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A Contract for Difference, also known as a CFD, is a leveraged ‘derivative’ financial product. That is, when a trader buys or sells a CFD, they enter a contract to exchange the difference in value of a financial instrument (the underlying asset) between the time at which the contract is opened and the time it is closed. Note: the physical asset itself is not traded.
Considered a popular form of derivative trading, traders are able to speculate on the rising and of falling prices on more than 12,000+ assets including commodity, bond, foreign exchange (FOREX), global equity, treasury and index markets.show more
Financier Brian Keelan and mathematician Jon Wood are widely credited with the early development of an equity swap product traded on a margin in the 1990’s which became the CFD. With only a small margin requirement and the ability to avoid capital gains liabilities, CFD’s were initially used by institutional and hedge fund traders as a cost-effective hedge to limit equity exposure from stocks traded on the London Stock Exchange (LSE). CFD trading has since exploded in global popularity.
With the uptake of online-based trading, retail traders joined the market in the late 1990’s when CFD trading was introduced by brokers as either an over-the-counter (OTC) or direct-market-access (DMA) investment tool. Utilising small margin requirements and favourable tax policy (depending on location), CFD trading flourished.
In a bid to better regulate the market for CFD trading, the Australia Stock Exchange (ASX) introduced exchange traded CFDs (Listed CFDs) in 2007 offering CFD trader’s regulation, transparency, fairness and counterparty risk. This instrument was later archived in 2014.
Now a mainstream trading tool, there are more than 250,000 active retail participants in the global CFD market.
A CFD is a cash-settled derivative product. That is, a contract between two parties (a buyer and a seller) of an underlying asset whereby their value is derived from the value of underlying (such as a commodity, index, share etc).
Mirroring the price movement of the underlying asset, CFD traders profit on both increasing prices (by entering a long position) and decreasing prices (by entering a short position) of the underlying financial asset. A CFD position can only be exited by a closing buy or sell trade.
Unlike financial assets such as futures or equities contracts, CFDs do not have a fixed lot size requirement. Therefore a trader has the capability to manage their trade size according to cash and margin requirements.
Traders who hold a shareholding in a company are entitle to dividends. CFD traders do not receive dividends from the underlying company but rather are paid ‘dividend cashflow’. That is, if a long position is held over the shares dividend payment period; when the share moves from with dividend to ex-dividend, the CFD trader is entitled to a credit of the cash dividend amount.
Depending on the broker and the underlying asset, CFD trading is typically based on the schedule for trading on the exchange for the underlying and as such, a CFD for can only be traded during that time. Typically, CFD FOREX markets are 24-hour.
There are three primary types or models of CFDs: Direct Market Access, Over-the-Counter or Listed CFDs.
Direct Market Access (DMA) trading delivers price quotes identical to the underlying market. Orders are replicated with a corresponding order on the underlying market with orders executed at current bid/ask prices which offers the benefit of fair and transparent pricing. DMA CFD trading also provides traders the opportunity to participate in opening, closing and intra-day price auctions directly on the relevant exchange.
Over-the-Counter (OTC) is also known as off-exchange trading. That is, the CFD trade is not made on a formal exchange but rather between two parties; CFD broker, financial institution or bank and the CFD trader. In OTC transactions, CFD brokers operate as market makers and price quotes are based on dealer quotes. OTC CFD instruments are less regulated and less formal subjecting parties to counterparty risk.
Listed CFDs are as the name suggest, listed on the exchange. The CFD price quote is identical to the current underlying price and available for trade during normal trading hours. Regulated, transparent and liability limited, listed CFDs provide the CFD trader full exposure to the movements of the underlying asset at a smaller margin than outright ownership.
A CFD is a leveraged product allowing traders to take a position that has a market value of more than the initial or margin amount. This offers the trader a greater exposure to the market and control of a larger position with only a small amount of capital and without owning the physical asset itself.
The initial margin amount (or deposit) required to access the leveraged facility differs between broker-to-broker. The balance of the position in effectively is lent to the trader. Because profit (or loss) is calculated on the full position amount, leverage offers a CFD trader the opportunity to accelerate profits (or losses).
EXAMPLE: A 5% margin means that for just $500 a CFD trader could get the same exposure as a $10,000 investment representing a leverage of 20 times, or 20:1. To buy 10,000 shares in ABC Ltd (for example) at a current share price of $1; total cost is $10,000. Using leverage and an initial margin requirement of 5%, a trader would pay 5% x $1 X 10,000 shares = $500. If the share price rose from $1.00 to $1.20, profit would total $2,000; the same profit amount if the trader had purchased the shares outright.
If at any time a position moves again the trader into loss and total capital in the CFD account drops below the margin requirement, a margin call will be issued. A margin call is a request from the broker (to the trader) to deposit additional money so their margin account is brought up to the minimum maintenance margin amount. If the amount is not deposited, the position may be closed and trade losses incurred realised.
CFD traders using leverage and margin accounts should always consider the risks.
CFD products can be traded on over 4,000 global markets across more than 12,000 financial assets. Traders can participate in CFD markets by trading shares, FOREX, metals, commodities, bond and interest rate markets throughout Europe, UK, America, Asia and Australia.
Both speculators and hedgers are active CFD trading participants.
Using leverage, speculators actively buy and sell CFD contracts favouring short-term trades with a higher than average risk in return for higher than average trading profits. In an attempt to anticipate future price movements, speculators will participate in markets which are both rising and falling.
Hedgers participate in the CFD market to offset risk in their existing portfolios. Rather than liquidating assets and realising losses, a hedger can protect their portfolio against falling or volatile prices using leveraged CFDs trading strategies. Hedgers bound potential gains by limiting losses.
CFD trading involves risk.
Counterparty risk is the risk that each counterparty of a contract fails to full fill its contractual or financial obligations. For CFD traders, the counterparty is the CFD provider which issues the asset for usually an over-the-counter transaction. Because CFD trading operates in the derivatives market and not on an exchange, trading is based on changes in price of an underlying asset such as a share, commodity or bond. Physical exchange of the asset does not occur, exposing the CFD trader to counterparty risk because the contract can only be closed out with the CFD provider that issued the contract. Should the counterparty to the transaction; the CFD provider, not full fill its financial obligation in trading and price of the underlying asset, the CFD trader is exposed to risk.
Investment risk is the risk that the financial market moves against the CFD trader resulting in a loss. Because CFDs are leveraged assets, investment risk may include the loss of initial margin and margin maintenance amounts resulting in a margin call or realised losses should the positions be closed.
Liquidity risk is the risk that a CFD trader may not be able to close out an open position for a price close to the underlying that it mirrors. It is also the difference between the buy or sell price and the price the order is confirmed at and is also known as ‘slippage’. Because liquidity is measured by trading volume, bid/ask spread, open interest and the number of buyers and sellers in the market, liquidity risk may result in slippage for the CFD trader exposing them to a potential trading losses.
Leverage risk is the risk that by using leverage to accelerate profits, will result in a loss because the value of the CFD trade has moved against the trader. While leverage magnifies the opportunity for trading profits, it also multiplies the scope for losses.