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What is CFD Trading

CFD Trading

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.

 

 

Risks

 

Market risk

 

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.[citation needed] 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.

 

 

Liquidation risk

 

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.

Counterparty Risk
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 are a number of different financial instruments that have been used in the past to speculate on financial markets. These range from trading in physical shares either directly or via margin lending, to using derivatives such as futures, options or covered warrants. A number of brokers have been actively promoting CFDs as alternatives to all of these products.[citation needed]
 
The CFD market most resembles the futures and options market, the major differences being:
 
  • 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.
 
Futures
 
Professionals prefer future contracts for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent. Futures contracts tend to only converge to the price of the underlying instrument near the expiry date, while the CFD never expires and simply mirrors the underlying instrument.
 
Futures are often used by the CFD providers to hedge their own positions and many CFDs are written over futures as futures prices are easily obtainable. CFDs don’t have expiry dates so when a CFD is written over a futures contract the CFD contract has to deal with the futures contract expiry date. The industry practice is for the CFD provider to ‘roll’ the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry, thus creating a rolling CFD contract.[citation needed]
 
Options
 
Options, like futures, are established products that are exchange traded, centrally cleared and used by professionals. Options, like futures, can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case. The main advantage of CFDs over options is the price simplicity and range of underlying instruments. An important disadvantage is that a CFD cannot be allowed to lapse, unlike an option. This means that the downside risk of a CFD is unlimited, whereas the most that can be lost on an option is the price of the option itself. In addition, no margin calls are made on options if the market moves against the trader.
 
Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument. CFDs cannot be used to reduce risk in the way that options can.
 
Covered warrants
 
Similar to options, covered warrants have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products. In markets such as Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, and may have been partially responsible for the decline in volume of covered warrant there.
 
Physical shares, commodities and FX
 
This is the traditional way to trade financial markets, this requires a relationship with a broker in each country, require paying broker fees and commissions and dealing with settlement process for that product. With the advent of discount brokers, this has become easier and cheaper, but can still be challenging for retail traders particularly if trading in overseas markets. Without leverage this is capital intensive as all positions have to be fully funded. CFDs make it much easier to access global markets for much lower costs and much easier to move in and out of a position quickly. All forms of margin trading involve financing costs, in effect the cost of borrowing the money for the whole position.
 
Margin lending
 
Margin lending, also known as margin buying or leveraged equities, have all the same attributes as physical shares discussed earlier, but with the addition of leverage, which means like CFDs, futures, and options much less capital is required, but risks are increased. Since the advent of CFDs, many traders have moved from margin lending to CFD trading. The main benefits of CFD versus margin lending are that there are more underlying products, the margin rates are lower, and it is easy to go short. Even with the recent bans on short selling, CFD providers who have been able to hedge their book in other ways have allowed clients to continue to short sell those stocks.

 

 

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M.Bashir

M.Bashir

Portfolio Manager
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