How to Trade CFDs
What are CFDs?
Equity CFDs are a very simple type of derivative that offer all the benefits of trading shares without having to physically own them. In essence, they are contracts that mirror the performance of the underlying cash market and as with trading the physical shares, the profit or loss is determined by the difference between the purchase price and the selling price. This same principle applies to all of the other markets for which CFDs are now available, including market and sector indices, treasuries, commodities and FX.
CFDs are open-ended contracts that automatically roll over from one day to the next. In theory, they allow trades to be maintained indefinitely but where long positions are held open overnight, they incur a small interest charge, reflecting the fact that most of the exposure is in effect financed on borrowed funds. This financing cost is common to most derivatives but debiting the interest to the account as a separate charge allows the actual pricing of the CFD to be that much more transparent.
A CFD is actually structured as an agreement between two parties – namely the trader and the CFD provider – to exchange at the close of the contract the difference between the opening price and the closing price of the contract, multiplied by the number of shares specified. By definition, such an agreement involves both a long party and a short party. If the client opens the contract by buying the CFD then he will have the long exposure and the CFD provider – his counterparty – will in effect be short on the stock. Conversely, if the client opens the position by short selling the CFD, it is the provider who has the long exposure.
Contracts for difference (CFDs) have come a long way since their inception in the early 1990s. They were first devised by brokerage firm Smith New Court, the UK’s largest independent stockbroker when it was bought by Merrill Lynch in 1995, in a deal worth £526 million. Initially CFD trading was a cost-effective way for Smith New Court’s hedge fund clients to short sell the market while using leverage and avoiding stamp duty. Now CFDs are a fixture of the retail investment scene, today’s private investors can enjoy the same benefits as Smith New Court’s institutional clients did when the product was first created.
Hedging your bets
In order to eliminate this conflict of interest, where one side’s loss is the other’s gain, CFD providers will invariably look to hedge their exposures in the underlying cash market. In practice, where a trader places an order to buy 3,000 XYZ CFDs, the provider would simultaneously enter the market and buy 3,000 XYZ shares as a hedge, writing the equivalent CFD to the client at the same price. The clients receive the position they want – long 3,000 XYZ CFDs. The provider has hedged his short CFD contract with the client by buying stock in the market.
In many respects, trading equity CFDs is very similar to normal share dealing. While it is true that they are cash-settled derivatives that can never involve delivery of the underlying, the most critical difference from a trading perspective is that CFDs are margined products.
This means that unlike share traders, who have to pay the full value of their positions, a CFD trader only requires a deposit or margin balance, which for blue-chip stocks may be as little as 10%.
For example, a deposit of £1,000 would be all that is required to take an equivalent position of £10,000 in the underlying equities.
Gearing up for opportunities
This represents a more efficient use of capital because, even though the CFD investor’s outlay is small in comparison with the equivalent physical trade, he will still be exposed to the same absolute profit and loss. As a result, the potential return on investment is magnified – an effect known as gearing – since a small percentage price change in the underlying equity can result in a far larger percentage gain or loss on the deposited funds.
With a stock quoted at 142/142.25, a trader could buy 10,000 CFDs for an exposure of £14,225 with a balance of as little as £1,423 in his margin account. Should the shares increase in price to 151/151.25, the position could be closed for a profit before costs of 8.75p per share or £875. For the share trader who had to put up the full value of the position, this would represent a gross return on investment of only 6.2%. In contrast, the CFD trader has made the same profit from an outlay of only £1,430 and has geared up his return to 62%.
Trading on margin is, however, a two-edged sword. Had the shares lost 8.75p, or 6.2%, then this would have wiped out almost two-thirds of the margin balance, which is why trading CFDs is riskier than normal share dealing.
Every CFD is revalued each day when the market closes. Where a position is in profit, the monies will be credited to the trader’s account and any losses debited. Should the overall account balance drop below the minimum level required to support the open positions, then an additional margin call will be made.
In practice, CFD holders will need to maintain margin funds in excess of the minimum requirement if they are to avoid the risk of having their positions prematurely closed should the price move against them and they are unable to top up their accounts in time. Realistically, a buffer of at least an extra 25% is advisable.
The percentage margin requirement for any particular instrument is set according to the volatility of the underlying. It is calculated so as to cover the worst-case loss that could reasonably be expected on a given trading day. Because of this, the margin requirements for individual equity CFDs will typically start at 10% for blue chips and increase to 20% or more for smaller stocks. Stock and sector index CFDs represent a more diversified exposure and as such will typically be less volatile than individual equities. Consequently, the margin requirement is usually lower – typically around 7.5% or less of the contract exposure.
Dealing spreads for CFDs
Spreads on CFDs usually vary according to the instrument involved and the exchange where the underlying is quoted. In the case of shares, as CFD prices are derived from the underlying equity market, you gain access to the underlying market liquidity. That means CFD dealing spreads are extremely competitive and will often mirror the cash price. The width of market spread is important as the narrower the spread, the less the market has to move in your favour before your trade becomes profitable.
This ‘How to’ guide is produced by Shares Magazine and is only for general information and use, and is not intended to address particular requirements.
The value of investments and the income derived from them can go down as well as up. Past performance is not necessarily a guide to future performance.
You should get professional financial advice before making any investment decisions.