What is a CFD?
A CFD (Contract for Difference) is a financial derivative that allows traders to profit, or incur losses, relative to the price movements of an underlying financial security. The Contract for Difference is an arrangement for one party to pay the difference in value from when the contract was opened to when it was closed. CFDs are offered on 1,000s of markets, including commodities, currencies, indices and shares.
History of CFDs
CFDs are a relatively new financial product. Devised in London in the 1990s, they were first used by hedge funds looking to short sell and place larger trades than they could on the underlying market. CFDs offered the perfect opportunity to trade with leverage and go short on 1,000s of financial markets whilst avoiding UK Stamp Duty.
The tech boom of the late 1990s provided a wealth of new markets ideally suited to CFDs, and CFD trading has now spread to other major financial centres. Approximately a third of the total volume traded on the London Stock Exchange is CFD related.
How does CFD trading work?
CFD trading enables speculation on market movements without owning the underlying asset. Contracts are bought instead of shares, with an agreement to swap the difference in value at the closing of the contract.
Example CFD trade:
A short trade is opened in expectation that the price of the UK100 index is going to fall. For instance, the UK 100 is currently trading with a bid-offer spread of 6,300.1 – 6,300.9. A trader decides to ‘go short’ 10 CFDs (with a pip location of 0.1 and a value per pip of £1) with a total value of £630,010 ((10/0.1) x 6,300.1).
As anticipated by the trader the market falls and at a quote of 6,290.4 – 6,291.2 the trader decides to close the contract at a price of 6,291.2. The difference between the opening value of the trade (£630,010) and the closing level of the trade (£629,120) is £890.
Opening Leg: £6,300.1
Closing Leg: £6,291.2
No. of Contracts: 10 (Pip location 0.1, Pip value GBP 1)
Profit on Trade: £8.90 x (10 / 0.1) = £890
A long trade is opened in anticipation of the market rising. For example, a trader believes that the value of the US Tech 100 is going to appreciate. The index is currently quoted at a bid-offer spread of 4,300.2-4,300.6, so the trader goes long with 10 CFDs entering a contract (with a pip location of 0.1 and a value per pip of $1) with a total notional value of $430,060 (10/0.1 x $4,300.6).
Against the trader’s expectations, the US Tech 100 falls and at a price of 4,280.2 – 4,280.6 the trader closes the trade, selling 10 CFDs at 4,280.2. The difference between the opening value of the trade ($430,060) and the closing level of the trade ($428,020) is $2,040.
Opening Leg: $4,300.6
Closing Leg: $4,280.2
No. of Contracts: 10 (Pip location 0.1, Pip value USD 1)
Loss on Trade: $20.40 x (10 / 0.1) = $2,040
A key difference between a CFD and traditional forms of trading is that it is a leveraged product. This means that only a small percentage of the total exposure to a trade needs to be deposited up-front.
In the above example the margin requirement to place a trade on the US Tech 100 is 1%. The total nominal value of the trade is $430,060, yet with margin trading only $4,300.60 needs to be deposited with a broker to open the trade.
This level of gearing means that CFDs offer the potential for significantly larger profits than standard forms of trading. However, it also increases the risk of incurring losses in excess of your deposits.
What are the benefits of CFDs?
Exempt from UK stamp duty: Because the underlying asset is never purchased or sold, CFDs are free from UK stamp duty.
Go long or go short: Unlike trading shares CFDs allow you to profit, or incur losses, when the market is falling.
Deductible against UK Capital Gains Tax: Losses from CFD trading can be offset against UK Capital Gains Tax liabilities. Conversely, profits are liable to UK CGT. Tax laws are subject to change and depend on individual circumstances, please seek individual advice.
Hedging: Traders can potentially offset any losses to their share portfolio by short selling the same security with CFD trades.
Leverage: CFD trading is leveraged which means that only a small amount of the total trade value needs to be deposited. This also means that losses may exceed deposits.
What are the costs of CFD Trading?
Spread: In both of the above examples the trader incurred the cost of spread. Whether the trade had resulted in a profit or a loss, this spread cost would remain the same. The tighter the spread, all things being equal, the lower the cost of trading.
Commission: Certain CFD trades are subject to commission. This will vary depending upon the market and currency traded.
Overnight financing: Overnight positions are often subject to financing charges. These are typically set around 2.5% + LIBOR for long positions, and LIBOR – 2.5% for short positions. This is in effect the charge for leveraging the position.
The majority of CFD trades do not have a set expiry date, position can be closed when a trader wants. However, there are some forward and futures contracts that expire at a set date. These contracts can still be exited early if the trader so wishes.
CFD positions that are left open overnight are known as ‘rolling’, and are subject to overnight financing charges.
Risk Warning: Financial spread bets and CFD trades are leveraged products. Losses may exceed deposits.