CONTRACTS FOR DIFFERENCE

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1 CONTRACTS FOR DIFFERENCE Contracts for Difference (CFD s) were originally developed in the early 1990s in London by UBS WARBURG. Based on equity swaps, they had the benefit of being traded on margin. They were used by hedge funds and institutional investors to hedge their exposure to stocks on the London Stock Exchange in a cost-effective manner. CFD s are now offered by a number of UK companies, whose offerings are typically characterised by innovative on-line trading platforms that make it easy to see live prices and trade in real time. CFDs are in essence a cheap and effective way to speculate both long and short on market movements in individual shares, indices, commodities, bonds and FX. What Are CFDs? CFD s are agreements formed by the trader which denote a nominal value of a particular asset. If the trader believes the relevant asset or market will rise over time beyond the nominal value, he buys the contract. When the asset rises above the nominal value as forecast, the trader then sells the contract, locking in the difference in trading profit. The reverse is true with shorting a particular market or asset - the trader sells in the first instance to later buy, and pockets the difference. The nominal value is tied to the underlying price of the assets traded, and therefore fluctuates in accordance with market movements. How do CFDs Work? A CFD is a contract between buyer and seller to pay the difference between the opening and closing value of the underlying instrument in cash when the contract is terminated (closed). Unlike conventional trading where you pay the full amount of the underlying value, with CFDs you only make a small payment via your broker to guarantee that you meet the obligations of the contract. This is called margin and you are required to maintain it at all times. If the trade goes the wrong way you will be asked for more money to restore your margin requirements. The easiest way to understand trading in CFDs is to look at it as buying an asset with a short-term loan from your broker. You get a loan and pay interest on the borrowed amount on a daily basis. When you terminate the contract you pay off the debt and pocket the profits. As a CFD is a margined (or leveraged) trading instrument your profits are magnified, the same applies to your losses and you can lose more than your initial margin. 1

2 CFD Trading Advantages CFDs & Dividends - investors in CFDs contracts will benefit from any equivalent dividends by the shareholder company as long as that contract is active. Longs & Shorts - CFDs allows you to go short. Margin Trading - you can make your capital go further as you trade on margin, which means that you do not invest the full value of the underlying instrument. This allows greater scope for diversification. Simplicity and Transparency - CFD trading is as simple way of trading in the underlying product. Transaction Costs - trading in CFDs may offer lower transaction costs than trading in the underlying. However overnight interest charges may apply when holding a long position. CFD Trading Disadvantages Margin Exposure - as you do not have to invest the whole value with CFDs you are potentially exposed to greater risks. You could lose your initial investment plus have to make margin payments frequently. In this case, you are potentially exposed to unlimited loss. Rights of Investors unlike in a direct share purchase, investors in CFDs have no voting rights as they do not physically own the shares. Guaranteed Stop Losses - although they play a big role in limiting the risks, the guaranteed stop loss may have a life limit and can be expensive. Dividends Are Charged - when opening a short CFD position, investors may end up paying the whole dividend if they hold their short position over the deadline of the transaction. Margin Requirements for CFD Trading Margin represents an integral part of derivatives trading, be it CFDs, financial spread betting, futures or options trading. It is an upfront payment to guarantee that you can meet your contractual obligations. Consider it as a deposit with your broker and it s returned to you when you terminate the contract. It plays an important role in CFD trading and understandably varies from broker to broker and vastly depends on volatility and liquidity of the underlying asset. Less volatile instruments such as FTSE100 index have low margin requirements whereas less liquid and more volatile markets such as AIM shares will have considerably higher margin requirements and can in theory ultimately reach 100%. Besides, brokers can lower or raise margin requirements depending on the market conditions. The banking crisis in 2008 was the best example, when FTSE100 had daily swings of more than 5% and margin requirements were raised to accommodate such circumstances. You have to bear in mind that it is not a good idea to use all the money in your account just for initial margin as if the trade goes the wrong way your broker will contact you and ask for more money to maintain the agreed margin, which is termed a margin call. You have to make sure that you can meet the margin call at all times otherwise your positions will be automatically closed even though the market turns around and goes your way. 2

3 CFD Financing Cost As CFDs are a margined product where you borrow money from your broker to buy assets it is very important that you understand financing costs associated with CFD trading. Make sure you understand how and when interest for long positions is charged and credited for short positions. Essentially, most brokers use LIBOR (London Inter Bank Offered Rate) as the base for financing costs. At times of economic stability LIBOR very closely follows the Bank of England s Base Rate but as the banking crisis of 2008 showed that is not always the case. Your CFD broker will quote something like LIBOR +/- 2% which means that long positions will be charged at a rate of LIBOR + 2% and short positions will be credited at a rate of LIBOR - 2%. For example, if LIBOR stands at 2.56% it means that you pay 4.56% for long positions and receive 0.56% for short positions. This is an annual charge. It may sound small but over time the charges build up and you still may end up with a loss even if the market goes the way you expected it. Make sure you keep an eye on the Bank of England s Base Rate and take into account the financing costs when you trade CFDs. Risks with CFD Trading Risk 1: Not understanding the CFD market can be a very costly mistake. You must fully understand CFDs, the various risks involved, be prepared to stay actively involved with them on a day-to-day basis, and develop some good trading strategies. You must have enough knowledge to make an informed decision. Risk 2: Do not overtrade. Risk 3: Becoming arrogant and bigheaded, a few good wins and you begin to feel you are infallible and start getting into the too large trading mode. You are surely in for a fall if you adopt this attitude. There certainly is no reason not to be proud and excited about a substantial win. Sometimes when this happens you let your defences down. You figure you won so even if you lose you can afford it. This is a very risky attitude. Once you lose you may start making the wrong decisions in order to try and gain back your losses. Risk 4: Don t trade in products that you don t know about. You have to realize that you will need to make decisions about your transactions; it s pretty hard to make a decision about something you know nothing about. 3

4 Risk 5: Take time to understand the pros and cons of leverage. This is a double edged sword. Risk 6: Know the pros and cons to short selling. Once you have researched what CFD s are really all about and what they entail you are naturally going to be far more knowledgeable. Just remember you are not going to learn trading overnight. You must do your homework. CFD Trading Strategies CFDs are derivative off-exchange instruments which allow traders to speculate on price movements. Traded directly with the broker rather than the market, CFDs are contracts to buy or sell an underlying instrument at some future point, at a price stipulated today. CFDs allow traders to adopt highly leveraged positions, and can provide traders with an alternative instrument on which to base their stock, market index, commodity and FX projects. There are numerous trading strategies applicable to trading CFDs. The importance of CFD trading strategies is hard to overstate, and without a coherent and defined plan of action it is extremely difficult to get to a stage where your CFDs consistently deliver a profit. Choosing which CFD trading strategies to employ for best effect is something of a balancing act, and requires you to factor in a number of considerations when making that decision, including your appetite for risk, your trading objectives, the impact of leverage on your positions and your available capital. Going Long with CFDs Whilst CFD s have gained in popularity the product still remains largely underutilised by traders and going long is still the most common strategy deployed by those that have turned their attention to the world of CFDs. Going long, as the name suggests, involves looking for markets, indices and securities that have upside potential and investing on that basis. Because CFDs are not time restricted, traders can afford to bide their time and cash in when prices do rise over the longer term, and looking for underlying instruments with a likely positive price movement over time narrows your focus to performance reports and indicators that suggest upside price movement. Given that most businesses and resultantly most markets are striving towards growth, this aligns your interests with those of the underlying businesses, meaning you re working with those in whom you invest, rather than against them. Going Short with CFDs In contrast to going long, going short is also an equally appropriate strategy for trading CFDs, and involves selling contracts up front only to buy them back when the price falls and lock in the intermediate profit. This can be particularly effectively employed where there are factors with a potential longer-term negative outlook for an 4

5 economy, industry currency or commodity. Going short requires the trader to identify such factors that could come to bear on the performance of a particular instrument or market, and taking out a short position to capitalise on downwards trends over time. The strategy is particularly popular among hedge funds who not only benefit from upward moves but from downward market moves as well, hence increasing profit potential and trading possibilities. Pairs Trading with CFDs One of the most popular strategies for trading CFDs, particularly amongst larger investors, is pairs trading. Pairs trading is often used as a hedging strategy against losses, and relies on traders identifying correlative shares and instruments which tend to fluctuate in tandem - i.e. where one instrument rises, a corresponding instrument falls. For example, a rise in interest rates might benefit mortgage lenders but adversely affect home builders, which could create a potential hedged pairing to mitigate losses and deliver a profit whatever the outcome. Similarly, pairs trading can be used to multiply earnings on the upside, where a pair of instruments relative to the same sector both tend to move in the same direction. For example, where one telecoms company announces good trading results, so too do other companies in the telecoms industry benefit from a boost in underlying share price. This allows traders to double-up on certain market movements, ultimately amplifying the earnings against a single instrument trade. Another example of pairs trading with CFDs is when investors identify potentially strong companies and go long on them, but to protect themselves from falling market or sector they go short on the whole index. Even if the markets rise they expect the shares of their chosen company to outpace the rise in the sector thus reducing the risk and exposure. Swing Trading with CFDs Another popular strategy when trading CFDs is swing trading, so-called because it attempts to anticipate swings in future prices off the back of data analysis. Swing trading strategies attempt to capitalise on price corrections following up or downtrading on the back of particular one-off announcements, where instruments become either over or underpriced as a temporary consequence of a particular external factor or announcement. When buying a temporarily undervalued instrument, the trader can ultimately cash in as the market corrects this under-pricing, and close the position to lock in the difference in the form of profit. While this tends to be a potentially lucrative trading strategy, it must also be remembered that what goes up doesn t always come down, and vice verse. Trading CFDs, like any other form of investing, is best controlled with the use of a trading strategy. In order to breed consistency into your trading, developing a strategy with which you are comfortable is a vital requirement, and plays a crucial role in maximizing winnings and minimizing downside losses. 5

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