Primer on CFDs

I would like to post this brief primer on Contracts for Difference (CFDs), aimed mostly at non-US traders who wish to trade leveraged products, or any trader who wishes to expand his/her product knowledge. From CFDs I will pass on to Spread Betting, which however would only interest residents in the UK and Ireland.

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 or when the contract is closed. (If the difference is negative, then the buyer pays instead to the seller.) For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares. So, CFDs are just another type of derivative contract.

Contracts for difference allow investors to take long or short positions, and unlike futures contracts have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis with margins typically ranging from 1% to 25-30% of the notional value, depending on the underlying product and the broker.

For example, today I decided to short the FTSE. I sell one (1) CFD on the FTSE at 4500. My margin requirement is 1%, so £45 (FTSE is denominated in pounds). I can hold positions overnight, and if I choose to do so, I pay or receive interest depending on my position. So, I am short the FTSE, hold the position overnight, and receive interest. My overnight margin requirement is the same: 1%. The next day, I buy the FTSE at 4450. I made 50 points, I had 1 contract open, hence I make 50 pounds.

Margins, commissions, P&L per point vary according to what you trade and your broker. But essentially, CFDs are products that allow you to take a leveraged position on an underlying financial product: for the FTSE example above, margin is set at 1%, thus leverage is 100x. Products available vary by platform, but usually include all main world indices in cash and future form, US, European and Australian equities, commodities (not all contracts though), bonds, and some even inflation and other products.

Now to Spread Betting...In the UK (and Ireland) there are no taxes on winnings from bets. That is because the UK tax man doesn't allow you to deduct gambling losses either: no deduction on losses hence no taxes on wins. To take advantage of this, UK finance houses repackaged CFDs as a bet, hence spreadbetting. Instead of buying a CFDs on the FTSE, you place a bet on the FTSE. Just like for CFDs, you can go long or short.

Let's look at the FTSE example above under a spreadbetting format. I believe the FTSE wil go down. I bet £1 per 1 point movement in the FTSE going short. My margin requirement is fixed to a set amount of pounds for every 1 pound I bet. So, for example it could be £30 margin for every £1 pound bet. I hold the position overnight on a short, and I receive interest. The next day I close the position for a 50 point gain: every point equals £1 pound, my profit is £50 pounds. This is just like the CFD trade above, only that it is wrapped as a bet: I could have bet £10 pounds per point and a similar CFD trade would have been to trade 10 contracts.

Spreadbetters to my knowledge don't charge commissions regardless of the product you are trading, in order for the trade to qualify as a bet. The make money by posting larger bid/offer spreads: so on the FTSE CFDs I have a 1 point difference between bid and offer, on the Spreadbet it might be 2 points. CFDs usually don't charge commissions on indices, fx and commodities, but do so on equities: again this depends on the broker.

CFDs are an alternative to trading futures for those traders seeking leverage. The advantage for say, the trader looking to take position on S&P 500 futures, is that when trading a CFD on the S&P 500 contract there is no commission.

These products are not available to US customers, as with most European products (and viceversa). However, there are obvious ways around this, but that's another discussion. That said, CFD brokers and Spreadbetters are some of the most regulated entities in London because of the risks involved with leveraged trading and their market being retail oriented, so they are closely monitored by the FSA.

I don't want to tout the goodness of the product, just explaning what it is: there are good brokers and bad brokers, good platforms and bad ones, great technical analysis and charting software and bad ones. However, CFDs (and spread betting) account for almost 25% of the volume on the London Stock Exchange. Prices reflect market movements, so the FTSE will reflect the movement on the underlying market, and the S&P contract will do so as well. However, as above...there are good brokers and bad ones.

Also, I have had a positive P&L example above...obviously if the trade goes the other way your losses would be of similar magnitude.

I hope this was helpful. On the column on the left, down below, you can find some links to CFD brokers if you wish to check out demos and such: I am not affiliated with any of the names mentioned, but I use those platforms and find them extremely reliable and well thought out.