TD Direct Investing A Guide to CFDs

TD Direct Investing A Guide to CFDs

Introduction This Contracts For Difference (CFD) eguide will help you to understand more about CFDs and how they can be traded by experienced share traders who already have a good understanding of the stock market. CFDs are derivative financial instruments which derive their value from an underlying asset, index, commodity, currency, exchange or interest rate. It used to be that they were only available to professional investors and financial institutions. However, during the past decade specialist derivatives providers have popularised these with individual traders. There are five main types of derivatives that are available to the individual investor to trade in, however in this eguide we will focus on. CFDs are regulated products in the UK and Europe and are primarily designed to take advantage of relatively short-term market fluctuations. CFDs are derivative products which are aimed at experienced traders rather than long-term investors. Derivatives are a niche financial instrument that will be unsuitable for many investors. Before you read on you should note the Risks highlighted to the right. This eguide is intended for educational purposes only and as such should not be treated as investment advice or a solicitation to make an investment decision based on the content of this eguide. Investors should be aware that the value of an investment can go down as well as up. You may not get back all the money that you invest. Please remember that derivatives are designed for active traders. Derivatives trading involves leveraged transactions, which means that you only deposit a fraction of the full value of the deal. Consequently profits or losses can quickly and substantially exceed your initial deposit and will require you to make further, possibly intraday, payments. Derivatives should only be considered if you have significant investing experience and knowledge, a thorough understanding of the risks involved and if you are dealing with money that you can afford to lose. If you have any doubt over the suitability of a particular investment for you then you should seek independent financial advice. The tax treatment of derivatives depends on the individual circumstances of each client and Taxation Law and may be subject to change in the future. The information within this eguide is based on our understanding at the time of writing. Version 0.1 February 2014 2

What are derivatives? Derivatives were created as a way of trading on the price movement of a specific asset such as stocks, bonds, currencies, indices and commodities without ever owning the underlying asset. They are a synthetic financial instrument which means that they are frequently created by the derivatives provider and traded directly with them. They replicate the price movements of the underlying asset and are quoted in a similar way to it. Exchange traded derivatives contracts are standardised to fixed quantity, quality and end dates, making Over the Counter (OTC) contracts, provided by specialist derivative providers, more attractive to individual investors. For that reason your account will be owned and operated by a derivatives provider even when they are offered by a well-known brokerage like TD Direct Investing. Because financial markets and instruments can experience rapid price movements and derivatives are made and offered by specialists, your access to derivatives is usually via a specialist account. This uses a dedicated online dealing platform that has sophisticated order types for risk management, plus comprehensive tools and research. There are usually demonstration facilities as well as live accounts. 3

What are derivatives? Experienced traders use derivatives to maximise their trading capital. This is because they only pay an initial deposit for the full value of the deal, which is known as Trading on Margin, or leverage. This method of funding substantially increases buying power. In most cases, derivatives also offer the ability of shorting, in other words they have the potential to profit from falling market prices as well as from market price rises. Derivatives also offer a very wide range of global markets and instruments, including those that would be difficult to access by other means. They have relatively low trading costs and, subject to individual circumstances and applicable tax laws, these instruments can also offer tax-efficiency. The benefits and potential rewards from trading derivatives come with a high degree of risk. Because they require only a small initial percentage of the trade value as deposit, this magnifies the volatility of profits and losses. This means that if markets move against you, losses can quickly exceed your initial deposit and require you to make further payments. These are known as Margin calls and may be made to you at any time, including intraday while the markets are open. If a margin call is not satisfied your position will be closed. This eguide will explain the risks involved with derivatives in more detail and it is important that you understand and are comfortable with the risks involved before starting to trade them. To help you understand whether derivatives are right for you, you will always be required to pass what is known as an Appropriateness Test as part of the derivatives account opening process. Regulation and Financial Services Compensation Schemes Derivatives are regulated financial instruments. In the UK they are regulated by the FCA and have the protection of the Financial Services Compensation Scheme (FSCS). They are also offered and regulated in Europe, hence a European derivatives house operating in the UK market may instead be regulated by its host country and the relevant terms of its financial compensation scheme will apply. You should understand this and the Terms of Service that will apply before opening an account. 4

are a derivative instrument which is popular in the UK because of their simplicity. They are defined as an agreement between two parties to exchange the difference in value of a particular market or instrument, between the time at which the contract is opened and the time at which it is closed. In other words, when you open a new CFD position you are entering into a contract directly with the CFD provider to exchange the difference between the opening and closing prices, which will either be your profit or your loss. You are therefore speculating on the price movements of financial instruments such as shares and indices without owning the underlying asset. CFDs are usually not traded on an exchange, they are frequently traded OTC with the Derivatives House. As with share trading, you decide how long you want to keep your position open and real-time prices constantly show your exact position and valuation. CFDs are made and traded on many thousands of different UK, European, US and Asia Pacific stocks, indices, commodities and currencies. One CFD is usually equivalent in value to one share or one point, and has a bid/offer price spread similar to that offered on the underlying asset. As with share dealing, you undertake to buy or sell a number of CFDs, deciding either that the market will rise (go long), or fall (go short). If you predict correctly and the market moves in your favour, you will make a profit. That profit will be your CFD size multiplied by each point that the market has moved in your favour. If you are wrong you will make a loss of your CFD size multiplied by each point that the market moved against you. As with share trading, you decide how long you want to keep your position open and real-time prices constantly show your exact position and valuation. Most CFDs do not have an expiry date, so you may decide to trade intra-day, overnight (subject to additional financing) or for longer as part of a hedging strategy. Because you are trading on Margin, your initial deposit required to open the CFD is substantially less than the full opening value. 5

ENLARGE Trading on Margin When you buy shares on the stock market, you are normally required to pay for them in full. Your broker will quote you the price and you must pay for them by settlement day. So if you bought 10,000 worth of shares you will need to pay for the full 10,000 value. However, because CFDs are margined, you pay for them in a different way. In this example you might only be expected to pay 10% of the value of the shares as an initial deposit, i.e. 1,000. This deposit has given you exposure to the price movement of 10,000 worth of shares for initially just 1,000, which is known as leverage. If you think the shares will rise in value, your opening deal will be a buy and you will go long. If on the other hand you believe that the shares will fall in value, your opening deal would be a sell and you will go short. Leverage magnifies your profits, but it can also equally magnify your losses. Let s assume that your CFD was a buy that was anticipating a rise in value and that you are correct. With the value of the shares increasing by 10% they are now worth 11,000 and you decide to close the deal by selling. If you had bought the actual shares, you would have made a 10% profit ( 1,000). However, since you bought the CFD instead and only had to set aside 1,000 to make the trade, you made a 100% profit ( 1,000) when you sold. However, the same principle can work against you in reverse. In this example, if the shares had declined 10% in value instead, your loss on your initial CFD deposit would have been 100%. 6

This simplified example doesn t include commissions and any daily financing, but illustrates two things. The first is the power and risks involved with using margin trading, particularly when markets are volatile and price fluctuations up or down can be large and rapid. For this reason you should monitor your positions closely. It is good practice to deposit more than the initial margin requirement to allow for any margin calls should the market go against your initial position, including intraday. The second is that CFDs allow you to trade long or short which opens up a new trading opportunity, unlike with equities you have the potential to profit in both rising and falling markets, providing the market moves in the way you anticipated. You can go some way to controlling your risk of loss if the market moves against you by employing various forms of risk management, which are explained below. For this reason you should monitor your positions closely. Margin Calls Although you have only been required to put up an initial margin deposit, you should be prepared to further fund your account to cover any potential losses. If price movements mean that you no longer have the margin required to sustain the positions on your account then this is known as a margin call. How this call is made will differ with the provider, though it is usually electronic rather than a phone call. You should fully understand the procedure used before placing a trade as markets can move quickly and additional money may be required immediately. Alternatively, the position will be closed and this will crystallise your loss. Besides margin calls, most Derivatives Providers also operate automated maximum limits to restrict losses from becoming unlimited. Again, these limits vary but are designed to protect both parties. It is always your responsibility to monitor the margin in your account and make further payments in sufficient time. In some situations, such as markets gapping which is explained below, you may not have time to fund your account and your positions will be closed, crystalising a loss which you will be required to pay. 7

Market Gapping In its simplest terms, market gapping is a break between prices that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Gapping can create significant quick gains, but also quick infinite losses. Direction of position Gapping up in share price Gapping down share price Long Short Order types Infinite profit as share could rise substantially Price could rise to infinite which would mean losing an amount which equals the total size of the new position (not just the margin) Price could fall to zero which would mean losing an amount which equals the total size of the position (not just the margin) Price can only fall as far as zero, therefore the maximum profit is gained when the share price falls to zero Derivative platforms usually offer a range of order types when opening a position that can be used to help you reduce the risks of financial losses, particularly when you may be unable to monitor your position. They are best seen as optional risk management tools. Limit orders These can enable you to take profit or make a purchase automatically if an order reaches a target market price. You can usually set these as being Good for the Day (GFD), Good until Cancelled (GTC) and some providers allow you to name an exact date the order is valid until. (NOTE TO REDWALL CAN WE MAKE THE ABOVE TEXT IN Stop Loss REALLY PROMINENT AGAIN REALLY IMPORTANT FOR CLIENTS TO This GET is an THIS) order that closes out your position if it is going against you once a certain chosen price has been breached. It is good practice to set one every time you open a position. You can also add one to an existing open position and it can be adjusted or cancelled by you as prices change. Stop Losses are particularly beneficial where a position is left unmonitored because the Stop Loss will be triggered if the CFD trades at the price set. However, it will not account for those instances where a market price gaps (jumps from one level to another without trading in between), which can happen under unusually volatile conditions or overnight. When the market recommences trading it is at a price below the stop loss level set. If this happens, the stop loss would not be effective and instead your position would close at the next available price and your loss could be bigger than anticipated and crucially, could be bigger than your initial deposit. This is why Guaranteed Stop Losses (explained on the following page) act as a Gapping/slippage tool. 8

Guaranteed Stop Loss This order type works like a Stop Loss but crucially also gives complete protection against market gapping/slippage in return for an additional payment and therefore brings additional peace of mind. View these as an insurance policy. Some derivative accounts offered are only available with Guaranteed Stop Losses made compulsory for every trade - though investors should remember that derivatives are still only suitable for experienced traders. A Guaranteed Stop loss will still only limit the size of your losses, not prevent them. The trailing stop allows investors to set an agreed distance between the current price, and the point at which they intend to exit the trade. Trailing Stop Loss These act in a similar way to a Stop Loss but move in tandem with the market price to protect profits as prices move up and down. The trailing stop allows investors to set an agreed distance between the current price, and the point at which they intend to exit the trade. If the current price should fall by this distance, the position will automatically be sold. If the current price rises, the percentage level will be recalculated from the new high. Using a trailing stop is an excellent method for potentially minimising loss, whilst locking in profits in the event that the markets move against a position. Buy Stop This has the opposite effect to a limit order. Placing this opens a position at the point you set, anticipating a price rise when your position is long. Sell Stop This opens a position at the point you set, anticipating a price fall when your position is short. 9

Linking order types Some Derivative providers allow you to combine order types to create a more comprehensive order management strategy. A popular order type is a One Cancels Other (OCO) order. This allows you to place a limit and stop order either side of your position at the same time. Once the limit or order stop is triggered, the other order is cancelled. Some brokers may let you place If Done OCO orders. This allows you to combine a limit order, which once triggered, means you will automatically have a stop and limit order either side of your new position. This allows you to place a limit and stop order either side of your position at the same time. Other combinations of linking order types include; n Limit or Market on Close (MOC) will be executed at the stipulated price during the day, or else it will be executed at the best available price towards the end of the day, usually within the last five or ten minutes of trading. It is guaranteed to be filled. n Market If Touched (MIT) a combination of a limit order and a market order. Initially, the trade specifies a limit. If the market trades at or through the price, the order becomes a market order and will be executed at the best prevailing price. n Fill or Kill (FOK) this means execute the whole quantity of the order if market conditions permit, otherwise cancel the whole order if the former cannot be achieved. They are often referred to as immediate or cancel orders. 10

CFD Choices CFDs offer thousands of diverse trading choices on Equities, Indices, Commodities and Currencies. n Equity CFDs can be traded on a wide range of UK, US, European and Asian markets. Non-UK shares will be traded in their underlying currency and so require a foreign exchange conversion. As well as trading the underlying equity, some investors use derivatives for hedging. This is where a derivative s short position is taken out with the intention of offsetting any potential short-term losses incurred by the long-term ownership of the underlying equity, so the investor does not need to sell and ownership and shareholder rights are protected. This is a complex technique that you must fully understand before attempting. n Index CFDs. Indices are popular if you would prefer to trade a market index rather than an individual share. Popular examples include the FTSE in the UK to Dow Jones, NASDAQ and S&P in the USA, or the Japanese Nikkei and Hong Hong Hang Seng. Sector CFDs work in a similar way, where you can take positions on individual market sectors such as Banks, Pharmaceuticals or Technology. n Commodity CFDs give direct exposure to commodity markets, ranging from oil and energies through to base and precious metals to a wide range of agricultural products n Currency CFDs allow you to speculate on currency price movements in Foreign Exchange Markets and are characterised by low initial margin requirements. Popular examples include the US Dollar, Euro, UK Sterling and Japanese Yen, but there are many others. Most CFDs will allow long and short positions, subject to any requirements that may be set by a regulator from time to time that may restrict short positions in times of particular economic crisis. These restrictions will be clearly shown by the Derivatives House while in force. 11

Costs to look out for As with any financial instrument it is important to understand the costs involved when trading CFDs and what you will be expected to pay along with the Margin requirement. Commission Just like equity share trading, a transaction commission per trade is usually charged on both the opening position and closing deal. This charge varies according to the Derivatives Provider and is usually a percentage of the overall transaction, though fixed rates can apply. Taxation Another reason for the popularity of CFDs is their tax treatment*. Unlike equities, CFDs do not currently incur UK Stamp Duty on buys. This is because CFDs are synthetic and you do not own the underlying shares. Any profits you make on a CFD are, however, subject to Capital Gains Tax. Corporate Actions With derivatives you do not own the underlying shares but you are entitled to the rights. Hence when companies pay dividends this is reflected as a credit or debit to your account made by the Derivatives house. Similarly with Corporate Actions the Derivatives House will seek to replicate the action. This may be by the adjustment of your position or cash balance. In some situations the derivatives provider will terminate the existing position. This may be because it determines that the CFD is no longer an adequate representation of the economics of the underlying instrument. This may occur in the case of certain corporate actions as but it could also terminate in other circumstances, for example in case of illiquidity in the underlying asset, absence of sufficient borrowing ability in the underlying asset and insolvency, dissolution or delisting of the underlying security. *tax treatment depends on the individual circumstances of each client and maybe subject to change in the future. It is recommended that specific tax advice, where required, is obtained from HMRC (or other taxation authority) or a qualified tax adviser. 12

Overnight Financing CFDs are traded on margin and therefore when you buy a CFD there will be a financing charge because you are effectively borrowing money to finance the purchase. This will be calculated daily on your account. The opposite occurs when you sell a CFD short; in this instance you are loaning money so any interest is payable to you and will appear as a credit. For Uk shares these charges are usually based on LIBOR** or LIBID*** and applied to the full value of your position, not the margin amount. As these are accrued daily they are only charged if your position remains open overnight. If LIBOR is low, overnight financing on a short position could result in a charge. Be aware that these costs can quickly build on positions kept open for long periods. Alternatively, some providers offer quarterly CFDs for longer-term positions where the overnight financing is built in. This can still be cheaper than buying the underlying share on extended settlement terms if available. Dividends Generally, an equity CFD will seek to replicate any dividend payments that occur on the underlying share on its ex-dividend date. If you hold a long CFD position then the net dividend will be credited to your account. Conversely, the gross dividend will be debited from an open short CFD position. Guaranteed Stop Losses As explained previously, these usually incur an additional insurance premium to pay for the guarantee that prevents exposure to market slippage/gapping. **London Inter-Bank Offered Rate. ***London Inter-Bank Bid Rate. 13

Choosing a Provider There are a large number of Derivatives providers in UK, so it is worth reflecting on how to choose one. Naturally, you will want your provider to offer competitive costs and attractive margin limits as well as the markets/instruments on which you wish to trade. The providers might be derivatives specialists or they in turn may operate the service on behalf of well-known equity brokerages. It is wise to check that the provider is regulated by the FCA and that your money is protected through the Financial Services Compensation Scheme (FSCS). When choosing a provider you should also consider the stability, security, speed of execution and ease of use of the internet based trading platform. You may also want a mobile trading option to be able to deal on the go. Customer service, reputation and the financial strength of the provider should not be ignored. The tools and educational materials offered to help you make decisions are important too: such features as real-time pricing, stop-losses, sophisticated charting, analysis and market news are all essential ways of helping you make informed trading decisions to manage your risks. Many providers offer online educational programmes, tutorials and seminars. Some offer telephone access as well as online trading. One reason to opt for a brokerage service such as that provided by TD Direct Investing is because the broker has researched and chosen to partner with a specialist who is a tried and trusted Derivatives provider who continuously prove their standards and reputation. 14

In summary In summary, it is worth restating that derivatives offer individual experienced investors considerable opportunities to trade. The rewards can be substantial but that potential means that these are high-risk instruments that are not suitable for everyone. Only experienced traders will pass the Appropriateness Test, which is designed to demonstrate that they not only understand the instruments and their risks but also are comfortable with taking the level of risks involved. It is good practice to only ever trade with money that you can afford to lose and be aware that unlike equities, losses can potentially be unlimited and mount up quickly. Successful derivatives traders are disciplined in their approach and also are aware of the psychology and emotion that can influence their trading decisions. Never underestimate the emotions that can be involved with this level of risk and reward. Experienced traders do not usually trade up to their Margin Limit and ensure that their open positions are covered by Stop Losses or Guaranteed Stop Losses. They use tools and research to help form their judgement, rather than trade on a hunch, and they monitor their open positions closely. They will close a position and take a smaller loss rather than bet the farm on a single trade and have losses escalate beyond their resources. Derivatives Providers invariably offer demonstration accounts and it is wise to familiarise yourself with the technology and instruments available and practice trading before embarking on placing live trades. If you would like to continue your derivatives fact-finding journey, please visit www.tddirectinvesting.co.uk for more information. 15

Legal Disclosure Brokerage Services provided by TD Direct Investing (Europe) Limited (a subsidiary of The Toronto-Dominion Bank). Incorporated in England and Wales under registration number 2101863. Registered office: Exchange Court, Duncombe Street, Leeds, LS1 4AX, United Kingdom. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London, E14 5HS, United Kingdom (Financial Services Register Firm Reference Number 141282), member of the London Stock Exchange and the ICAP Securities and Derivatives Exchange. VAT Registration No. 397103051. www.tddirectinvesting.co.uk Banking Services provided by TD Bank N.V. Incorporated in the Netherlands and registered as a branch in England and Wales under branch registration number BR006780. Authorised by the Dutch Central Bank (De Nederlandsche Bank DNB Institution Number 481) and subject to limited regulation by the Financial Conduct Authority and Prudential Regulation Authority (Financial Services Register Firm Reference Number 216791). Details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request. 16

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