CFD Survival Guide

CFDs Trading Frequently Asked Questions

What are CFDs?

CFD stands for Contract for Difference and is a contract between a CFD provider and the trader. The CFD trader makes a decision on whether they believe a certain share will rise or fall and decides on the number of shares they wish to trade. If the trade is correct, the CFD provider will pay the trader the profit which equals the difference between his opening and closing price multiplied by the amount of shares traded. If the trade is incorrect then the trader will have to pay the CFD provider the difference.

Where can CFDs be placed?

CFDs can be placed on a vast range of global financial markets including domestic and global shares, indices, interest rates, forex pairs (forex or FX), and commodities such as gold and oil using a single trading account. As such CFDs are available on a wide range of exchanges including FTSE, ASX, NYSE, Nasdaq and most of the far east and European exchanges. CFDs are usually available on the top companies traded on the relevant exchange in addition to CFD contracts on the actual index itself.

CFDs have no fixed expiry date, so investors have even more flexibility than futures or options. CFDs are normally used for short term trading but like other investment products, the utilities of CFDs vary depending on an investor’s individual circumstances and investment time-horizon. It is worth noting that the CFD trading market is growing rapidly and is now not just restricted to professional investors.

Contracts for Differences are nowadays widely used by private investors as well as fund managers and trading companies, and their success all over the globe demonstrates how useful they can be. CFDs will always be a specialised and focused tool to help hedge a portfolio against systematic risks.

What is Margin?

One of the main appeals regarding CFD trading is the ability to add ‘gearing’ to your positions. Generally speaking when you enter a CFD trade you will only have to deposit approx 10% of the contract value thus gearing your trade by 10 times. This obviously can magnify potential profits and of course losses.

How can CFDs leverage an investment?

Using contracts for differences investors need only put down a fraction of the total value of a trade. This is typically 10% (and lower than this for the more widely traded markets such as forex pairs trading); this means that investors can potentially make more, whilst putting down less money as they can trade often 10 or 20 times (and probably much more but leveraging yourself to the tilt is not recommended!) the size of their deposit; but of course they can also lose more. Profits or losses can quickly exceed the initial capital outlay.

Leverage allows an investor to outlay a smaller amount than is normally required to invest in world markets.

This means that with CFDs there is no need to make a large initial outlay to get started. That’s because rather than buying the stocks outright, you simply put a deposit on them. Of course it is recommended that you are adequately capitalised.

For instance, if you were to purchase a CFD over Vodafone shares the deposit required might be just 5% of the value of the trade. This deposit is referred to as initial margin in financial markets terms. So if Vodafone is trading at 167p a share and you wanted to buy 10,000 shares it works out something like this: £1.67 x 10,000 x 5% = £835. So only £835 would be needed to open this position rather than £16,700 to purchase the Vodafone shares outright. You still enjoy the possible gains in owning 10,000 Vodafone shares as if you owned them outright.

What costs are involved?

Your CFD provider will usually charge a commission for each trade usually between 0.10% and 0.25% but this can fluctuate depending on whether the provider is giving an advisory service or including the charges in the share price by widening the spread. Other charges will include be a funding charge where typically your CFD provider will be funding on average 90% of the trade value so you will be charged interest on the total value of your position at about 2-3% above the base rate of the country in which the underlying stock is traded. (see CFD examples for more clarification).

Are there any disadvantages to holding a CFD rather than a share?

You don’t get a say in the company’s operations; for instance CFD holders don’t get an invite to the company’s annual meeting, or get to vote on shareholder issues because with a contract for difference you do not own the underlying securities.

How can CFDs be used to make money when markets go down?

Another trading strategy made possible with CFD trading is shorting which gives investors the capacity to profit from falling markets. Using CFDs investors are able to open up a ‘short’ position on a financial instrument (investment), which in practice means they may make money if a stock price or market goes down. This allows traders and investors to gain in a falling market. Shorting in effect means to sell something that you don’t currently own, knowing that at some point in the future you will have to buy the same quantity back. To make a gain in the financial markets you can either ‘buy low and sell high’ or ‘sell high and buy low’. If you sell something at a high price and then manage to buy it back at a lower price, then the difference makes up your profit. It is a strategy often used by more sophisticated investors that either believe the market is going down or as part of a hedging strategy.

Shorting is very difficult to do with conventional share trading. The risk of shorting is that the price of the market you’re trading rises, meaning a loss that could even exceed your initial investment.

What is ‘going short’?

A large number of tradeable CFDs give you the ability to ‘go short’ which simply means selling first and buying back later. Traders would use this facility to take advantage of falling prices or to protect a current long position.

How can CFDs be combined with traditional share dealing to reduce risk?

Investors can utilise CFDs to hedge against adverse market movements. Let’s say you owned banking stocks and feared that they would fall in value but didn’t want to sell; you could enter a short CFD trade in the same stock to temporarily neutralise that position. The advantage here is that you are utilising leverage so you don’t need so much capital to setup the hedge.

Hedging isn’t limited to individual shares either. For instance, you may own a portfolio of FTSE 100 blue-chip share investments that you wish to continue holding but you are worried that in the short term the investment might lose some value because you believe the share markets are heading down. You can take out a short contract for difference contract so as to profit from a drop in the share price and thereby in this way help offset any losses incurred on the physical holdings. To protect your position, you could sell a FTSE 100 Index CFD against this position to minimise losses if the market subsequently falls. As your share investments lose value, your CFD position becomes profitable. This investment strategy is largely referred to as ‘hedging’ your risk and is commonly utilised by experienced investors alongside their shares portfolios.

Example: Let’s say the FTSE 100 is presently trading at 5,600. An investor with a diversified portfolio of blue chip shares worth £100,000 could ‘protect’ his positions by setting up a short on the corresponding index CFD. Assuming a single index CFD is equivalent to an exposure of a pound a point the investor would need to short 18 contracts to cover his investment. Assuming a margin requirement of 2%, one would need £2,000 to establish this hedge (plus extra funds to cover running losses). There would also be the overnight financing fee of about £6 each day the position is kept open.

Note that hedging is just a way of protecting an investment against downside loss by making balancing or opposing contracts or transactions with another investment. In other words with hedging you are trying to minimize unexpected movements against your position.

What are the trading costs and commissions?

Most DMA CFD providers will mirror the prices of the underlying market so the bid-offer spread will normally be very close (if not the same) as if you were buying the shares directly. In such cases the provider will then charge a commission on the transaction. The amount of this commission differs between providers but is typically computed at 0.1% of the market exposure on the buy and sell side, subject to a minimum charge of £8 or £10. Market Makers on the other hand might add a fixed percentage spread on the bid and offer prices of the market instrument without charging direct commission. The other cost you have to take into account is the financing fee which is debited daily on rolling overnight positions. This reflects the fact that you are effectively borrowing most of the funding for the position from the provider.

What about dividend payments?

Despite the fact that you aren’t taking physical delivery of the shares dividends are still applicable. On long positions you will receive 100% of the dividend and on short positions you will pay out 100% of the dividend.

What are the tax implications of CFDs?

UK stamp duty does not currently apply to CFDs. This can mean a saving of 0.5 per cent, for example in the case of CFDs referenced to UK shares. As always, investors should be aware that tax laws can change.

If an investor has a holding of physical shares they can sell CFDs against this, without crystallising a potentially taxable capital gain. This gives the investor control over the time at which capital gains or losses can be crystallised and may help reduce their tax liability.

It has to be noted that CFDs profits are taxable, but active traders and investors are especially attracted to contracts for differences because of the possibility of offsetting losses against tax on any gains.

What are the benefits and risks?

With CFDs being a leveraged product, the benefit should be clear – even relatively modest gains in a stock or commodiity you are trading in can translate into much larger returns than you’d get from other investment products. The risk is that of course this also works in reverse; small losses will also be magnified, resulting in bigger losses than other investment products, including the risk of you losing more than your initial investment. If you are just starting out it is recommended that you utilise leverage conservatively.

What is DMA Access and what are the advantages of trading DMA?

DMA access allows investors and traders to place their buy and sell orders on the central limit order book of the stock exchange. This enables them to trade SETS and SETSmm stocks directly with other market participants, rather than having to go via a market maker and pay their spread. In particular, this is especially valuable when combined with Level 2 prices which allows you the ability to see all the outstanding orders on the actual order book including the volumes of buy and sell orders which make up the supply and demand for a stock. If a share is trading at 184p-188p, an investor using traditional broker would have to cross the spread by buying at the offer of 188p and selling at the bid of 184p. On a round trip trade of 10,000 shares this would cost £400. A DMA CFD trader who was looking to buy could try and improve on the price by entering their own quote inside this spread. This would join the best priced orders at the top of the book and would stand a good possibility of being executed. Other advantages of DMA access i that is allows participating in an exchange opening and closing auctions.

Traders commonly keep an eye on Level 2 by checking the the total number of shares on the bid and offer sides of the book so as to have an idea of the overall levels of supply and demand of a stock. Direct Market Access also allows investors to participate in an exchange’s opening and closing auctions which is when a stock is most likely to reach its high or low point of the day meaning that those with DMA have the possibility to get filled at the very best prices.

Are there ways of limiting risk?

CFDs can be placed on a vast range of global financial markets including stocks, indices, commodities, interest rates and forex pairs.

Where available, investors and traders can utilise stop loss orders to automatically close out a trade if it falls and thus cap losses.

How can you use CFDs as a hedging mechanism?

Being able to go long and short and to leverage trades makes contracts for difference a good tool for executing hedging strategies. If an investor has a physical portfolio of shares he believes could take a hit in coming weeks, he could hedge that risk by taking an opposing position with a CFD.

Let’s suppose it is the last week in January and an investor holds a portfolio of blue-chip stocks worth about £60,000. The FTSE is trading at about 6,000. For capital gains tax purposes the investor would prefer not to sell his shares until the new tax year in April, but is still concerned that his portfolio would fall in the meantime because of widespread troubles in North Africa.

The investor would need to short 10 FTSE 100 CFDs to hedge his market exposure (or alternatively he may opt for a partial hedge). The initial margin requirement is usually 1% so with the FTSE 100 trading at 6,000 each CFD would need an initial deposit of £60. Thus the investor would need about £600 to open the CFD hedge and a few more thousands in cash reserves to cover any losses.

On the 10th of March, the FTSE falls nearly 8% to around 5,520 and the drop has wiped about £4,800 off his stock portfolio. The CFD has moved 480 points in his favour, earning him the equivalent of his shares portfolio loss on that trade. For only a nominal amount (financing fees), he has bought himself an almost perfect (short-term) hedge.

So basically you take a position opposite to your physical holding and wait until the crisis and market volatility have subsided. In this respect it is preservation strategy rather than a way of making money. This hedging system works best in the short term, for instance if an investor owns a portfolio of stocks he believes could fall in the near but would rather not sell, perhaps because the new tax year is approaching and he wants to defer any CGT liability to that coming period. In this case he could short the same shares with a contract for difference, utilising leverage to achieve the same exposure. Any losses incurred on the shares portfolio due to the adverse market conditions would be offset by the profit on the CFD.

Do you recommend any particular CFD providers?

CFD providers are a bit like banks – most offer a satisfactory service, however some are only market makers while others also offer DMA Access.

I like IG Markets as they offer both a quote-driven service (market maker) as well as the ability to trade directly on the exchange (DMA Access) so in effect they offer the best of both worlds. IG Markets quote over 8000 global share CFDs from the world’s top exchanges, as well indices including the Singapore Blue Chip, Japan All-Share, Hong Kong HS34, India 50, Korea KOSPI 200, Taiwan All-Share, China H-Shares, Australia 200, FTSE 100, FTSE 250, Wall Street, USA S&P 500 and Nasdaq; Germany DAX 30, France CAC 40 and other European indices. I also like the fact that IG Markets are themselves a FTSE 250 public limited company and thus quoted on the London Stock Exchange.

Here are some additional benefits of using IG Markets as a CFD provider -:

• Live real-market tradeable prices using Direct Market Access (DMA) functionality, ensuring your share CFD orders go straight into the underlying exchange.
• Live news and charting.
• Participate in share market price auctions – both open and closing market price auctions.
• Real Market Depth is available on all instruments online, allowing clients to view, in real-time, exactly what prices and volumes are available.
• Multiple order types with market alerts including Market, Stop Entry, Stop Exit, Limits, Iceberg and GTC.
• Customisable trading platform.

What About the USA?

CFD trading is not currently permitted in the USA although there they have futures and options which provide similar leverage. Isn’t it strange that the USA continue to be twitchy about letting traders use CFDs? Let’s face it, margin is available anyway on the futures and options, and even 50% on equities. But the governing body, the Securities and Exchange Commission and lobbying powers seem against the trading products.

Perhaps they should have been watching the companies a little more, before the financial houses used all that leverage to contribute to the global financial crisis! I don’t know any individual who could have caused that amount of devastation.