Contracts for diff e rence (CFDs)

The Australian Journal of Financial Planning Volume 1 Number 2 19 Contracts for diff e rence (CFDs) an intro d u c t i o n By Andrew Leelart h a ep i n ANDREW LEELARTHAEPIN is a CFD and derivatives broker with the Man Financial CFD Desk. His qualifications include a Bachelor of Economics at The University of Sydney and is currently completing a Master of Applied Finance. Andrew has been working in the finance industry for over five years in varying roles and has been specialising in CFDs and margin foreign exchange trading for the past four years. Prior to joining Man Financial in 2005, Andrew has worked for various financial institutions including a one year stint at JPMorgan. Andrew has been involved in CFDs since their inception in Australia, and is an experienced presenter in the areas of CFDs and margin foreign exchange trading. W H AT IS A CFD? A contract for differe n c e, also commonly known as a CFD, is defined as an agre e m e n t b e t ween two parties to exchange the difference between the opening value and the closing value of a contract, with re f e rence to the underlying security or financial i n s t ru m e n t. CFDs are traded over the counter (OT C ), w h e re one of the two part i e s is typically a bro ke r. Simply put, a CFD is an equity deriva t ive that allows inve s t o rs to gain exposure to s h a re price movements without the need for ow n e rship of the underlying share s. CFDs efficiently allow inve s t o rs to take long or short positions, w h e re the inve s t o r p rovides a cash deposit (known as margin) as collateral rather than the payment of the full value of the underlying position. Trades are conducted on a margin basis, w h i c h means the investor does not pay the full purchase price of the share. U n l i ke other equity deriva t ive s, CFDs do not have an expiry date. So as long as the inve s t o r s account can support any va riation in margin and interest incurre d, a CFD position can be held indefinitely. CFDs are currently ava i l a ble on listed markets in A u s t r a l i a, the UK, the US, Ja p a n, Hong Kong and Singapore. CFDs provide an altern a t ive approach to trading on the s h a re marke t. CFDs can potentially offer opportunities for trading when there are s h o rt to medium term price rises (or falls) or to hedge against adve rse movements in the market place. B A C K G R O U N D The product was first introduced by the deriva t ives desk of Smith New Court in the early 1990s. The advantage of CFDs was that it allowed the firm s large hedge fund clients to be able to easily short the market whilst being able to benefit from the l everage as well as the stamp duty exemptions enjoyed by members of the London Stock Exchange. It also gave clients the advantage of not having to physically settle s e c u rity transactions and clients also avoided the need to have a stock borrow i n g capability when shorting the stock. In 1998 GNI Touch (now part of Man Group plc) adapted the product for the priva t e client marke t. GNI offered the CFD product alongside an innova t ive trading system which provided clients with the ability to trade via the internet directly into the London Stock Exchange. When the Financial Services Reform Act came into effect in 2002,it opened the door for international firms to offer products previously unseen in A u s t r a l i a, such as CFDs. Since their introduction in A u s t r a l i a, CFDs have become one of the fastest grow i n g financial products to enter the Australian market place. a Financial Standard publication Autumn 2006

20 The Australian Journal of Financial Planning Volume 1 Number 2 F E ATURES OF CFDS P ricing/contract va l u e The contract va l u e, also known as the face value of a CFD, i s defined as the number of shares specified in the contract multiplied by the price of the underlying share. The contract value will change in line with the movements in the price of the underlying share. CFDs are marked to marke t, which means that the contract is revalued daily at the close of business of the underlying share. The price of the underlying share and the CFD are the same.t h i s means that CFDs give you access to the liquidity of the underlying marke t. Because the prices of a CFD mirror the underlying marke t, CFDs are one of the most transpare n t d e riva t ives ava i l a ble to retail inve s t o rs. TABLE 1. CFD POSITIONS CFD Share Share Interest on D i v i d e n d p o s i t i o n price rises price falls open positions p a y m e n t s L o n g P r o f i t L o s s Pay interest Receive cash d i v i d e n d S h o r t L o s s P r o f i t Receive interest Pay cash dividend M a r gi n CFDs are traded on margi n, and the margin is the amount of deposit re q u i red to open up a position. By trading on margi n, t h e i nvestor does not pay the full purchase price of the shares and m a r gins typically start from 5 per cent. M a r gins are calculated as a percentage of the overall value of the position. M a r gins are charged to cover the trader s account in the event that the position held moves against them.the margin amount is re t u rn e d to the trader when the position is closed out. Va riation margin is the difference between the value of the CFD at the time of buying or selling and its value marked to market at the end of the trading day. In the advent of any adve rse price movements and the inve s t o r s total equity falls below the initial margin re q u i re m e n t, the bro ke r issues a margin call.the investor now has to either increase the m a r gin deposited or close out one or more of the open positions to meet the minimum margin re q u i re m e n t. F i n a n c i n g CFDs are subject to a daily financing charge, which is applied at a previously agreed rate (haircut) above or below the re l eva n t i n t e rest rate benchmark for that country. I nve s t o rs who hold a long CFD position ove rnight are subject to pay interest on the full value of the open position. I nve s t o rs who hold a short CFD position ove rnight will be paid interest on the full value of the open position. I n t e rest is paid or re c e ived on 100 percent of the value of the underlying position. T h e re are no deductions for the perc e n t a g e used as the initial margin to secure the trade.the reason for this is that the initial margin is not a down payment on the rest of the value of the position. It is security held by the bro ker against any p o s s i ble losses incurred on the position. If the official cash rate in Australia (set by the Reserve Bank of Australia) is 5.5 per cent the bro ker may charge a haircut above and below of +3/-3 per cent. In this example, a holder of a long CFD position is charged 8.5 per cent per annum (5.5 per cent plus 3 per cent) daily for holding positions open ove rn i g h t, and a holder of a short CFD position is paid 2.5 per cent per annu m (5.5 per cent minus 3 per cent) daily for holding the position ove rn i g h t. Example of financing An investor is holding 1,000 units in XYZ CFDs at a price of $ 1 0. 0 0. The value of the contract is $10,000. If the financing charge for open long positions is 8.5 per cent per annu m financing is calculated as follow s : ($10,000 x 8.5 per cent) / 365 = $2.33 per day at contract value $10,000 If on the following day the share price has ri s e n, and the closing value of the contract is now $11,000,the financing charge for that d ay is calculated as follow s : ($11,000 x 8.5 per cent) / 365 = $2.56 per day at contract value $11,000 On the other hand, if on the following day the share price has fa l l e n, and the closing value of the contract is now $9,000, t h e financing charge for that day is now calculated as follow s : ($9,000 x 8.5 per cent) / 365 = $2.10 per day at contract value $9,000 C o s t s Commissions are charged on each CFD trade.when you open or close a CFD position a commission is charged upon exe c u t i o n. The commission is based on the contract va l u e, in much the same way as when trading the underlying share s. Generally the commissions are cheaper than commissions charged for share t r a d i n g, and are typically expressed as a percentage of the contract value with a minimum charge. GST is not charged on c o m m i s s i o n s. Example of commission An investor wishes to purchase 1,000 units in XYZ CFDs at a p rice of $10.00. The value of the contract is $10,000. If the commission charge is 0.125 per cent per annum the commission cost is calculated as follow s : $10,000 x 0.125 per cent = $12.50 Autumn 2006 a Financial Standard publication

The Australian Journal of Financial Planning Volume 1 Number 2 21 C o rporate actions C o rporate actions like dividends and rights issues that affect a stock will be reflected in the value of your CFD account. T h e effect of corporate actions on your CFD will fully replicate that of the stock on the ASX (exclusive of franking and imputation c re d i t s ). H oweve r, CFDs do not entitle you to voting rights in connection with the underlying share s. The benefits are cre d i t e d to inve s t o rs in a long CFD position and deducted to those with open short positions. If a company pays a div i d e n d, the holder of a long CFD will re c e ive, on the ex dividend date, a payment that equates to the gross unfranked dividend on the underlying share. CFDs do not confer rights to any dividend imputation cre d i t s. In contrast, t h e holder of a short CFD will, on the ex dividend date, be charged an amount equal to the gross unfranked div i d e n d. Example of dividend adjustment An investor is holding 1,000 units in XYZ CFDs and the position is still open at the time of the XYZ ex dividend date. T h e amount of the declared cash dividend is 6 per share and this is c redited to the inve s t o r s account.the adjustment is calculated as f o l l ow s : 1,000 shares x $0.06 = $60 A P P L I C ATIONS OF CFDS Trading any market dire c t i o n CFDs offer the opportunity to trade the market in both d i re c t i o n s. So whether the underlying share is rising or fa l l i n g, t h e i nvestor is able to speculate on future share price movements with C F D s. S h o rt selling is the act of selling a position that you do not h ave and buying it back later at a lower price ie when we expect the price to fa l l, the exact opposite of what to do when we expect a price to ri s e. CFDs also allow the investor to obtain the benefits of short selling s h a res without being subject to the re s t rictions imposed on short selling the share in the underlying marke t, or the need to borrow the stock in order to short sell. Trading short with CFDs also gives the investor the added bonus of re c e iving interest on open p o s i t i o n s. G e a ri n g G e a ring is the ability to take a position with an exposure gre a t e r than the cash outlay re q u i re d. Because CFDs are traded on a m a r gined basis, i nve s t o rs are able to use their capital more e f f i c i e n t l y. T h ey only need to allocate a small pro p o rtion of the total value of the position to secure a trade while still maintaining full exposure to the marke t. For example, s h a re trading gives the investor leverage of 1:1. T h a t i s, for eve ry $1 of investment the investor is re q u i red to pay $1 in c a s h. A CFD position with a 5 per cent margin re q u i rement has a leverage factor of 20:1. This means that for eve ry $1 of i nvestment the exposure is $20, or multiplied by a factor of 20. This increased gearing means that re t u rns on investments are multiplied and this applies equally to gains and losses. The advantage of being able to trade on margin or gear yo u r i nvestments is that you can either trade the same size positions as you would do with traditional shares but you free up equity to use elsew h e re. This capital pre s e rvation is a more efficient use of capital because you only have to allocate a small pro p o rtion of the total value of the position to secure a trade, while still maintaining full exposure to the marke t. H e d gi n g By using CFDs as part of an existing port f o l i o, you can efficiently and effectively hedge against any adve rse price movements in your share port f o l i o. A decrease in the price of a share can be counter balanced by taking a short position in a CFD over the same share. This is particularly useful if the investor has a negative s h o rt - t e rm view on the share s pri c e, but has a more positive l o n g e r - t e rm view on the share s price or otherwise would like to hold onto the underlying share s. By hedging in this manner, i nve s t o rs are also using their capital more efficiently, as they can fully hedge their share portfolio with a fraction of the cost. EXAMPLE 1. PROFITABLE LONG TRADE CFDS VERSUS SHARES Two traders have $10,000 to invest in XYZ shares in anticipation of positive interim results from the company. XYZ is trading at $ 1 0. 0 0. Trader one buys 1,000 XYZ CFDs, re q u i ring an initial margi n deposit of 5 per cent (1,000 x $10.00 x 5 per cent) at a commission rate of 0.125 per cent (1,000 shares x $10.00 x 0.125 per cent) and has free equity ava i l a ble of $9,500 to inve s t e l s ew h e re. Trader two buys 1,000 XYZ shares for $10,000 through a traditional stockbro ker at a commission rate of 1 per cent. While the CFD position remains open, the account is debited to reflect interest adjustments and credited to reflect any div i d e n d s. Each day s interest calculation will be differe n t. I n t e re s t adjustments are calculated daily and posted to the account on a daily basis. The interest cost for the CFD position held over three day s : ($10,000 x 8.5 per cent) / 365 x 3 = $6.99 over three day s Fo l l owing the positive announcement, XYZ moves to $10.50 and both traders sell three days after buying the share s. Trader one sells 1,000 CFDs at $10.50.The commission on the transaction is 0.125 per cent (1,000 x $10.50 x 0.125 per cent) or $13.13. a Financial Standard publication Autumn 2006

22 The Australian Journal of Financial Planning Volume 1 Number 2 P rofit on trade Opening level $10.00 Closing level $10.50 D i f f e rence $0.50 P rofit on trade: $0.50 x 1,000 = $500 P rofit on trade $500 Less total commission ($25.63) Less interest adjustment ($6.99) Total profit on trade: $ 4 6 7. 3 8 By looking at the tabl e, it is clear that the re t u rn on inve s t m e n t with a CFD is much greater (87.75 per cent) than the re t u rn of i nvestment with the traditional shares (2.68 per cent). T h i s example highlights the powerful gearing effect of CFDs. EXAMPLE 2. LONG TRADE AT A LOSS A CFD trader decides that XYZ is underva l u e d. XYZ is trading at $11.00.The trader buys 1,000 XYZ CFDs, re q u i ring an initial m a r gin deposit of 5 per cent (1,000 x $11.00 x 5 per cent).t h e commission on the trade is 0.125 per cent (1,000 shares x $11.00 x 0.125 per cent) or $13.75. Each day s interest calculation will be differe n t. I n t e re s t adjustments are calculated daily and posted to the account on a daily basis. The interest cost for the CFD position held over three days is: ($11,000 x 8.5 per cent) / 365 x 3 = $7.68 over three day s XYZ rises over the three days and the trader decides to cut the loss and close the position.the trader sells 1,000 CFDs at $10.50. The commission on the transaction is 0.125 per cent (1,000 x $10.50 x 0.125 per cent) or $13.13. Loss on trade Opening level $11.00 Closing level $10.50 D i f f e rence -$0.50 Loss on trade: $0.50 x 1,000 = $500 Loss on trade $500 Plus total commission $26.88 Plus interest adjustment $7.68 Total loss on trade: $ 5 3 4. 5 6 TABLE 3. Amount of CFDs 1, 0 0 0 XYZ buy price $ 1 1. 0 0 Contract value $ 1 1, 0 0 0. 0 0 Initial outlay (5% margin) ( $ 5 5 0. 0 0 ) Commission 0.125% (to buy) ( 1 3. 7 5 ) Initial outlay ( $ 5 6 3. 7 5 ) XYZ sell price $ 1 0. 5 0 Contract value $ 1 0, 5 0 0. 0 0 Gross profit/loss ( $ 5 0 0. 0 0 ) Commission 0.125% (to sell) ( $ 1 3. 1 3 ) Financing cost ( $ 7. 6 8 ) G S T Net profit/loss ( $ 5 3 4. 5 6 ) Initial outlay (including costs) ( $ 5 8 4. 5 6 ) Return on outlay 9 1. 4 5 % TABLE 2 C F Ds VERSUS SHARES Share broker Amount of CFDs 1, 000 Amount of shares 1, 000 XYZ buy price $ 10. 00 XYZ buy price $ 10. 00 Contract value $ 10, 000. 00 Contract value $ 10, 000. 00 Initial outlay (5 per cent margin) ( $ 500. 00 ) Initial outlay (5 per cent margin) ( $ 10, 000. 00 ) Commission 0.125 per cent (to buy) ( $ 12. 50 ) Commission 1 per cent (to buy) ( $ 100. 00 ) Initial outlay ( $ 512. 50 ) Initial outlay ( $ 10, 100. 00 ) XYZ sell price $ 10. 50 XYZ sell price $ 10. 50 Contract value $ 10, 500. 00 Contract value $ 10, 500. 00 Gross profit/loss $ 500. 00 Gross profit/loss $ 500. 00 Commission 0.125 per cent (to sell) ( $ 13. 13 ) Commission 1 per cent (to sell) ( $ 105. 00 ) Financing cost ( $ 6. 99 ) Financing cost G S T - G S T ( $ 20. 50 ) Net profit/loss $ 467. 38 Net profit/loss $ 274. 50 Initial outlay (including costs) ( $ 532. 62 ) Initial outlay (including costs) ( $ 10, 225. 50 ) Return on outlay 87.75 per cent Return on outlay 2.68 per cent Autumn 2006 a Financial Standard publication

The Australian Journal of Financial Planning Volume 1 Number 2 23 EXAMPLE 3. PROFITABLE SHORT TRADE Stock markets have one major shortcoming for the inve s t o r: it is not easy to trade short.when you trade CFDs,it is as easy to trade s h o rt as it is to trade long. A CFD trader decides that XYZ is about to fa l l. XYZ is trading at $15.00.The trader sells 1,000 XYZ CFDs, re q u i ring an initial m a r gin deposit of 5 per cent (1,000 x $15.00 x 5 per cent).t h e commission on the trade is 0.125 per cent (1,000 shares x $15.00 x 0.125 per cent) or $18.75. Each day s interest calculation will be differe n t. a re calculated daily and posted to the account on a daily basis. In this example, the trader does not hold the CFD position ove rn i g h t, hence no interest adjustments are made to the account. O ver the course of the trading day XYZ has fa l l e n, and the trader decides to take profits and close the position. The trader bu y s 1,000 CFDs at $14.50. The commission on the transaction is 0.125 per cent (1,000 x $14.50 x 0.125 per cent) or $18.13. P rofit on trade Opening level $15.00 Closing level $14.50 D i f f e rence $0.50 P rofit on trade: $0.50 x 1,000 = $500 P rofit on trade $500 Less total commission $36.88 Plus interest adjustment $0.00 Total profit on trade: $ 4 6 3. 1 2 TABLE 4. C F Ds TRADED AT A PROFIT Amount of CFDs 1, 0 0 0 XYZ sell price $ 1 5. 0 0 Contract value $ 1 5, 0 0 0. 0 0 Initial outlay (5 per cent margin) ( $ 7 5 0. 0 0 ) Commission 0.125 per cent (to sell) ( $ 1 8. 7 5 ) Initial outlay ( $ 7 6 8. 7 5 ) XYZ buy price $ 1 4. 5 0 Contract value $ 1 4, 5 0 0. 0 0 Gross profit/loss $ 5 0 0. 0 0 Commission 0.125 per cent (to buy) ( $ 1 8. 1 3 ) Financing credit G S T Net profit/loss $ 4 6 3. 1 2 Initial outlay (including costs) ( $ 7 6 8. 8 8 ) Return on outlay 60.23 per cent EXAMPLE 4. SHORT TRADE AT A LOSS A CFD trader decides that XYZ is about to fa l l. XYZ is trading at $15.00.The trader sells 1,000 XYZ CFDs, re q u i ring an initial m a r gin deposit of 5 per cent (1,000 x $15.00 x 5 per cent).t h e commission on the trade is 0.125 per cent (1,000 shares x $15.00 x 0.125 per cent) or $18.75. Each day s interest calculation will be differe n t. I n t e re s t adjustments are calculated daily and posted to the account on a daily basis. In this example, as the trader is short the CFD position, the trader is paid interest for holding the CFD position open ove rn i g h t. The interest paid for the CFD position held over one day : ($15,000 x 2.5 per cent) / 365 = $1.03 over 1 day XYZ rises over one day, and the trader decides to cut the loss and close the position. The trader sells 1,000 CFDs at $15.50. T h e commission on the transaction is 0.125 per cent (1,000 x $15.50 x 0.125 per cent) or $19.38. Loss on trade Opening level $15.00 Closing level $15.50 D i f f e rence -$0.50 Loss on trade: $0.50 x 1,000 = $500 Loss on trade $500 Plus total commission $38.13 Less interest adjustment $1.03 Total loss on trade: $ 5 3 7. 1 0 TABLE 5. C F Ds TRADED AT A LOSS Amount of CFDs 1, 0 0 0 XYZ sell price $ 1 5. 0 0 Contract value $ 1 5, 0 0 0. 0 0 Initial outlay (5 per cent Margin) ( $ 7 5 0. 0 0 ) Commission 0.125 per cent (to sell) ( $ 1 8. 7 5 ) Initial outlay ( $ 7 6 8. 7 5 ) XYZ buy price $ 1 5. 5 0 Contract value $ 1 5, 5 0 0. 0 0 Gross profit/loss ( $ 5 0 0. 0 0 ) Commission 0.125 per cent (to buy) ( $ 1 9. 3 8 ) Financing credit $ 1. 0 3 G S T Net profit/loss ( $ 5 3 7. 1 0 ) Initial outlay (including costs) ( $ 7 8 7. 1 0 ) Return on outlay 68.24 per cent a Financial Standard publication Autumn 2006

24 The Australian Journal of Financial Planning Volume 1 Number 2 Autumn 2006 a Financial Standard publication