CFDs

Definition
A Contract For Difference (CFD) is an agreement made between two parties to exchange, at the closing of the contract, the difference between the opening and closing prices of the underlying share, multiplied by the number of shares detailed in the contract. They are geared (or leveraged) instruments. When trading a share via a CFD, instead of paying the full consideration a margin payment from as little as 10% of the value of the contract may be paid. Consequently you can hold a position up to 10 times greater than would be possible with a traditional investment. Anticipating the right price movement will magnify profits. Conversely, losses can magnify if the price moves against you.

CFD’s are available on the shares of most listed companies in the UK and major economies around the world as well as indices, interest rates, foreign exchange, gold, silver, commodities and more.

How CFD’s work?
Assume there is a stock (Company A) that you think has the potential to rise in price and are interested in purchasing £10,000 of it. You have 2 options; you could either buy shares in the stock or buy a CFD on the stock. Choosing to purchase the actual shares would mean that you would be required to use your full £10,000 plus an additional 0.5% on stamp duty (excluding brokers commission charges). Your full £10,000 would be tied up in the stock and it is only this amount which you would risk losing should your investment in Company A go totally wrong.

Alternatively, you could take out a CFD on Company A with the full £10,000 capital you have available or even a smaller amount and still maintain the same £10,000 exposure as the direct equity investment.

Margin Requirements
Whilst different CFD brokers operate on various margin percentages, an industry average is around 10%. This £10,000 available for your investment could imply ten times leverage - your CFD position being valued at £100,000. On the other hand, should you not wish to tie up all the £10,000 in your CFD position, you could choose to use only £1,000, still maintaining the 10% margin requirement and hence reduce your total exposure of your CFD position. There are several possible alternatives available to the investor depending on their appetite to risk. Whilst your gains could be magnified ten times, so could your losses.

Gearing
Should you choose to opt for the full £10,000 as margin, the gearing element makes the maximum possible loss on your direct equity investment above only £10,000, whilst your CFD position could loose you ten times that - £100,000. A very risky scenario!

Stamp Duty
Furthermore, your CFD position would also do away with you having to pay stamp duty on the investment. Because you never actually own the underlying shares via a CFD, your therefore do not need to pay stamp duty on the purchase of the CFD.

Funding Charges
On long CFD positions one would need to pay an overnight funding rate on the amount that has been loaned to you (£90,000) from the brokerage house you are trading with. Conversely, on short positions, in theory you are loaning money to your broking institution and hence would usually receive interest for the duration of your position. As a result, an overnight lending rate is received.

Shareholder Attributes
Other than shareholder privileges (voting rights for example), a CFD reflects all corporate actions affecting the underlying share. Holders of a ‘long’ CFD will receive the net dividend on the ex-dividend date, whilst holders of ‘short’ CFD’s pay the net dividend.

Long and Short
You can choose to buy (‘go long’) of a CFD in the expectation that the price of the underlying equity will rise, or sell (‘go short’) of a CFD if you expect its price to fall. When the price movement happens you close the contract (i.e. take a position in the opposite direction), to realise your profit or loss. There is a distinct advantage with CFD’s over direct equity investments. The ability of ‘going short’ allows the investor to make money as shares prices fall. Investors can sell shares they don’t actually own, or ‘go short’, in anticipation of buying back at a lower level and profiting from a price fall. However, potential losses could be unlimited. See below for some examples of long and short CFD positions.

Example
Below are summarised examples of going long and short with a CFD. In both cases there are two outcomes – profit and loss.
 

• Company A is trading at 99/100 and you think the price is going to rise in value. You decide to buy Company A CFD’s at 100p
• You decide to trade 100,000 shares. You buy 100,000 CFD’s at 100p giving you a position size of £100,000 (100,000 x 100p)
• Both shares and CFD’s attract commission charges, but for simplicity of this example, we shall assume there is none
• Your margin requirement with for Company A is 10%, therefore £10,000 will be allocated from your account against this trade as initial margin. Remember if the share price moves against you, it is possible to lose more than this £10,000 initial margin requirement *
• Three days later there has been positive economic news and the shares price of Company A has risen to 162/163p. Furthermore, there is expectation of no further price rises and you decide to close your CFD position
• Therefore you sell 100,000 CFD’s in Company A at 162p and realise your profit.
• You sold at 162p and bought initially at 100p. Company A rose by 62p. Therefore, a profit of £62,000 (62p x 100,000 CFD’s)
• Your initial margin of £10,000 has resulted in a £62,000 profit on your position. Thus, your initial £10,000 plus your additional amount of £62,000 profit (minus funding costs and commission charges) is paid to you by the broking house you took out the CFD with.
• Alternatively, had you opted from the beginning to purchase the underlying shares, your profit on sale would have only been £6,200 (62p x 10,000 shares), from your initial £10,000 investment (assuming no stamp duty and commission charges)
• The return on the direct equity investment being 62% versus the return on the CFD of 620% of your initial investment of £10,000
• The effect of CFD’s is to magnify your gains should you get the investment decision right

* It is possible to reduce your total exposure by taking a smaller CFD position – say £10,000 and only using £1,000 as your 10% margin requirement.

Going Long & Getting it Wrong

• Company A is trading at 99/100 and you think the price is going to rise in value. You decide to buy Company A CFD’s at 100p
• You decide to trade 100,000 shares. You buy 100,000 CFD’s at 100p giving you a position size of £100,000 (100,000 x 100p)
• Both shares and CFD’s attract commission charges, but for simplicity of this example, we shall assume there is none
• Your margin requirement with for Company A is 10%, therefore £10,000 will be allocated from your account against this trade as initial margin. Remember if the share price moves against you, it is possible to lose more than this £10,000 initial margin requirement *
• Three days later there has been seriously poor economic news and the shares price of Company A has fallen to 62/63p. Furthermore, there is expectation of further price falls and you decide to close your CFD position
• Therefore you sell 100,000 CFD’s in Company A at 62p and realise your loss.
• You sold at 62p and bought initially at 100p. Company A fell by 38p. Therefore, a loss of £38,000 (38p x 100,000 CFD’s)
• Your initial margin of £10,000 has resulted in a £38,000 loss on your position. Thus, an additional amount of £28,000 (plus funding costs and commission charges) is owed to the broking house you took out the CFD with
• Alternatively, had you opted from the beginning to purchase the underlying shares, your loss on sale would have only been £3,800 (38p x 10,000 shares), and you would still have £6,200 (assuming no stamp duty and commission charges) remaining from your initial £10,000 investment
• The effect of CFD’s is to magnify your losses. A very costly product should you get the investment decision wrong

* It is possible to reduce your total exposure by taking a smaller CFD position – say £10,000 and only using £1,000 as your 10% margin requirement.

Going Short & Getting it Right

• Company A is trading at 99/100 and you think the price is going to fall in value. You decide to sell Company A CFD’s at 99p
• You decide to trade 100,000 shares. You sell 100,000 CFD’s at 0.99p giving you a position size of £99,000 (10,000 x 0.99p)
• Both shares and CFD’s attract commission charges, but for simplicity of this example, we shall assume there is none
• Your margin requirement with for Company A is 10% therefore £9,900 will be allocated from your account against this trade as initial margin. Remember if the share price moves against you, it is possible to lose more than this £9,900 initial margin requirement *
• Three days later you see that Company A has fallen to 62/63p. Thankfully, it has moved in your favour
• Therefore you buy 100,000 CFD’s in Company A at 63p, to you close your position and realise your profit
• You sold at 99p and bought back at 63p, which means Company A fell by 36p. Therefore, a profit of £36,000 (36p x 100,000 CFD’s)
• Your initial margin of £10,000 has resulted in a £36,000 profit on your position. Thus, your initial £10,000 plus your additional amount of £36,000 profit (plus funding costs minus commission charges) is paid to you by the broking house you took out the CFD with
• On short positions, in theory you are loaning money to your broking institution and hence would usually receive interest for the duration of your position. However, for simplicity we will assume zero financing. Likewise zero commission charges
• The CFD allows you to sell something you do not have so as to profit from a falling share price. Had a product like this not existed, one would not be able to sell a share if they were not it possession of it in the first place – like normal shares
• The return on the CFD is 360% of your initial investment of £10,000
• The limitation of going short is that the upside potential is limited to zero. A share price can never fall lower than £0.00p

* It is possible to reduce your total exposure by taking a smaller CFD position – say £10,000 and only using £1,000 as your 10% margin requirement.

Going Short & Getting it Wrong

• Company A is trading at 99/100 and you think the price is going to fall in value. You decide to sell Company A CFD’s at 99p
• You decide to trade 100,000 shares. You sell 100,000 CFD’s at 0.99p giving you a position size of £99,000 (10,000 x 0.99p)
• Both shares and CFD’s attract commission charges, but for simplicity of this example, we shall assume there is none
• Your margin requirement with for Company A is 10% therefore £9,900 will be allocated from your account against this trade as initial margin. Remember if the share price moves against you, it is possible to lose more than this £9,900 initial margin requirement *
• Three days later you see that Company A has risen to 162/163p. Unfortunately, it has moved against you
• Therefore you buy 100,000 CFD’s in Company A at 163p, you close your position and incur a loss
• You sold at 99p and bought back at 163p, which means Company A fell by 64p. Therefore, a loss of £64,000 (64p x 100,000 CFD’s)
• Your initial margin of £10,000 has resulted in a £64,000 loss on your position. Thus, an additional amount of £54,000 (minus funding costs plus commission charges) is owed to the broking house you took out the CFD with
• On short positions, in theory you are loaning money to your broking institution and hence would usually receive interest for the duration of your position. However, for simplicity we will assume zero financing. Likewise zero commission charges
• The CFD allows you to sell something you do not have so as to profit from a falling share price. Had a product like this not existed, one would not be able to sell a share if they were not it possession of it in the first place – like normal shares
• When a position goes in the wrong direction and rises, the investor will always be closing a position at a higher price than he had initially sold at. As a result, sustaining a loss. The problem with short positions is that the price of the underlying security can rise to infinity, thus making the investors potential loss unlimited
• The return on the CFD is a loss of 640% of your initial investment of £10,000
• The effect of CFD’s is to magnify your losses. A very costly product should you get the investment decision wrong

* It is possible to reduce your total exposure by taking a smaller CFD position – say £10,000 and only using £1,000 as your 10% margin requirement.

Not Useful						Very Useful
Thank You for Rating!