CFD’s (Contracts For Difference)
Introduction
Equity Contracts for Difference (CFDs) are growing rapidly in popularity and, for the experienced investor, are proving an attractive means of gaining exposure to the economic performance and cash flows of individual equities without the need to invest in the physical share.
A CFD is a financial instrument linked to the underlying share price. Consequently, no rights are acquired or obligations incurred relating to the underlying share and, depending on your view of a company’s share price, you can buy (go long) or sell (go short). The ability to go short is one of the principal attractions of CFDs as other methods of going short are both expensive and inconvenient.
Key Features
CFDs are geared or leveraged instruments. This means that a deposit from as little as 10% of the value of the CFD is required. Consequently, it is possible to hold a position 10 times greater than would be possible with a traditional investment. Clearly, this degree of gearing means that for a correctly anticipated price movement a greater profit will be generated. On the other hand, the risk of loss increases commensurately if the anticipated price movement proves to be ill founded. If the case of substantial and adverse market movements the potential exists to lose all of the money originally deposited and to remain liable to pay additional funds immediately to maintain the margin requirement.
CFDs are available on the stocks or shares of companies comprising the FTSE 350, in the UK, the S & P 500, Top 200 ASX shares, Dow Jones and Nasdaq 100 in the USA and most of the major continental European companies.
The counterparty to the holder of a long CFD position will have had to borrow the stock in the market and in order to fully mirror the economics of physical purchase interest will charged. The margin deposit is held to secure the performance of the contract and is not available to be set-off against the Contract Value. Therefore, a long CFD holder will pay interest on the day-to-day Contract Value. Conversely, the holder of a short CFD position will receive interest also based on the day-to-day Contract Value. Interest is typically calculated at a margin above or below the relevant Inter-Bank Offered Rate for long and short positions respectively.
Other than shareholder privileges, a CFD reflects all corporate actions affecting the underlying stock or share. The net dividend declared by a company will be paid to the holder of a long CFD on the Stock Exchange ex-dividend date. This will be advantageous in cash flow terms as the dividend pay date will normally be several weeks after the ex-dividend date. Holders of short CFDs pay 100% of the gross dividend declared and this must also be paid on the ex-dividend date. These payments reflecting the dividend are made on the ex-dividend date as, all things being equal, the share would be expected to fall by the amount of the declared dividend per share. Similarly, bonus and rights issues and splits are replicated in the CFD on the corresponding 'ex-date'
Equity CFDs offer a number of investment opportunities and strategies, some of which are unattainable in traditional share investing. They can be summarised as: -
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An alternative to traditional share trading |
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Providing economic exposure to a company’s share performance without taking or making physical delivery |
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Counterbalancing economic exposure on an existing physical share holding, i.e. as a hedging or risk management tool |
| Affording access to a wide geographical range of markets and exchanges |
| No Stamp Duty is payable |
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Delivering a geared return on the capital employed |
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Freeing-up capital not required for margin for other uses |
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Allowing you to close-out a position at any time |
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Potentially positive daily cash flows |
Some Questions and Answers
Q1. What is an Equity Contract for Difference?
A. An Equity Contract for Difference is an agreement (made between two parties) to exchange, at the closing of the contract, the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract.
Q2. What is the Contract Value?
A. Every CFD has a Contract Value. It is the number of shares in the contract multiplied by the price of the underlying share. The Contract Value will change in line with the changes in the price of the underlying share. A CFD is marked-to-market (i.e. valued) daily at the close of business mid-price of the underlying share.
Q3. Do I have to pay the full Contract Value of an Equity CFD?
A. No, an Equity CFD is a Margined Transaction.
Q4. What is a Margined Transaction?
A. A Margined Transaction is a transaction where the deposit of cash or other acceptable security (the Margin) is required to secure the
Q5. Can I buy or sell an Equity CFD?
A. Yes. You can buy (go ‘long’) a CFD and will make a profit if the value of the CFD increases. Conversely, if you sell (go ‘short’) a CFD you will make a profit if the value of the CFD decreases.
Q6. Why and how frequently is interest charged or credited?
A. When going long a CFD the economic aspects of a conventional share purchase are replicated. Accordingly, interest, calculated on a daily basis, on the Contract Value will arise. On the other hand, with a short CFD position, a conventional share sale is simulated and interest, also calculated on a daily basis, will be earned. Whether you are long or short the interest calculation is based on the day-to-day Contract Value is usually applied to the account weekly in arrears. Interest is typically calculated at a margin above or below the relevant Inter-Bank Offered Rate for long and short positions respectively. The applicable rates will be notified in writing on opening the account.
Q7. What happens when a company pays a dividend?
A. The holder of a long CFD will receive, on the ex-dividend date, a payment that equates to the net dividend on the underlying share. This payment will be credited to the account. A short CFD holder will, on the ex-dividend date be charged the gross dividend by way of a debit to the account.
ISF's (Individual Share Futures)
An Individual Share Future is futures contract traded on an individual stock, such as News Corp or BHP as opposed to a commodity like Wheat or Corn.
Each Australian ISF contract is equivalent to 1,000 shares of the underlying stock to be delivered at a set point in time. For example, one News Corp ISF is equivalent to 1,000 News Corp shares to be delivered in either Feb / May / Aug / Nov and each 1-cent movement is worth $10.
ISF’s have the same straight-line profit and loss profile as a share, one-cent movement in the ISF is worth $10 per contract for or against the trader. In terms of profit and loss, ISF’s are the same as trading the underlying stock. They do not decay over time so if the ISF is bought or sold and the market does not move, the position can be closed out at the same price, for a breakeven trade (less commission).
Although trading an ISF is very similar to trading the underlying stock, there are a number of characteristics that are very much in the favour of he trader. Some of the benefits include increased leverage, lower brokerage costs, cash efficiency and flexibility of orders.
So Why Should We Trade ISF’s instead of the Physical Stock?
One of the major differences between the two products is the leveraging that is available to ISF traders. This means that instead of having to outlay the total value of the physical stock when opening a position, you only need to put down a minimum deposit (initial margin) when trading an ISF. You may be familiar with this concept in share trading through margin lending products. The major difference is that unlike margin lending the leveraging in ISF’s does not incur an interest cost over the monies borrowed. This is because a futures contract is an agreement to buy or sell in the future, no physical stock has changed hands and therefore there is no requirement for interest to be paid. The factor alone brings with it many benefits including:
§ Greater Leverage Without the Expense
When funds are leveraged to trade the physical stock (maximum 70% on the top 200) the client is obligated to pay interest on the borrowed monies, which can be up to 8%. With an ISF you are simply buying the contractual obligation to buy/sell at a set price in the future so there is no stock traded or monies borrowed and therefore no interest charges.
§ Lower Initial Margins
ISF’s traditionally have lower initial margin (deposit) requirements than trading leveraged or outright physical stocks. For example, in a margin lending physical stock position the maximum leverage is up to 70% of the overall value of the position. ISF futures require roughly an outlay of 4%-7% of the overall value of the position. For example, if you were going to buy 1,000 NAB shares at $31, it would cost you $31,000 outright or $9,300 at 70% leveraged plus interest incurred. To buy 1 NAB share future (equivalent to 1,000 shares) you would need an initial deposit of only $1,300 – a significant saving!
§ Cash Efficient Trading
ISF’s use “marked to market” (profit and loss is calculated daily at the close of the market) meaning that profits and losses fluctuate with the market allowing funds to be allocated elsewhere whilst still holding the position.
Lower brokerage costs are also a huge benefit that has made many traders turn to using ISF’s. Let us compare the brokerage savings in two examples, the first buying 5,000 RIO shares versus 5 December RIO ISF’s and the second selling (shorting) 10,000 WOW versus shorting 10 Dec WOW ISF’s:
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Buy 5,000 RIO shares |
Buy 5 Dec RIO |
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Entry Price |
34.00 |
34.00 |
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Exit Price |
36.00 |
36.00 |
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Gross Profit |
10,000.00 |
10,000.00 |
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Brokerage
Funds Required |
(1.5%) 5,100.00
170,000.00 |
250.00
7,000.00 |
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Net profit/loss |
$ 4,900.00 |
$ 9,750.00 |
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Sell 10,000 WOW |
Sell 10 Dec WOW |
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Entry Price |
11.00 |
11.00 |
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Exit Price |
10.00 |
10.00 |
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Gross Profit |
10,000.00 |
10,000.00 |
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Brokerage
Funds Required |
(1.5%) 3,300.00
110,000.00 |
500.00
4,500.00 |
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Net profit/loss |
$ 6,700.00 |
$ 9,500.00 |
As you can see if you bought and sold 5,000 Rio shares and you payed 1.5% in brokerage it would cost you $5,100. Using ISF’s you could buy and sell 5 Dec RIO contracts (1 contract = 1,000 shares) giving you the same exposure as the physical stock for a cost of only $250 plus GST which includes all fees and covers entry and exit costs.
Furthermore if the stock moved to $36 and you closed the position it would represent a profit of $10,000 both in the physical stock and the ISF. However in the case of the physical stock you would have had to come up with $170,000 (assuming no leverage is used) to make the trade and pay $5,100 in brokerage representing a total profit of $4,900. In contrast the ISF would only require $7,000 in deposit (initial margin). This would represent a profit of $9,750 or 71.4% on your initial outlay on the ISF, which includes a saving of $4,850 on the brokerage. This is exactly the same trade except using ISF’s, certainly something worth taking a look at!
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