Contract For Difference
In finance, a contract for difference (or CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.) In effect CFDs are financial derivatives that allow traders to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.
For example, when applied to equities, such a contract is an equity derivative that allows traders to speculate on share price movements, without the need for ownership of the underlying shares
CFDs were originally developed in the early 1990s in London as a type of equity swap that was traded on margin. The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, on their Trafalgar House deal in the early 90s. They were initially used by hedge funds and institutional traders to hedge their exposure to stocks on the London Stock Exchange in a cost-effective way. Mainly because they required only a small margin and avoided the UK stamp duty tax, as no physical shares changed hands.
In the late 1990s CFDs were first introduced to retail traders. They were popularised by a number of UK companies, whose offerings were typically characterised by innovative online trading platforms that made it easy to see live prices and trade in real time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities); GNI and its CFD trading service GNI touch was later acquired by MF Global. They were soon followed by IG Markets and CMC Markets who started to popularise the product in 2000.
It was around 2000 that retail traders realised that the real benefit of trading CFDs was not the exemption from stamp tax but the ability to trade on leverage on any underlying instrument. This was the start of the growth phase in the use of CFDs. The CFD providers quickly responded and expanded their product offering from just London Stock Exchange (LSE) shares to include indices, many global stocks, commodities, bonds, and currencies. Trading index CFDs, such as the ones based on the major global indexes e.g. Dow Jones, NASDAQ, S&P 500, FTSE, DAX, and CAC, quickly became the most popular type of CFD that were traded.
Around 2001 a number of the CFD providers realised that CFDs have the same economic effect as financial spread betting except that the tax regime was different, making it in effect tax free for clients. Most CFD providers launched financial spread betting operations in parallel to their CFD offering. In the UK the CFD market mirrors the financial spread betting market and the products are in many ways the same. However unlike CFDs which have been exported to a number of different countries, spread betting relying on a country specific tax advantage has remained primarily a UK and Irish phenomenon.
CFDs are traded between individual traders and CFD providers. There are no standard contract terms for CFDs, and each CFD provider can specify their own, but they tend to have a number of things in common.
The CFD is started by making an opening trade on a particular instrument with the CFD provider. This creates a ‘position’ in that instrument. There is no expiry date so the position is closed when a second reverse trade is done. At that point the difference between the opening trade and the closing trade is paid as profit or loss. The CFD provider may make a number of charges as part of the trading or the open position. These may include, bid-offer spread, commission, overnight financing and account management fees.
Even though the CFD does not expire, any positions that are left open overnight will be ‘rolled over’. This typically means that any profit and loss is realised and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. The industry norm is that this process is done at 10pm UK time.
CFDs are traded on margin, and the trader must maintain the minimum margin level at all times. A typical feature of CFD trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on screen. If the amount of money deposited with CFD broker drops below minimum margin level, margin calls can be made. Traders may need to cover these margins quickly otherwise the CFD provider may liquidate their positions.
To see how CFDs work in practice see the examples of typical CFD trades. The ‘margin percentage’, and ‘charges’ shown may vary from provider to provider, but are typical of CFD providers.
Example 1 - an Equity based CFD trade
In this example we show an equity based CFD trade. The share price of IBM is $194.38. We believe that the share price will rise and so decide to take a long CFD position. Our CFD Provider is quoting a price of $194.36 bid and $194.42 offer.
|Step 1 - Opening a position|
|Buy 100 IBM CFDs at offer price||100 x $194.42 = $19,442.00|
|Margin requirement is open position x margin percentage. Typical margin for equities is 3%-15% depending on the liquidity of the underlying instrument. In our example IBM CFDs require margin of 5%.||$19,442.00 x 0.05 = $972.10|
|You get charged commission of 0.1% on this transaction||$19,442.00 x 0.001 = $19.44|
|Step 2 - Overnight Financing|
|To hold this position a financing charge is made each night. This is normally based on a benchmark rate per cent like LIBOR + broker margin per cent / 365. For simplicity we will assume the price of IBM shares stayed the same until the market close and so no P&L was generated on this day.||$19,442.00 x (0.0025 + 0.02) / 365 = $1.20|
|Step 3 - Closing the position|
|The next day IBM share price has risen by $6.15. Our trade has moved in our favour and we decide close the position and take profit.|
|Our CFD provider is quoting $200.50 bid and $200.58 offer.|
|Sell 100 IBM CFDs at bid price||100 x 200.50 = $20,050.00|
|The position is now closed and so margin requirement is now zero||$0.00|
|You get charged commission of 0.1% on this transaction||$20,050.00 x 0.001 = $20.05|
|Gross profit is difference between opening position and closing the position||$20,050.00 - $19,442.00 = $608|
|Net profit is gross profit less costs. The costs are commissions and overnight financing. In this example we have been charged commission twice, once to open the position and once to close it, and we have been charged one day overnight financing.||$19.44 + $20.05 + $1.20 = $40.69|
|Profit & Loss shows a profit after costs||$608.00 – $40.69 = $567.31|
In summary we have had to deposit $972.10 to cover margin on this trade and made a profit of $567.31. If the price of IBM shares had instead dropped by $6.15, we would have sustained a loss of $647.47 ($608 plus commissions).
Example 2 - An Index based CFD trade on the S&P 500 Index
In this example we show an index based CFD. The S&P500 Index is at 1093.9. We believe that the Index will go down and so decide to take a 'short' position. Our CFD broker is quoting 1093.7 bid and 1094.1 offer.
|Step 1 - Opening a position|
|Sell 10 S&P500 CFDs at bid price||10 x $1093.7 = $10,937|
|Margin requirement is open position x margin percentage. Typical value for major indices is 0.5%||10,937 x 0.005 = $54.68|
|Commission – typically no commission is charged on index CFDs|
|Step 2 - Overnight Financing|
|To hold a position a financing charge is made, however as we are holding a short position we will instead receive the financing. The rate is normally based on a benchmark rate per cent like LIBOR, from this we subtract the broker margin and divide by 365 to get the daily financing. For simplicity lets assume the US interest rate is 4% and the broker margin is 2%.||$10,937 x (0.04 - 0.02) / 365 = +$0.60|
|Step 3 - Closing the position|
|The next day the S&P has dropped by 10 points to 1083.7 bid and 1084.1 offer|
|Our trade has moved in our favour and we decide to take profit and close the position|
|Buy back the position at the lower price||10 x 1084.1 = $10,841|
|The position is now closed and so margin requirement is now zero|
|Gross profit is difference between opening position and closing the position||$10,937 - $10,841 = $96.00|
|Net profit is gross profit less costs. In this example financing is actually positive and there are no other costs. So we get a credit of||$0.60|
|Profit and Loss shows a Profit after costs||$96.00 + 0.60 = $96.60|
In summary we have had to deposit $54.68 to cover margin on this trade and made a profit of $96.60. If the S&P 500 Index had risen instead by 10 points we would have sustained a loss of $95.40 ($96.00 + Costs). Note that the amount of gain or loss was bigger than the margin requirement. In other words, you would have gained or lost more money than you deposited.
The contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR or some other interest rate benchmark e.g. Reserve Bank rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.
Traditionally, equity based CFDs are subject to a commission that is a percentage of the size of the position for each trade. Alternatively, a trader can opt to trade with a market maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument.
Traders in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (usually ranging from 0.5% to 30%). One advantage to traders of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a substantial part of the assets.
CFDs allow a trader to go short or long on any position using margin. There are always two types of margin with a CFD trade -
Initial Margin - (normally between 3% and 30% for shares/stocks and 0.5% - 1% for indices, foreign exchange and commodities)
Variation Margin - (which is then 'marked to market').
Initial margin is fixed at between 0.5% and 30% depending on the underlying product and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility in the world's stockmarkets.
Many refer to initial margin as a deposit. For example, for large and highly liquid stocks such as Vodafone the initial margin will be nearer 3%, and depending on the broker and the client's relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher.
Variation margin is applied to positions if they move against a client. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £100 in variation margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in running profits.
Variation margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.
One of the benefits (and risks) of trading CFDs is that they are traded on margin meaning that they provide the trader with leverage. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. The margin requirements on CFDs are low meaning that only small amount of money is required to take large positions.
CFDs compared to other products
There are a number of different financial products that have been used in the past to speculate on financial markets. These range from trading in physical shares either direct or via margin lending, to using derivatives such as futures, options or covered warrants. A number of brokers have been actively promoting CFDs as alternatives to all of these products.
Although no firm figures are available as trading is off-exchange, it is estimated that CFD related hedging accounts for somewhere between 20% and 40% the volume on the Major Stock Exchange. A number of people in the industry back the view that a third of all MSE volume is CFD related. The MSE does not monitor the numbers but the original 25% estimate as quoted by many people, appears to have come from a MSE spokesperson.
The CFD market most resembles the futures and options market, the major differences being:
- There is no expiry date, so no price decay.
- Trading is done off-exchange with CFD brokers or market makers.
- CFD contract is normally one to one with the underlying instrument.
- Minimum contract sizes are small, so it’s possible to buy one share CFD, low entry threshold.
- Easy to create new instruments, not restricted to exchange definitions or jurisdictional boundaries, very wide selection of underlying instruments can be traded.
What are Contracts for Difference CFDs
A 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 shares specified in the contract.
CFDs are traded in a similar way to ordinary shares. 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 charge 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.
Risks of Contracts For Difference (CFDs)
The geared nature if margin trading markets means that both profits and losses can be magnified and unless you place a stop loss you could incur very large losses if your position moves against you.
It is less suited to the long term investor, if you hold a CFD open over a long period of time the costs associated increase and it may be more beneficial to have bought the underlying asset.
You have no rights as an investor, including no voting rights.
Key Features of Contracts for Difference (CFDs)
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. 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. A Long Trade is where you BUY an asset with the expectation that it will rise, just as you would when buying a normal share. A Short Trade is where you SELL an asset that you do not own in the expectation that the price will fall and you can buy the asset back at a cheaper price. 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 don't actually physically buy the underlying shares, you don'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 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
CFDs allow you to take a view on shares and indices and some CFD providers also allow trading on currencies and sectors.
Risk Management Facilities
Because of the higher risk nature of trading on margin, many CFD providers offer comprehensive Stop Loss and Limit Order Facilities so that Investors can manage their risk in fast moving markets.
| General Rules CFD - Solution Keys
|Initial Margin : $10.000 / New Account
Commission Charge : USD 50 / Lot Settled
|Contract Size||Tick Size||Max Volume||Spread|
|CFD - Stocks||1000||0.01||20||Market|
|Cfd - Stocks||8%||10%|
|Code||Company||Contract Size||Tick Size||Max Volume||Spread||Trading Time|
|AA||ALCOA INC||1000 share||0.01||20||market||16.30 - 23.00|
|AXP||AMERICAN EXPRESS||1000 share||0.01||20||market||16.30 - 23.00|
|BA||BOEING CO||1000 share||0.01||20||market||16.30 - 23.00|
|C||CITIGROUP INC||1000 share||0.01||20||market||16.30 - 23.00|
|CAT||CATERPILLAR INC||1000 share||0.01||20||market||16.30 - 23.00|
|DD||DUPONT EI De Nemours CO||1000 share||0.01||20||market||16.30 - 23.00|
|DIS||DISNEY WALT CO||1000 share||0.01||20||market||16.30 - 23.00|
|AIG||AMERICAN INTERNATIONAL GROUP||1000 share||0.01||20||market||16.30 - 23.00|
|GE||GENERAL ELECTRIC||1000 share||0.01||20||market||16.30 - 23.00|
|GM||GENERAL MOTOR CORPS||1000 share||0.01||20||market||16.30 - 23.00|
|HD||HOME DEPOT||1000 share||0.01||20||market||16.30 - 23.00|
|HON||HONEYWELL INTERNATIONAL||1000 share||0.01||20||market||16.30 - 23.00|
|HPQ||HEWLETT INTERNATIONAL||1000 share||0.01||20||market||16.30 - 23.00|
|IBM||INTERNATIONAL BUSSINES MACHINE||1000 share||0.01||20||market||16.30 - 23.00|
|VZ||VERIZON COMMUNICATIONS||1000 share||0.01||20||market||16.30 - 23.00|
|INTC||INTEL CORP||1000 share||0.01||20||market||16.30 - 23.00|
|JNJ||JONHNSON & JOHNSON||1000 share||0.01||20||market||16.30 - 23.00|
|JPM||JP MORGAN CHASE||1000 share||0.01||20||market||16.30 - 23.00|
|KO||COCA COLA CO||1000 share||0.01||20||market||16.30 - 23.00|
|MCD||MCDONALDS CORP||1000 share||0.01||20||market||16.30 - 23.00|
|MMM||3M CO||1000 share||0.01||20||market||16.30 - 23.00|
|MO||ALTRIA GROUP INC||1000 share||0.01||20||market||16.30 - 23.00|
|MRK||MERCK & CO||1000 share||0.01||20||market||16.30 - 23.00|
|MSFT||MICROSOFT CORP||1000 share||0.01||20||market||16.30 - 23.00|
|PG||PROCTER & GAMBLE||1000 share||0.01||20||market||16.30 - 23.00|
|TAT||T & T INC||1000 share||0.01||20||market||16.30 - 23.00|
|PFE||Pfizer||1000 share||0.01||20||market||16.30 - 23.00|
|UTX||UNITED TECH CORP||1000 share||0.01||20||market||16.30 - 23.00|
|WMT||WAL-MART STORE||1000 share||0.01||20||market||16.30 - 23.00|
|XOM||EXXON MOBILE CORP||1000 share||0.01||20||market||16.30 - 23.00|
Click Here to Download US CFD Contract Specification
Please be informed that Mini Acc can trade CME contract ( EC , JY, BP, SF, AD , CD , ES , NQ ) , NYmex ( CLM = Crude Oil , QG = Natural Gas ) , and Cbot
( YG=Mini Gold , YI=Mini Silver ) It can be traded for june contract month / New Contract.
If Any client(s) / trader(s) have a transaction then client(s) / trader(s) has known and agreed the trading rules of Solution Keys. For further information please contact our support departement or introducing brokers.
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