Contracts for Differences
What is a CFD?
A CFD is an agreement between two parties to settle, at the close of the contract, the difference between the opening and closing prices of the contract, multiplied by the number of underlying securities specified in the contract.
CFDs are traded in a similar way to securities such as ordinary shares. The prices quoted by many CFD providers are the same as the underlying market prices and can be traded in any quantity.
Investors will usually be charged a commission on the trade and the total value of the transaction is simply the number of CFDs bought or sold multiplied by the market price. However, there are some distinct differences from trading securities that have made them increasingly popular as an alternative instrument to speculate on the movements of securities markets.
Key features
Traded on margin
Rather than pay the full value of a transaction investors only need to pay a percentage when opening the position called Initial Margin. The key point is that margin allows leverage, so that investors can access a larger amount of securities exposure than they would be able to if buying or selling the securities themselves.
The margin on all open positions must be maintained at the required level over and above any marked to market profits or losses in order keep the position open. If a position moves against the CFD holder and reduces their cash balance so that they are below the required margin level on a particular trade, they will be subject to a “Margin Call” and will have to pay additional money into their account to keep the position open or they may be forced to close it.
Trade in rising or falling markets
CFDs allow investors to trade LONG or SHORT. A Long Trade is where an investor buys an asset with the expectation that it will rise, just as you would when buying a normal share. A Short Trade is where investors sell an asset that they do not own in the expectation that the price will fall and they can buy the asset back at a cheaper price. Shorting in the ordinary share market for instance, is almost impossible. With CFDs, however, investors can go short as easily as they go long. This provides the ability to profit even if a share price falls – assuming the investors trade in the “right” direction.
No Stamp Duty
Because with CFDs, investors don’t actually physically buy the underlying securities, they don’t have to pay stamp duty. Saving 0.5% when compared to a traditional share deal for example.
Commission
Commission is charged on CFDs. The commission is calculated on the total position value not the margin paid.
Overnight Financing
Because CFDs are traded on margin, if an investor holds a position open overnight, it will be subject to a finance charge. Long CFD positions are charged interest if they are held overnight, Short CFD positions will be paid interest.
The rate of interest charged or paid will vary between different brokers and is usually set at a % above or below the current LIBOR (London Inter Bank Offered Rate).
The interest on a position is calculated daily, by applying the applicable interest rate to the daily closing value of the position. The daily closing value is the number of securities multiplied by the closing price. Each day’s interest calculation will be different unless there is no change at all in the share price.
Trade Shares and Indices
CFDs allow investors to take a view on for example, shares and indices and some CFD providers also allow trading on currencies and sectors.
Risk Management Facilities
Because of the higher risk nature of trading on margin, many CFD providers offer comprehensive Stop Loss and Limit Order Facilities so that Investors can manage their risk in fast moving markets.