Contract for difference
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Revision as of 10:54, 8 July 2005
A contract for difference (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 units (e.g shares) specified in the contract.
CFDs are derivatives traded in a similar way to ordinary shares; however CFDs are traded principal-to-principal with no centralised market quote. As such, they are deemed to be off-exchange or over-the-counter (OTC) products and are not specifically covered by any stock exchange rules. The prices quoted by many CFD providers is the same as the underlying market price and the you can trade in any quantity just as you would with an ordinary share. You 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 ordinary shares that have made them increasingly popular as an alternative instrument to speculate on the movements of shares or indices.
Traded on margin
Rather than pay the full value of a transaction you only need to pay a percentage when opening the position called initial margin. The key point is that margin allows leverage, so that you can access a larger amount of shares than you would be able to if buying or selling the shares 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. This is known as maintenance margin. If a position moves against you and reduces your cash balance so that you are below the required margin level on a particular trade, you will be subject to a margin call and will have to pay additional money into your account to keep the position open or you may be forced to close your position.
Trade in rising or falling markets
CFDs allow you to trade long or short. Shorting in the ordinary share market is almost impossible. With CFDs, however, you can go short as easily as you go long. Giving you the ability to profit even if a share price falls if you trade the right way.
No stamp duty
Because with CFDs, you donâ€™t actually physically buy the underlying shares, you donâ€™t have to pay stamp duty, saving 0.5% when compared to a traditional share deal.
Commission is charged on CFDs just like on an ordinary share trade, the commission is calculated on the total position value not the margin paid.
Because CFDs are traded on margin if you hold 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 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 shares 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
Risk Management Facilities
The best way to demonstrate how a CFD works is to look at some key examples:
Share CFD Example: Long Trade
A long trade is a position that is opened with a buy in the expectation that the share price will rise.
Vodafone is currently trading 140 â€“ 140.5
Investor A believes that Vodafone is going to rise and places a trade to buy 10000 shares as a CFD at 140.5p. The total value of the contract would be Â£14050 but they would only need to make an initial 10% deposit (initial margin) Â£1405.
The commission on the trade is Â£28.10 (Â£14050 x .20%) and because they are buying a CFD there is no stamp duty to pay.
A week later Investor Aâ€™s prediction was correct and Vodafone rise to 145 â€“ 145.5 and they decide to close there position. By selling 10,000 Vodafone CFDs at 145p. The commission on the trade is Â£29 (Â£14500 * .20%).
The profit on the trade is calculated as follows:
Opening Level 140.50p
To take calculate the overall profit you must take into account the commission and financing charges on the deal.
Profit On Trade Â£ 450.00
Share CFD Example: Short Trade
A short trade is a position that is opened with a sell transaction in the expectation that the share price will fall.
Barclays is currently trading at 555 â€“ 556
Investor B believes that Barclays is over valued and is going to fall and places a trade to SELL 2000 shares as a CFD at 555p. The total value of the contract would be Â£11,100. Even though they are selling short, they would only need to make an initial 10% deposit (initial margin) Â£1,110. The commission on the trade would be Â£22.20 (Â£11,100 x .20%)
A week later Investor Bâ€™s prediction was correct and Barclays falls to 545 â€“ 546 and they decide to close there position. By Buying 2000 Barclays CFDs at 546p, the commission would be Â£21.84.
The profit on the trade is calculated as follows:
Opening Level 555.00p
To calculate the overall profit you must take into account the commission and financing charges on the deal, remember with a â€œShortï¿½? sell the financing charge is credited to the holder.
Profit On Trade Â£ 180.00
Example Trading Strategies
Short Term Trading
The ability to gear up your trading capital by trading on a margin combined with no stamp duty make the CFD an ideal instrument for short-term trading.
You can also use a CFD to protect your long-term holdings against variable market conditions. It may be cheaper to open a short CFD position in the shares rather than sell the physical shares in order to buy them back later.
If you believe that one company is undervalued compared to another company (e.g. Barclays against Lloyds) you can use CFDs to go long on the cheaper stock whilst going short the more expensive stock.
Tax Efficient Trading
If you have a holding of physical shares you can sell CFDs against this without crystallising a potentially taxable capital gain. This enables you to control the time at which you realise capital gains or losses and may reduce your tax liability.
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