What are CFDs?

• CFDs are complex financial instruments, often offered through online platforms. They are a form of derivative trading.

• CFD trading enables you to speculate on the rise or fall of the price, level or value of an underlying, including such asset classes as currencies, indices, commodities, shares and government bonds. You do not need to own the underlying asset.

• CFDs are typically offered with leverage which means you only need to put down a portion of the investment’s total value. However, financing costs and transaction costs (such as bid-ask spreads) are typically based on the investment’s total value.

• Leverage also multiplies the impact of price changes on both profits and losses. This means you can lose or gain money very rapidly.

Main Characteristics of CFD

Leverage

When buying for instance €10,000 of shares in Apple, there is no leverage. Therefore, it will cost you 10,000 plus commissions. Using a CFD however you are trading on margin. So, if the shares we are trading have an initial margin requirement of 10%, what it means is that we only have to put up 10% of the value. Basically, we are still investing in €10,000 worth of Apple shares but initially we are putting just €1,000. The risk is that if the price is falling, we need to make sure that there is enough money in the account to cover for the losses.

While leverage allows you to magnify your returns, your losses will also be magnified as they are based on the full value of the CFD position, meaning you could lose more than any capital deposited.

Shorting

Using CFDs, unlike direct shares, you can bet the market both ways (i.e. you can go long or short)

Costs

Spread: When trading CFDs you must pay the spread, which is the difference between the buy and sell price. You enter a buy trade using the buy price quoted and exit using the sell price. The narrower the spread, the less the price needs to move in your favour before you start to make a profit, or if the price moves against you, a loss.

Holding costs: at the end of each trading day positions open in your account may be subject to a charge called a 'holding cost'. The holding cost can be positive or negative depending on the direction of your position and the applicable holding rate.

Advantages of using CFDs

  • Liquidity - CFD prices mirror directly what is happening in the underlying market. This means that CFDs provide you access to the liquidity in the underlying market, in addition to the liquidity offered by the CFD provider.

 

  • Tradeable on Margin - CFDs are a leveraged product, so you only need to deposit a percentage (typically from 5-10% to for shares and 1% for indices) of the total value of the trade. This allows you to enhance returns and levels of market exposure. For a similar and usually smaller cost per trade you can gain 10 times the results (if not more) from a trade due to the inherent leverage. This means a more efficient use of your capital as that there is no need to invest in the full value of the shares.

 

  • Low transaction costs - brokerage using CFDs is usually MUCH cheaper than buying shares through a full service broker.

 

  • Transparency and ease of execution - trading or investing with CFDs is almost exactly the same as trading with shares. One share usually = one CFD, so they are not confusing to use.

 

  • Trade long or short with equal ease - this empowers traders to profit from a falling market by taking advantage of share price declines.

 

  • Ability to markets from one account – you will be able to trade global shares and also assets which are not easily tradable like Gold, Silver, Oil, Indices, Sectors, Commodities, Tresuries etc.

 

  • Ability to trade out-of-hours - many providers offer extended hours meaning that you can trade some markets (like the FTSE or Dow) even after the underlying exchange has closed for the day.

 

  • Participate in rights issues, share splits and other company activities (like normal stock)

 

Disadvantage of using CFDs

  • Leverage can be a double-edged sword. i.e. margin trading means your potential profits are magnified, but it is important to remember that losses are also magnified so it is essential to apply appropriate money-management techniques

 

  • Trading CFDs is higher risk than trading shares. Even though you don't need to deposit the whole value you still could lose your initial margin plus if the market moves against you, you may also need to meet a margin call where you either contribute more cash or be forced to sell down assets. For a short position investors are exposed to potentially unlimited loss.

 

  • Over trading: Easy of access and low capital requirements can lead to over-trading.

 

  • Positions that are held overnight are subject to overnight financing

 

  • Contracts for difference have a collateral requirement which means that open positions are 'marked to market', and should the position move against you this will reduce your cash balance. If there is insufficient collateral on account to support the open position losses, the trader will be subject to a 'margin call' which means that you will have to deposit additional funds into the account (or close the position).

 

  • A CFD investor has no rights as a shareholder since there is no physical ownership of the underlying asset (which implies no voting rights or say in the company).

 

  • As CFDs are an over-the-counter derivative product it's important to note that you don’t own the underlying share or instrument over which the CFD is quoted, this also means that you cannot transfer your position to a different CFD provider or stock broker, you can only deal with the CFD broker that you opened the position with.

 

  • For an investor who opens a short CFD position, he is liable to pay out the full dividend value if he holds his short position over the record date.