on CFD trades gone wrong.

With £5,000 in your account, you might easily be allowed to take out a total position worth £100,000. A sharp move of 10 per cent would wipe out your £5,000 and leave you owing £5,000 to the broker. The problems clearly multiply the more positions and the greater degree of leverage you employ. You need to be sure that you have the money in reserve to cover losses in the event of big moves. If you don't have it, then you should be taking smaller positions – or not trading CFDs at all.

How can I control the risks involved in CFDs?

It's important always to think in terms of your total position size, rather than the margin you put down as deposit with your provider. Hence, instead of saying to yourself that you've a £5,000 position, think in terms of £100,000. If you're long of a particular share, then that total position value is what you'd stand to lose if the company went into administration and its shares were suspended.

Once again, you need to think very carefully about how much you can afford to lose. And you need to practise good money management to reflect this. As well as ensuring your positions are the right size in terms of your overall resources, you also need to use stop-losses.

A stop-loss is an order to exit your position at a certain price if things don't go to plan. It means you don't have to monitor the market every minute to avoid making horrendous losses.

You should always trade with a stop-loss. One of the main causes of losses among CFD traders is failing to place one. When a position goes against them, some people stubbornly sit tight, determined to break even on the trade. All too often, the losses simply become larger and larger, before finally the trader comes to his senses or incurs a bigger loss than he can afford and his broker closes the position against his will.

Money management is as important in CFD trading as the actual ideas that inspire your trading. It takes time to learn and discipline to enforce. For more on this subject, see our article on technical analysis and money management 'The art of charts'.

How long does a CFD last for?

There is no expiry date on a CFD, so you can keep it running for as long as you choose. In practice, however, you're unlikely to do so, as it would be expensive. This is because of the borrowing costs involved.

Even though you may have put down a deposit of 10 per cent, you will have to pay interest on the entire value of your position. So, for £100,000-worth of contracts where you'd put down £10,000, your financing costs would be calculated on £100,000 and not £90,000.

Even if you handed over 100 per cent of the value of your position, you'd still be charged interest on the value of that position. For that reason, there's no point depositing any more 'margin' than the broker actually requires you to.

"You have to want to use leverage when trading CFDs," says Yusuf Heusen, head of CFDs at IG Markets. "If you don't want to use leverage or are going to hold a position beyond the short term, you're better off owning the actual asset."

For an example of how to calculate the costs involved, see 'Counting the cost of CFDs' (below).

"CFD traders should factor in the cost of funding when calculating potential returns," says John Prior, a director at Killik Capital. "Traders are often very sensitive when it comes to commission rates, but fail to consider interest costs on positions that they're sitting on. These costs rack up quickly and can exceed the commission quite quickly."

"Another angle to consider is how long it will take for funding costs to exceed the 0.5 per cent stamp duty saving that you make by trading CFDs instead of trading the real thing," says Mr Prior.

So does the broker pay me money on my position if I go short of an asset instead of long?

Yes. However, you don't get the same rate that you'd pay the broker if you were long. So, while a broker might charge you Libor (the London inter-bank offered rate) plus 2.5 per cent on the value of your long position, he'd typically pay you Libor minus 2.5 per cent on a short position.

When you are long, you can also reduce your financing charges by keeping funds equivalent to funds that the broker doesn't require as margin in an interest-bearing account. So, if the broker asks you for 10 per cent of your position as margin, you put the remaining 90 per cent of the total position's value in a savings account.

Finally, you may be able to earn some interest on unused funds that you hold with the broker. Typically, you might hold a cash reserve in your account with them to take advantage of any opportunities that may arise. For substantial amounts, a broker might pay you some interest on funds held. However, this will not be automatic and you will have therefore to negotiate terms in advance.

Can I trade CFDs as a substitute for buy-and-hold investing?

No. CFDs are not intended to replace traditional buy-and-hold investing. The funding charges on CFD positions quickly add up, so you'd have to make large profits all the time to offset these costs. However, markets often go nowhere or move against you, so CFDs are really only suitable for trading when you've a strong view that a share is going to move significantly in the near term.

CFDs can be used in conjunction with the rest of your portfolio of assets. For example, you could use CFDs to protect the value of your large-cap shares against a short-term fall in the market by short-selling a CFD on the FTSE 100. CFDs are more suitable than spread bets for this purpose as any losses on a CFD position will be offsettable against your tax liability, whereas those on spread bets are not.

What's the difference between spread betting and CFDs?

Spread betting and CFDs work in pretty much the same way. They are both essentially ways of trading the markets short-term. The most obvious difference is that profits made on CFDs are taxable whereas those made on spread bets are not. That being the case, you might wonder why anyone would bother with CFDs at all. The answer lies in the other differences between the two.

Pricing is a key consideration in whether to choose spread betting or CFDs. Spread betting prices are synthetic – based on the actual market price but set by the bookmaker. The spread will be wider than the market price as the bookie adds a bit in for his commission. By contrast, CFD prices are the best bid and offer from the actual offer. And if you have direct market access, you can actually trade on even more favourable terms. So, if placing orders at a specific price is a big consideration, a trader will opt for CFDs over spread bets.

While a spread betting firm makes some of its money from charging a wider bid-offer spread than is available in the underlying markets, a CFD firm charges a percentage commission on each trade. This can range from roughly 0.1 per cent on each trade to 0.5 per cent.

The currency in which you place bets is another key distinction between CFDs and spread bets. With CFDs, your bet will be denominated in the currency of the underlying asset. So, if you're betting on the price of oil, your profits or losses will be in dollars, and if you're punting on the Nikkei 225, it'll be in Japanese Yen. But if you were placing a spread bet on these, your profits and losses would be in sterling. This is often more convenient for small investors.

If you opt for an advisory account with a CFD firm, your broker can provide you with recommendations on what do buy and sell. There’s no equivalent in spread betting, as the firms are not allowed to advise you what to do.

CFD traders usually have much greater resources than spread betting customers. Accordingly, they want to take bigger positions and be assured of getting their orders filled at a particular price. With spread betting, this is much harder, as the prices are merely derived from the market, rather than set by it. So, such people trade CFDs, where they will get keener pricing on big orders. Paying tax on their profits is the price of this approach. But because the profits are much greater in absolute terms, having to share some of it with the taxman may worry them less than it will smaller players.

Apart from betting on up and down moves, what else can I do with CFDs?

Although CFDs can be used for taking risks, they can also be used for limiting risks. For example, say you've a large portfolio of UK shares but are fearful of a big drop in the market in the short term. Selling a CFD on the FTSE 100 could help to offset at least some of this risk. So, as the market falls and your shares decline in value, you’d be making money on your short FTSE CFD. See our article 'Strategies with a difference' for more on the other uses of CFDs.

Are CFDs suitable for me?

This depends on quite a few factors: your trading style, your resources, and your knowledge and experience of markets.

Obviously you need to be interested in taking short-term positions – a few days or a weeks at most. CFDs are not really suitable for longer-term moves.

The rules require CFD brokers to assess whether CFDs are suitable for you when you open an account. You are supposed to fulfil at least two of the following three criteria: net assets exceeding E500,000; practical experience of trading; and knowledge of the markets.

Apart from the net worth test, these criteria are somewhat open to interpretation. You do not have to demonstrate these things when opening a CFD account, you simply have to say that you fulfil them.

Practical experience of trading would obviously include having worked in a trading capacity in a City job or having been a spread bettor. Regular dealing in physical equities would also count as experience here.

You may come across a broker who sees these issues as a mere bureaucratic formality and who seems keen to sign you up regardless of whether you tick all the boxes or not.

Naturally, you should question such a firm’s motives for wanting to recruit insufficiently savvy customers. Such behaviour is usually the precursor of an exploitative relationship, where you will likely end up losing large amounts of money.

If the broker doesn’t think that you’re suitable for a CFD account, he can still offer you a limited-risk CFD account.

With a limited-risk account, you will not be permitted to trade as wide a range of markets as with a full CFD account and you won’t be able to lose anything more than you put down. You will be obliged to place guaranteed stop-losses – at your own expense – so that you won’t incur huge losses if a market suddenly jumps sharply against your position.

Although a limited-risk CFD account can offer a safe way to learn about the mechanics of CFD trading, you should question whether you should be getting into it at all if a broker won’t offer you a full trading account. Instead, you should go away and build up some more experience of trading, perhaps via spread betting.

How can I practise CFD trading without risking real money?

Leading CFD providers typically provide virtual accounts that allow you to experience their trading platforms before you commit any resources. This is probably worth doing even if you already know about CFDs. It will give you a feel for the software and let you decide whether you like the layout of the trading screen and the functionality of the programme. While this may sound trivial, it is important to feel absolutely comfortable with the set-up, including details such as these.

COUNTING THE COST OF CFDS

• Let's say you want to take a £100,000 position in Vodafone in expectation of a rise to 160p in the next three weeks.

• The bid-offer spread is 150.1p-150.2p.

• Dealing through an execution-only CFD provider, you pay 0.1 per cent commission when you open a position and when you close it.

• For a long position, you are charged interest on your position based on LIBOR (the London Interbank Offered Rate) plus 2.5 per cent.

• Buy 66,578 contracts at 150.2p = £100,000

• You put down £5,000

• Vodafone rises from 150.1p to 160.2p in 21 days

Start position value = £100,000

Total position value at end = £106,658

Profit £106,658 - £100,000 = £6658

Less opening commission of £100

Less interest charges of £443.70*

Less closing commission of £100

Net profit = £6,014

Return is £6,014/£5,000 = 120.2 per cent

*The annual financing charge is LIBOR + 2.5 per cent, so for 21 days it's (7.5 per cent x 21/365) = 0.43 per cent. Total financing charges 0.43 per cent x £103,185.60 = £443.70 We assume for simplicity that LIBOR remains constant throughout the period

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