Contract For Difference: How It Works
As you can understand from the name, a contract made with a settlement scheduled for a future date when the difference in price on the date of issue and the settlement day is the investor’s net gain/loss. In this case, the payment is essentially by cash and does not involve any transaction of physical goods or securities.
Definition Of Contract For Differences
In simple financial term, it is a contract that allows you to enjoy the benefit/risks of buying a security without actually doing so. The settlement being only in cash is a lot simpler way to resolve than a physical transaction. The seller of the CFD will pay the buyer the difference between the current value and what the value was when the contract was made. In case there is a loss, the buyer will pay the seller instead of the vice versa.
Essentially these are specially devised derivative instruments that enable investors in the financial market to take advantage of the rise or fall in price of the underlying security. This is more of a speculative tool and is used for both long and short positions.
History Of Contract For Difference
The CFDs or the Contract for Difference was first developed in the 1990s. It was used as a type of equity swap and traded in London for the first time. Brian Keelan and Jon Wood of UBS are considered the fathers of CFD and they created this instrument for their famous Trafalgar House deal in the last decade of the last century.
They were soon used by hedge funds to cover their exposure in stocks on the London Stock Exchange. This was a cost-effective option for these hedge funds as only a small margin was required, and there was no related, associated cost like physical transfer of shares and the like. No stamp duty was levied on it either. Many UK based companies like the Gerrard & National Intercommodities which was later taken over by MF Global, IG Markets, and CMC Markets popularized its usage in the early 2000s.
Retail traders woke up to its benefits when they realized that the CFDs could be used to leverage any underlying financial entity without exception. Soon the offerings on the CFD platter included global indices, stocks, commodities, currencies, and bonds. Given the widespread popularity and broad-based acceptance of CFDs, the providers started spreading their wings elsewhere too. Australia that way has the distinction of being the first international CFD destination after UK. It was introduced by IG Markets and CMC Markets in 2002. The next step was in 2007 when the Australian Securities Exchange listed CFDs traded on exchanges on the top 50 Australian stocks, and they were no longer traded as mere Over-The-Counter entities. However, their charm began to fade gradually and by June 2014, ASX stopped offering Contracts for Difference.
Understanding How CFD Works
To completely grasp the function of a CFD, you need to understand it with the help of an illustration. Let’s assume that you are a retail investor interested in buying CFDs. So how do you decide which CFD to take and when to sell and many other questions? Let’s say you have a stock with an asking price at $50.00, and the cost of 100 shares at this price would be $5000. A conventional broker will charge nearly 50% margin so you would need nearly $2500 in cash, but a CFD broker charges only 10% margin and your cash outlay drastically lowered to merely $500.
CFD: Main Advantages
So what are the key advantages of using Contract For Difference as against traditional financial market instruments?
- Leverage Is Higher: The significantly higher leverage compared to a traditional trade is surely one of its primary positives. With margin requirements as low as 2% compared to relatively higher rate of margins needed in conventional trades. This means more capital can be deployed to put in your trading positions and hence there is a hope of better returns.
- Global Presence: Most brokers who offer Contract for difference offer their products across global markets. This enables an investor to easily get exposure to foreign markets even when the local ones are shut.
- Pre-Requisites For Day Trading Not Necessary: There are no special requirements for day trading Contract For Difference. Investors can open accounts with as little amount as $1,000.
Disadvantages Of Contract For Difference
However, there are some pockets of concern too while trading a contract for difference or a CFD.
- No Gain From Small Moves: The fact that the spread on entries and exits have to be paid, it nullifies any small gain that could be made as a result of relatively smaller moves. A part of the profit is eaten up in this fashion.
- Financing Fees Charges: As there is a huge margin financed by your broker, there will have a financing fee of 2-5% applied. The fees will be divided by a year and paid daily.
- Lack Of Regulation: Another big worry is the lack of regulation in the the CFD market. It is still a significantly small fraction of the market and has no special regulation governing it. A major portion of the dealings are on the basis of the credibility of the broker and good relationship that the broker and the investor might share. However, Monetary Authority of Singapore (MAS) has a list of regulated brokers dealing with securities in Singapore.
Essentially the Contract for difference is an instrument devised by market participants to take advantage of the loopholes in the regulatory regime. The require limited capital outlay but given the lack of regulation they always have the associated risk of bigger losses in case of a fall in markets. Therefore, investors who decide to invest their time and resources in these type of unconventional financial market instruments need to make a realistic assessment of the risk involved and the chances of gains against losses.