CFDs - Why CFDs are cost effective
CFDs offer many advantages over traditional share dealing - not least in trading costs and financing
Active traders in particular will find equity CFDs considerably more cost-effective than conventional share dealing. The impact of charges on the two different approaches can be seen in the table, which compares an identical exposure to 10,000 shares in Company X.
The most difficult element of the cost to quantify is the bid-offer spread – the difference between buying price and selling price. Even in the underlying cash market, this varies between shares and will fluctuate during the day in response to market conditions. Because of this, most CFD providers calculate and display in their systems the volume-weighted average price or VWAP to give an indication of the average price dependent on size traded.
No stamp duty
Since the majority of CFD providers charge the true underlying cash market price without adding any mark-up to the bid-offer spread, both trades are included in the comparison at the identical price of 141p. Consequently the first key difference is the absence of stamp duty from the CFD purchase, representing a saving of 0.5% or £70.50 in this example.
Both the conventional share trade and the equivalent CFD transaction incur a commission charge. The actual cost will depend on the particular broker but generally a FTSE100 CFD would be in the region of 0.15% to 0.20% of the contract value with the share trade possibly costing slightly more. Some CFD providers and conventional share brokers do, however, offer fixed-ticket commission charges that would work out better value when dealing in large orders.
Closing the positions will also incur commission. Assuming the share price increases in value to 150p over the subsequent three days, then both routes would have realised a profit before costs of £900. The absence of stamp duty and the lower commission charge both make the CFD cheaper. Unlike the share trade, however, the long CFD position attracts a daily financing charge.
This is because the client has only had to keep a margin balance on his account of 10% of the underlying contract value to maintain the position. In effect, the CFD provider has lent the other 90% at an agreed rate over base rates – typically 2.5%. The financing charge is debited on a daily basis in respect of all overnight positions. After taking this into account, the CFD trade works out £77 cheaper and was possible with around one-tenth of the funds needed to finance the equivalent position in the underlying cash market.
Crossover point
Setting aside the slight variation in commission levels, the critical difference between the long CFD position and the equivalent share trade is the stamp duty saving versus the daily financing charge. This means there is a clear crossover point when the saving on the former is cancelled out by the accumulation of the latter. Based on a financing rate of 2.5% over base on 90% of the value of the transaction, this occurs after around 11 weeks. In other words, it is economically more beneficial to hold the CFD for a short-term trade. If the investment is held for longer than about 11 weeks, it will probably be more efficient to pay the stamp duty.
The situation is rather different for short positions, which actually earn interest when held overnight. The rate applicable to sterling-denominated positions is based on the London interbank bid rate and is typically LIBID minus 2.5%.
Relationship management
The majority of equity CFD providers look to offer a relationship along the lines of a traditional stockbroker, acting as an agent on behalf of their clients. In other words, they are not risk-takers but instead look to hedge their CFD transactions in the underlying cash market.
So if a client was, for example, to submit an order to buy 10,000 CFDs in Vodafone, the provider would simultaneously enter the market, buy 10,000 shares in Vodafone as a hedge and write a CFD to the client at the same price. The client receives the position that he wants – 10,000 long Vodafone CFDs – while the provider has hedged his short CFD contract with the client by buying stock in the market. Although counterparties to the CFD transaction, the fact that the CFD provider is hedging means that any price improvement can be passed on to the client, who as a result pays the best cash market price.
The relationship between the client and CFD provider is crucial. Traders need transparent prices that track the cash market without any delays. Where a provider adopts the broker type model, always hedging and charging the true underlying market price, there is very little scope for a conflict of interest despite the fact that the client and provider are counterparties to each other.
With this type of approach, the CFD provider makes his money from the overnight financing charge and by levying commission on each transaction. The amount varies slightly between providers and will typically range from 0.15% to 0.25% of the contract value. This will apply to both the opening and the closing trades, making a 0.3% to 0.5% charge for the two-way trip.
Some providers choose to offer a fixed-ticket commission of around £10 on the FTSE100 constituents, which is extremely cost-effective for large orders. The alternative adopted by those who charge no or low commission is to add a mark-up to the cash market bid-offer spread. This can work out good value, depending on how competitive the quote is, but has the effect of making the pricing less transparent.
Getting a quote
The majority of equity CFD traders prefer the ease and cost- effectiveness of a quote-driven service, where they are simply presented with their provider’s bid and offer prices. The main limitation, other than having to accept the price as presented, is that those trading in large sizes may be subject to liquidity curbs leading to dealing delays.
Sophisticated traders unhappy with these restrictions can sign up to one of the growing number of providers offering a direct market access (DMA) service. This technology effectively allows clients to execute directly into the London Stock Exchange’s electronic order book, providing access to the greater liquidity of the main market and the choice of entering their order at whatever price they wish.
A DMA service together with Level 2 market-depth data showing the full extent of the order book opens up some sophisticated trading opportunities. One of the main attractions is the greater transparency – traders can see the full order book and know exactly where they are in the queue. This means they can choose to trade on the bid/offer or can enter their price to get the fill they want – for example ahead of a large order. Seeing this information can also help to determine the size of the order by revealing the levels at which it is likely to be filled. It also makes it possible to trade the opening, closing and intra-day auctions.
Underlying value
Index CFDs will be priced according to the underlying index level or based on the futures price as adjusted for fair value. These products are generally traded commission-free, with the providers adding a fixed spread to their quotes – the most competitive being around three to six points on the most common indices.
They may be a point or two wider when traded outside normal market hours and the prices at such times would take their lead from the futures markets as the best indication of where the cash market would stand were it open.
Opening trade
Share
CFD
Price of Company X
141p
141p
Number of shares
10,000
10,000
Opening value of shares
£14,100
£14,100
Stamp duty
£70.50
0
Commission
(0.25%) £35.25
(0.20%) £28.20
Initial investment
based on 10% margin
£14,205.75
£1,438.20
Closing trade
Share
CFD
Price of Company X
150p
150p
Number of shares
10,000
10,000
Opening value of shares
£14,100
£14,100
Closing value of shares
£15,000
£15,000
Profit on trade before costs
£900
£900
Stamp duty
£70.50
£0.00
Total commission(buy and sell)
£72.75
£58.20
Financing (3 days at 7.50%)
£0.00
£7.82
Overall profit on trade
£756.75
£833.98
Return on investment
5.33%
57.99%
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.