CFD Trading - Contact for Difference
Origin of CFD’s
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 cost-effectively hedge their exposure to stocks on the London Stock Exchange, mainly because they require only a small margin. Moreover, since no physical shares changed hands, it also avoided the stamp duty in the United Kingdom.
The main risk is market risk, as contract for difference trading is designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, and the leveraging effect of this increases the risk significantly. Margin rates are typically small and therefore a small amount of money can be used to hold a large position. It is this very risk that drives the use of CFDs, either to speculate on movements in financial markets or to hedge existing positions in other products.[contradictory] One of the ways to mitigate this risk is the use of stop loss orders. Users typically deposit an amount of money with the CFD provider to cover the margin and can lose much more than this deposit if the market moves against them.
If prices move against an open CFD position, additional variation margin is required to maintain the margin level. The CFD providers may call upon the party to deposit additional sums to cover this, in what is known as a margin call. In fast moving markets, margin calls may be at short notice. If funds are not provided in time, the CFD provider may close/liquidate the positions at a loss for which the other party is liable.
Another dimension of CFD risk is counterparty risk, a factor in most over-the-counter (OTC) traded derivatives. Counterparty risk is associated with the financial stability or solvency of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD trader could potentially incur severe losses, even if the underlying instrument moves in the desired direction. OTC CFD providers are required to segregate client funds protecting client balances in event of company default, but cases such as that of MF Global remind us that guarantees can be broken. Exchange-traded contracts traded through a clearing house are generally believed to have less counterparty risk. Ultimately, the degree of counterparty risk is defined by the credit risk of the counterparty, including the clearing house if applicable.
Comparison with other financial instruments
- There is no expiry date, so no time decay
- Trading is done over-the-counter with CFD brokers or market makers
- CFD contract is normally one to one with the underlying instrument
- CFDs are not available to US residents
- CFDs are not available to HK residents
- 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.