T2W Trading Community

CONTRACTS FOR DIFFERENCE

1. Introduction

Contracts for Difference (CFDs) are derivatives that are settled daily on the basis of the movement in the underlying asset price.

A CFD is a contract between an investor and a broker or market maker rather than between two investors. In theory CFDs can be created in just about any financial commodity, but are usually confined to individual shares and market indices.

Currency CFDs are a rarity.

How it works

If you think that one currency will rise relative to another, you buy or ‘go long in’ at the offer price. If you think that the price of the underlying currency is going to fall, then you sell or ‘go short’ at the bid price. You can therefore use CFDs to speculate, or to hedge against an adverse change in the exchange rate.

Each contract represents a “lot” of 100,000 units of the base currency. Your “marked to market” account is debited or credited daily in accordance with the movement of the underlying currency. This process continues indefinitely until you close out your position and crystallise your gains or losses by conducting an equal and opposite trade in the same currency pair through the same broker. Your realised gains or losses are then posted to your interest-bearing ledger account.

3. Margin trading

You do not have to pay for full exposure to the underlying asset when opening a position. The broker requires initial margin of a fraction of your underlying exposure
As your position is marked to market every day, your margin requirement changes daily. If the funds in your account (‘equity balance’) fall below the minimum margin then you will have ‘shortage in equity’ and will face a ‘margin call’.

4. Charges

There are two main charges on currency CFDs: -

• The bid-offer spread which reflects the spread in the spot market
• Interest adjustments

Interest is debited for running a short position and credited for a long position. This is the reverse of the practice on equity CFDs where long positions are charged interest and short positions credited with interest on the client account.

In any event, the amount of interest debited or credited to your account depends on the interest-rate differential.

5. Controlling Risk

With conventional (free) stop losses, the broker does not guarantee to close out the position at the precise stop rates. Guaranteed stop looses are available, however, at the cost of extra points on the spread.

6. Worked examples

6.1 Speculating on a rise

USD/JPY is quoted at 124.34/124.38 by the broker. You expect USD/JPY to rise, so you buy 5 CFDs worth 500,000 USD at 124.38 = 62,190,000JPY. The broker wants 3% margin i.e.

3% of 62,190,000 = 1,865,700 JPY or 15,000 USD

• Three weeks later USD/JPY is quoted at 127.55/127.50
• You decide to close out your position at the bid price. You make:-
  
  (127.55 – 124.38) X 500,000 = 1,585,000 JPY

However, there is an interest adjustment to your account based on the USD and JPY interest rate differential. Since you are long in USD and short in JPY and because USD interest rates are higher than JPY interest rates, you will receive three weeks worth of credit interest.

6.2 Hedging with guaranteed stop loss

You are bearish about GBP/USD and sell one GBP/USD contract quoted at 1.5844/50. However, you want a guaranteed stop loss which costs you 6 points from the mid-price and another 3 points for the Limited Risk premium. That means that that the effective bid rate is 1.5847 – 0.0006 – 0.0003 = 1.5838

• You set a guaranteed stop loss at 1.6000 in case you have misread the entrails and GBP/USD rises. Even if the market gaps to 1.6500 you are guaranteed to close out at 1.6000. Your maximum loss on this position is therefore:-
  
  (1.6000 – 1.5838) X 100,000 = 1,620 USD


• GDP/USD quickly falls to 1.5825/30 and you are sitting on a paper profit of: -
  
  (1.5838 – 1.5830) X 100,000 = 80 USD credited to your margin account.
• However, GBP/USD subsequently recovers to 1.5949/55 after 30 days and you decide to close out because you think that it will go higher. By IG concession you close out your position from the mid-point of the spread rather than at the offer rate. You lose:-
  
  (1.5952 – 1.5838) X 100,000 = 1,140 USD
• In the meanwhile, you have been charged interest at GBP rates and receiving interest at USD rates. Since GBP interest rates are higher than USD rates, there will be a debit interest adjustment to your ledger account.