Understanding CFD's
Understanding contract for difference (CFD)
What is contract for difference?
To understand CFD we have to look at it from a seller and buyer point of view. Simplest way to put it is a contract between a buyer and a seller agreeing to settle the trade, where the difference between opening price and closing price of an underling asset is settled as cash settlement. Here the seller will pay the difference in trade price to the buyer or will receive the difference in traded price is the price of the underline asset goes negative.
History of CFD’S
All though the origin of CFD’s is debatable it is widely
Accepted that the first contract for difference was created in early 1990’s in London as equity swap that was traded on margin. Brokerage firm Smith new court had created the first CFD as a short sell in the market for a client using leverage. Smith New Court was later bought by Merrill Lynch. The unique feature of this CFD was less margin and higher leverage, it did not have stamp duty thus making CFD’S even more popular with traders. As there is no physical stock holding thus no stamp duty.
CFDs for retail clients.
The CFD’S are brand new financial instruments when compared to other existing financial products like futures contract. Just because CFD’s are new it done not mean they are not popular. They are one of the largest traded instruments in the world and still continuing to grow rapidly. As more and more Retail investors are trading CFD’s using online trading platform with brokers providing various CFD’s and higher margin.
All though the retails trader were offered trading in London stock exchange without having direct access via online trading system created by the company GNI. MF global in late 2002 took over GNI, thus becoming the world leader in both futures and CFD’S.
HOW CONTRACT FOR DIFFERENCE WORKS.
CFD’s offer trading opportunity in price moment of underlying asset without owing them. They are simple to trade as the profit or losses are calculated based on difference between entry and exit based on price change of underlying asset. CFD’S are not traded on any exchange as they are over the counter (OTC) products. The CFD for any stocks, forex, commodity or futures is executed between client and the broker and not via any exchange. CFD’s allow traders to trade in price variation of futures but CFD’s are not futures contract themselves. They do not have expiration dates unlike other instruments where the have expiry date.
Consider an example for a stock xyz having ask price $10 per share and the trader buy 5000 share, the cost of the transaction will be $50,000.00 the trader might have to pay the entire amount to purchase them also including commission and fees. Where as in CFD the broker usually require 2% as margin thus trader has to keep only $1000. The margin percentage changes from product to product. CFD’s are high leverage products thus cost to cover the contract is way less than what is required in futures contract.
CFD’s have spreads which is the difference between the bid and the ask price of the underlying asset. They may also have commission and swap/overnight charges as they do not have expiry date.
While trading a CFD a loss equal to the size of spread and or commission is applicable at the time of transaction. So if the spread is $10 that means the stock has to gain $10 for position to reach break-even price you will gain profit only after the price have outright the spreads and commission charged.
Advantages and disadvantages.
All though there are many advantages over disadvantages but some of the most notable are as follows:
a) CFD’s allow traders to trade various asset such as stocks, currency’s, commodities, indices ETF’s and even cryptocurrencies.
b) Trader can trade on any asset price moment without owing the actual asset.
c) CFD’s are traded as OVER THE COUNTER products having no expiry time and can be traded through a broker 5 days a week in same cases 24*7.
d) Leverage is high on CFD’s thus the margin required to enter a contract is very less.
e) Traders can hold both long and short position in the same asset.
f) Flexible small contact size can be traded.
g) New trading instrument can be created as no exchange is involved in OTC products. The recent eg: CFD’s for cryptocurrencies.
Some of notable disadvantages of CFD;s are :
a) As CFD’s are over the counter products they are not regulated by any central authority. The market is decentralized.
b) CFD’s have highly leverage products which can exponentially increase the potential loss and gain.
c) Bucket shops try to exploit investors under market maker model.
d) Lack of transparency as they are trade over the counter. concerns over liquidity, margin call , stop outs , requotes and slippage have always earned a bad name.
Difference between spread betting and CFD’s.
Leverage products offer traders the opportunity to trade with small deposit size. Spread betting is popular in United Kingdom.
CFD’s and spread betting are both leverage products providing exposure to equity, forex , commodities , indices ,ETF’s and even cryptocurrencies.
Although CFD’s and spread betting are similar as they both allow the trader to take position on the future value of an asset. They can take a buy price if they thing the price will appreciate or sell if the price will depreciate. However there are some differences in these two products.
a) The difference between the bid and the ask price is the spread which is similar to difference In opening value and the closing value and there gain. But spread betting is measure In basis point having option to go long or short.
b) CFD’s have no expiration dates where as Spread bets have fixed expiration date.
c) Spread bets are completely OTC where as CFD’s could be OTC or Direct market access.
d) Spread bets charge only spreads where as CFD’s have spread, commission and in come cased transaction fees. The profit in spread bet will be the change in the basis point multiplied by the pound amount negotiated in the initial bet.
e) Most important when the profits are realized for CFD trades the investor have to pay capital gains tax, whereas in spread betting the profits are tax free.
It is always advised to understand the market if you want to be an investor. Trading in CFD’s could be highly rewarding but it can also be extremely risky. If you want to understand these products you can also try the Demo trading account which is easily available with CFD brokers.
Ashutosh Gedamkar
Account Manager India
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