CFD Trading: Contracts for Dummies?



CFD Trading is an important financial innovation, and the use of Contracts for Difference (CFDs) by hedge funds and individual traders has grown exponentially over the past few years, especially in the UK, Continental Europe and in Australia. CFDs are mostly traded OTC and only the ASX (Australian Stock Exchange) has been providing some standardized regulated CFDs since 2007. But what are these CFDs exactly? Why do our forex brokers seem to be continuously enhancing their product offering with more CFDs? Why should a trader prefer a CFD over a stock or future trade? Let's try to answer these questions in this article.

CFD Trading

1. What is a Contract For Difference?

CFDs are future-style derivatives designed such that their theoretical price (without transaction costs) should be equal to the price of the underlying security. They provide traders with the opportunity to take highly leveraged (margined) “effective” positions in stocks or other traded financial instruments without actually owning them.

CFDs have become popular because they enable much more flexibility and lower capital required to trade than outright futures or equities. They were originally introduced into the London OTC market in the early 1990s, only for institutional investors (due to the degree of counterparty risk, complexity and leverage involved). 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. In November 2007 the Australian Securities Exchange (ASX) became the first exchange to design and list exchange-traded CFDs. In London, the CFD market has grown exponentially and already in 2007 was at 35% of the value of the LSE equity transactions. The first company to provide CFD trading to retail investors was GNI (originally known as Gerrard & National Intercommodities). GNI and its CFD trading service GNI touch was later acquired by MF Global. They were soon followed byIG Markets and CMC Markets who started to popularize the service in 2000. In October 2013, LCH.Clearnet in partnership with Cantor Fitzgerald, ING Bank and Commerzbank launched centrally cleared CFDs in line with the EU financial regulators’ stated aim of increasing the proportion of cleared OTC contracts.

So what are the main issues that regulatory bodies are facing when addressing CFDs?

Bottom Line: CFDs are a high leverage investment vehicle that must be understood thoroughly before attempting to incorporate them into your portfolio. Use your common sense: if brokers are so happy to push CFDs onto their clients, there must be a good (and lucrative) reason for it.

2. CFD Trading: Structure and Pricing Mechanism

To understand a CFD's pricing structure, we first need to remind ourselves of the logic behind a future's pricing structure. What follows is NOT an extensive description of pricing mechanisms. It is just enough to get the point across.

Future Price = Ft= St * ert where S = spot price and ert is the discount factor. “r” is the risk-free rate available at the time.

CFD Trading: futures pricing

The Future price must equate to 2 strategies:

  1. Buy Spot right now and hold until time T.
  2. Buy Future right now and invest the current value of F in a Bond at the risk-free rate “r”.

ST = + ert – FT which with Dividends becomes FT = ST * ert – DT

Now let's see what the CFD pricing conditions are. CFD Price = PT and Underlying Price = UT so the 2 parties get into a CFD trade at time t less than T and the condition must be that:

1. For each moment in time t less than T the only cash flows between parties are: the Buyer of the CFD must pay the Seller interest of r*Ut-1 (contract rate of interest per day, applied at rollover) and the Seller must pay the Buyer any Dividends Dt

2. At time T (the close of the position) there is a cash flow of PT - Pt = UT - Pt

So the CFD pricing mecchanism that would keep the CFD price locked to the Underlying price at all times, and that would satisfy the Futures pricing mecchanism, would be:

PT-1 = FT-1 – (UT-1*(er-1)) + DT = UT-1

This is the financing cost (contract interest) justified by the fact that the CFD issuer should have a physical position in the underlying, for which it has set aside margin, and they are not doing this pro-bono.

The explicit financing calculation is usually in the form of:

Financing = (amt*close*rate)/365

Where:

amt = Trade Size

close = daily closing price of the CFD contract

rate = relevant 3Month LIBOR rate (usually), to which the CFD issuers usually add (for long positions) or deduct (for short positions) a certain amount. For example, if your broker adds 3% to longs and deducts 3% for shorts, so effectively their haircut is 6% (because they make you pay 3% more on the longs and they give you 3% less on the shorts)

And now let's try to understand a little more what the pricing formula means:

Long 1 CFD = PT-1 = FT-1 (UT-1*(er-1)) + DT so the client benefits from (positive) Future price variation and the dividends, and pays Libor 3M+3% (in our example)

Short 1 CFD = - PT-1 = - FT-1 + (UT-1*(er-1)) – DT so the client benefits from (negative) Future price variation and Libor 3M-3% (in our example), and pays the dividends.

And finally, let's take a look at why it's beneficial for the CFD issuer to offer as many CFDs as possible:

Time

Client

CFD Issuer

MKT

At any time t less than T

+CFD - (UT-1*(er-1)) + DT

- CFD + (UT-1*(er-1)) - DT

+ Future - margin

At time T

- CFD + (UT-1*(er-1)) - DT

+ CFD - (UT-1*(er-1)) + DT

- Future + Margin

The above example is a case of the CFD issuer acting as a DMA issuer (not a Market Maker) and hedging its CFD exposure in the market with the underlying future. So the Issuer is acting in the most transparent way possible, eliminating any potential conflicts of interest.

It would appear that all the terms cancel themselves out (without transaction costs, obviously) but this obviously cannot be true, because the Issuer does not offer CFDs for free. So where is the hidden benefit?

The hidden benefit is in the financing term! In our example, the market rate at which the Issuer can transact is Libor3M, while it charges the client 3% on the long side, and deducts 3% from the interest that the client would otherwise benefit from on the short side. The total haircut that the issuer (in our example) is receiving is 6%. In reality, it's probably safe to say that the issuer benefits from at least 2*Libor applied to the client. But remember that the Issuer also benefits from the spread it applies which is much wider in %-terms than the spread applied to the underlying stock or future.

3. Main observations from the Pricing Mechanism

a) the purchase of a CFD is similar to borrowing in order to purchase the underlying (but avoiding ownership of the underlying) and the amount borrowed changes daily with the value of the underlying asset price.

b) the sale of a CFD is similar to short selling the underlying each day, investing the proceeds, closing out the previous day's short.

c) Basis Risk: most CFD providers are OTC Issuers (like FX spot trading) and they can create prices for clients that are not necessarily tied to the underlying. However, there are some OTC Issuers that provide Direct Market Access (DMA) and they automatically hedge their exposure in the marketplace on the underlying – so their pricing is a lot closer to the actual market price of the underlying asset.

d) Gapping risk: there can be a time difference between the moment that the client “clicks” to open/close a CFD position, and the actual execution of his order. Time of execution can differ from time of sale. This can be a technological issue or a way with which CFD issuers “slip” client orders and benefit from the delayed execution. The gapping risk is high when liquidity is low (either because the liquidity on the underlying security is inherently low or the market is uni-directional and there is not much 2-way transacting).

Trading CFDs is a high risk/high reward activity. The Risk:Reward profile of CFDs is similar to that of Futures, and is higher than Options, Equities or Bonds. The fact is that CFDs, just like FX trading, offers a significant degree of Leverage, which can be a big disadvantage since the value of CFDs can change significantly in a short period of time.

Due to the risks described above, and the financing costs, CFDs are definitely a “trading vehicle” more so than an investment vehicle. Most CFD positions are closed out in a 1-2 day period, and rarely reach 1 week in duration (due mostly to the fact that the financing costs make it inefficient to hold for longer periods of time). So basically, if you are not comfortable with high volatility or cannot afford to actively manage your positions, then CFDs may not be the right asset for you.

4. Example of a CFD trade

One of the main selling points that brokers use, to entice their clients into trading CFDs is that they can gain “beta exposure” by playing the CFDs on the main indicies like the S&P, the Dow Jones, the FTSE, the Nikkei, or other world indicies. Let's take a look at an example of a transaction.

Please take note that many CFD Issuers make things easy for their clients to trade them, so in the example below, we will use a typical Market Maker CFD issuer scenario where the Margin and the Tick size are pre defined. CFD issuers can do this: they can effectively “chop” 1 position in the physical underlying into as many pieces as they want, to make sure even clients with very small accounts can trade CFDs.

1. Client shorts 1 S&P CFD quoted 1845.5/1846

Sell S&P CFD at bid price (spread is 5 ticks or half a point)

$1845.5 * 1 = $1845.5 and each point is worth $10 so the initial spread to recover is $10/2 = $5 in order to break even.

Margin requirement = amt * % or fixed amt for some brokers as in our case

$80

Commission – typically none for indicies

0

2. Overnight Financing

We will receive the financing as we are short. We know the rate is usually based on a benchmark rate like the Libor, from which we must subtract the broker's margin and divide by 365. In our example, Libor3M is 0.5% and the broker takes 3%.

($1845.5*0.005-0.03)/365 = $ -0.126

So we are actually paying and this can happen when interest rates are very low. The clients then pay financing on the long positiong and on the short position.

3. Closing the position

On the next day, the S&P CFD has dropped by 10 points to 1835,5 bid / 1836 ask

We decide to close the position at the ask price

1*1836 = $ 1836

The margin is now zero as the position is closed. Please note that some brokers change their margin requirements overnight, and can range from 2 to 3 times the amount requested during the day. In our case, we should have at least $500 in our account because our broker may request up to $240 in margin for holding our trade overnight.

Gross Profit/Loss

1845.5 – 1836 = 9.5 points; * $10*9.5 = $95

Net profit = gross +/- financing

$95-$0.126 = $94.874

Source: proprietary example

Bottom Line: as you can see, in this (realistic) example, we have gained more than the margin requested for the trade. We could have easily lost more than the margin requested for the position. In this sense, CFDs are high leverage products. The financing cost seems very low at this point, but we are in a moment of low interest rates. In these moments, Issuers gain marginally less on their financing haircut BUT they get to charge clients on both the long AND the short positions.

5. What type of broker am I trading with?

It's important to read your broker's disclosure documents carefully, in order to understand what type of execution problems you might have with them. For example, if you are trading CFDs with a Market Maker, then you probably don't want to scalp CFDs with them. They tendentially are not able to hedge their positions on scalps, and they might actually block you from trading like that – even if it's not put in writing anywhere. Use common sense.

Comparison of OTC CFDs (more common than Exchange Traded CFDs)

MM CFDs

DMA CFDs

Operation

MMs quote their own prices, which may diverge from the underlying asset. Traders are expected to be price takers. The MM may retain or hedge the client's position. MM can create CFDs and provide liquidity even if the underlying asset is seldom traded.

DMA CFD prices correspond directly to the prices in the underlying market. DMA issuers automatically place each client order into underlying markets, and therefore traders are price makers. Issuers do not carry any market risk from the trade. These CFD issuers will only provide CFDs if there is enough liquidity on the underlying asset.

Pricing

Traders are price takers. CFD prices are determined by the MM.

Traders are price makers. CFD prices are determined directly by the market price of the underlying asset.

Contract Specifications

Varies depending on the issuer. Contracts are between clients and individual issuers, not standardized or transferable.

Varies depending on the issuer. Contracts are between clients and individual issuers, not standardized or transferable.

Replication of trades in Underlying asset market

At the discretion of the issuer.

Yes.

Range of CFDs offered

Extensive. They can create synthetic CFDs on any asset, independently from the liquidity of the underlying asset.

Somewhat limited. As DMA providers hedge all trades in an underlying market, they can offer only CFDs over listed assets.

Margin Requirements

Varies depending on the CFD, generally ranging from 0.5% to 100%, with lower margins for FX and index CFDs.

Varies depending on the CFD, generally ranging from 4% to 100% with lower margins for FX and CFDs.

Significant Risks

Margin Call.

Risk of loss that equals or exceeds the investor's initial investment.

Gapping or market illiquidity, if there is significant market volatility or lack of participation.

Risk of opaque pricing.

Risk of re-quotes.

Counterparty risk.

Margin Call.

Risk of loss that equals or excees the investor's initial investment.

Gapping or market illiquidity, if there is significant market volatility or lack of participation

Counterparty risk.

Source: Contracts for Difference and Retail Investors – ASIC Report 205/2010

Bottom line: if you must trade CFDs, it would be better to trade with a DMA broker because of the lower amount of conflicts of interest and the fact that you are not profiting at the expense of your broker. Vice-versa, when trading CFDs against a Market Maker, you are profiting if they are losing (because they usually only hedge their net exposure and run everything in their book). Whilst FX trading has progressed to the point where outright market making is rare these days, and brokers' profitability has probably decreased because of this, CFDs are the new fad that can allow brokers to fill up their pockets once again.

Note: the above affirmations are the authors' point of view only.

To sum up: CFDs are flexible instruments that can allow the retail trader to gain exposure to a multitude of assets in a very easy way. Issuers also reduce the contract size in order to allow clients with small account balances to transact if they desire to. However, professional traders will generally avoid the use of CFDs for various reasons (preference for the transparency of an exchange traded vehicle, avoidance of any shady pricing by brokers, avoidance of conflicts of interest with brokers, avoidance of financing costs). CFDs have become very popular however. If you desire to trade CFDs, do your due diligence and find out exactly who your counterparty is (MM or DMA or even an exchange like the ASX) and what the costs are. Also, do not overestimate your own talent in market timing. Poor timing, when trading a CFD, can cost you a substantial amount of money. They are high risk/high reward financial instruments after all.

References:

1. Lee & Choy “The performance of Investors in Contracts for Difference” March 2013 – Accounting & Finance.

2. Wikipedia http://en.wikipedia.org/wiki/Contract_for_difference

3. Have CFDs affected Irish equity market volatility? - Corbet & Twomey 2013

4. ASIC Report 205/2010 – Contracts for Difference and Retail Investors

5. Exchange Traded Contracts for Difference: Design, Pricing and Effects – Brown, Dark, Davis & The Melbourne Institute for Financial Studies 2009

6. ASIC Report – Thinking in Trading Contracts for Difference (CFDs)? - November 2010

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