CFD Education

CFD Video Tutorial

 


CFD - Contract for Difference

A contract for difference (or CFD) is an equity derivative that allows users to speculate on share price over-the-counter movements, without the need for ownership of the underlying shares. CFDs are traded (OTC). In finance, a contract for difference (CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time (If the difference is negative, then the buyer pays instead to the seller). The term "Contract for Difference" means that the product is a cash-settled product. There is no receipt or delivery of an underlying instrument, such as a share certificate. The result of the trade is the cash difference between the bought and sold price.


History of CFD's

CFD EducationOriginating in Futures and Options, CFDs were originally developed in the early 1990's by the derivative desk of Smith New Court - a London based brokerage trading firm that was later purchased by Merrill Lynch in 1995, in a deal worth £526 million. The innovation is accredited to Mr. Brian Keelan and Mr. Jon Wood of UBS Warburg.

CFDs first emerged in the over-the-counter (OTC) or equity SWAP markets which were used by institutions to cost-effectively hedge their equity exposure by utilising certain risk-reducing and market neutral trading strategies. Initially, CFD trading represented a cost-effective way for Smith New Court’s hedge fund clients to easily sell short in the market (the London Stock Exchange) with the benefit of leverage, and to benefit from stamp duty exemptions that were not available to outright share transactions. In particular, by using CFDs, institutional traders and hedge funds no longer needed to physically settle their equity/share transactions which in practice meant that such contracts didn't require delivery or acceptance of the underlying instrument. In this way these large clients were also able to avoid the cumbersome and sometimes costly process of borrowing stock when they wanted to sell short.

Towards the end of the 1990s as the dotcom boom started to take hold, the product was adopted for the private client market by GNI Touch, the newly developed online trading arm of London based GNI (Gerrard & National Inter-commodities, now part of Man Group plc). GNI offered the CFD product alongside an innovative trading system which in addition provided clients with the ability to trade via the internet directly into the London Stock Exchange order-driven trading systems. For the first time, individuals trading their own accounts, as well as small institutions and investment funds who did not have the resources available to allow them direct connectivity to the London Stock Exchange, could trade the UK equity market on a level footing with the largest institutions. They have now become widespread with some commentators suggesting that up to 25 percent of UK stock market turnover is attributable to CFDs. Similar products were introduced in Australia in 2002 and supported by companies such as First Prudential Markets, and have now spread to Canada and some Far East markets such as Singapore.


CFD Advantages

In addition to avoiding stamp duty, increased flexibility and leverage are other advantages of CFD's over more conventional forms of margin trading. All forms of margin trading involve financing charges, although in the case of CFD's and futures contracts these are embedded in the price of the instrument. This leverage can make CFD’s seem attractive, but because you are trading with leverage, both gains and losses are magnified – and you can end up losing more than you put in.


CFD Disadvantages

CFDs are highly geared products. This means the money you invest will generally only be a fraction of the market value of the shares (or other market asset) you're 'contracting' for. 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.

The contract is a legally binding agreement, no matter what the market value of the asset is. If the market turns against you, the issuer of the contract:

  • Will require you to pay extra money
  • May close out your contract, for whatever it's worth at the time, to recover some money. If there's not enough money, you will still be legally obliged to make up the difference.

Costs Associated with CFD’s

Spread: When trading CFD’s 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, so the narrower the spread, the less you need the price to move in your favour before you start making a profit or loss.

Holding costs: At the end of each trading day, any 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. To hold this position a financing charge is made each night. This is normally based on a benchmark rate per cent like LIBOR + broker margin per cent / 365.

Commissions (only applicable for share CFD’s): You must also pay a separate commission charge when you trade share CFDs. Commissions on AU based start from 0.10% of the full exposure of the position, and there is a minimum commission charge of $8. Commission charges for CFDs are calculated as a percentage of the transaction value for most markets and as cents per share for the US and Canada.

D = n x C x i / 365

D = daily interest adjustment

n = number of shares

C = official closing share price

i = applicable annual interest rate

Trading hours for CFD’s

  • Australian shares: 10:00-16:00 (Sydney time)
  • UK shares (LSE): 08.00-16.30 (London time)
  • American shares: Typically 09.30 to 16.00 (New York time)
  • Singapore shares: 09.00-17.00 (Singapore time)

How a CFD Trade Works

Prerequisite knowledge: One CFD equals one share.

Key:

Company – XYZ

Fees and Commissions based on industry average

The following table is an example only and is being used for demonstration purposes only.

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Short Selling and Pairs Trading

Short: The sale of a borrowed stock with the expectation that the price will fall in value. The seller assumes that they will be able to buy back the stock at a lower price than the price at which they sold short.

Long: Buying an asset with the expectation that the price will rise in value. The buyer assumes that they will be able to sell the stock at a higher price than the price at which they bought it at.

CFD: CFD stand for Contacts for Difference. A CFD is a leveraged financial instrument that mirrors the price movements of an underlying stock. CFD’s give us the ability to trade on margin meaning we only need to pay a small percentage of the stock’s price in order to trade it.

Correlation: Is a statistical measurement of the degree of association between two variables. Correlation ranges from +1 to -1. A zero correlation indicates that there is no statistical relationship between the two variables. A +1 correlation indicates that the two variables move perfectly together. A -1 correlation indicates that the two variables move directly opposite to each other.

Figure 1. Shows an example of two highly correlated stocks. Notice when one moves up the other one also moves up and vice versa.

Figure 2. Shows an example of two negatively correlated stocks. Notice when one moves up the other moves down and vice versa.

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Cointegration: For the purpose of this article cointegration can be defined as the ability for two correlated stocks to return back to their equilibrium over a period of time. In other words when two correlated stocks start to become uncorrelated cointegration is the measurement of how likely they will return to being correlated again.

Figure 3. Shows and example of two stocks that are both highly correlated and have a high cointegration. Notice that not only do the stocks share very similar movements they also travel closely together and when they via apart more than normal they quickly return back to the norm.

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Standard Deviation: In stock market terms, standard deviation is the measurement of how far away a stock or pair of stocks are trading from their average price over a period of time. For example, say we have two stocks that on average over the last six months have been trading about $2 apart in price. So one stock may be trading on average at $10 and the other at $12. Now if by chance they drift farther apart than normal, say one is trading now at $9 and the other at $13 then we would now say that their standard deviation is high.

How does Pairs Trading work?

Now that you understand some of the key terminology used in pairs trading we can move on to tell you exactly how it works.

When two stocks that have a high correlation and cointegration like in Figure 3. Suddenly start to diverge or move apart we can take advantage of this by selling one of the stocks short and at the same time buying the other stock with the expectation that the spread between the two will gradually decrease back to its norm.

For example, say we have stock ABC currently trading at $13.25 and we have stock XYZ trading at $20.55. These two stocks are highly correlated and cointegrated so they are a suitable pair to track. By historically tracking the spread on these two stocks (the difference between the prices of these two stocks) we found that on average it normally is around $4.40. Recently the spread has widened and is now at $7.30 being the price of XYZ at $20.55 minus the price of ABC at $13.25.

We can now take advantage of this price difference of $7.30 by selling the stock that has recently moved up and buying the stock that has recently moved down. Remember we expect the price difference to eventually move back to $4.40.

Let’s take a closer look!

Ok, so we have identified a situation where two stocks that normally move closely together suddenly deviate apart and we are ready to take advantage of this.

We sell $10,000 worth of stock XYZ which is currently trading at $20.55 giving us a position of short 486 shares.

At the same time we buy stock ABC currently trading at $13.25 giving us a position of long 754 shares.

Over the last couple of weeks there has been really bad economic data released overseas and our market has declined sharply. ABC is now trading at $11.30 so we have lost $1.95 per share. So our total value of our ABC shares is now worth about $8,520 being 754 shares x $11.30. We are on paper negative $1480 on stock ABC.

In the same period stock XYZ had also dropped sharply and is now trading at $15.85 giving us a paper profit of $2284 being $20.55 minus $15.85 equalling a profit of $4.70 per each of our 486 shares.

At this point we note that the price difference between the two stocks is now just $4.55 which is pretty close to what it has been historically so we close out both trades. On stock ABC we made a loss of $1480 and on stock XYZ we made a profit of $2285 giving us an overall net profit of $805 in two weeks. That is our $2285 profit minus our $1480 loss.

As you can see, even though the overall market fell sharply we still profited from this strategy. Below is a chart that demonstrates this strategy.

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What are the Costs Involved with this Trade?

In order to take this trade we use CFD’s instead of buying and selling the shares outright. This enables us to put up a margin deposit of just 5% to 10% on each of the two stocks instead of the full $10,000. For example, say for instance both XYZ and ABC require a margin deposit of 5%, we simply require $500 for each stock and this deposit allows us to do the trade.

What are the Risks?

The main risk we have with this strategy is if the two previously correlated stocks continue to deviate in price after we enter the trade. In this case we monitor the overall loss on the position and exit them both if the loss gets to around $500. We sometimes may exit the trade earlier if we have been in it too long and we think that the trade may eventually fail.

Do you Place Stop Losses and Targets?

We do place very distant stops and targets when we initially take the trade and we move these stops and targets as the trade progresses. We monitor our risk by monitoring the overall net worth of the trade rather than each trade individually.

What are the Benefits of this Strategy?

With this strategy we don’t mind if the market is steaming up or even crashing, our only concern is the price difference between the two stocks. Even if the market is whipsawing sideways it doesn’t matter, we can still profit as this is a “market neutral” strategy.

Gaps in the market meaning when the market jumps up or down based on overnight market action is less of an issue. Say for instance, if the Dow Jones Industrial Average jumps 500 points overnight it could be disastrous if we had an outright short position but with this strategy we are covered because we have one long position and one short position so while one stock has moved quickly into a loss the other has moved quickly into a profit.

Why Doesn’t Everyone use this Strategy?

This strategy has been used by banks, large hedge funds and very large financial institutions for a long time.

In order to use this strategy you need

  • The knowledge to know which the right pairs to trade and when the right time to enter and exit is and when is the right time to stay out altogether.
  • You need sophisticated software in order to do the complex calculations involved with the analysis.
  • You need to be able to monitor the stocks every minute of the day to take advantage of quick price movements.

This is a fairly complex strategy but when used correctly can be a safe and profitable way to trade. We hope this has shed some light on the subject of pairs trading.


Risk and Stop Loss

Risk

CFD's are promoted as an ideal short-term trading tool. However there are risks. Potential traders need fully to appreciate the risks and costs involved. Because profits and losses are based on the full transaction value they can be significantly larger than the initial margin required to establish the trade. For example a trader going long $100,000 of a share that has a collateral base of ten percent (10 times leverage) will only be required to place an initial margin of $10,000. A move of 10% in the share price will mean a 100% return or loss on the initial capital.

Stop Loss Vs Guaranteed Stop Loss (GSL)

A stop loss order allows the trader to set a price which if reached will automatically trigger a sell order (for long positions) or buy order (for short positions) to close their current position. With a simple stop loss if the share or index breaches the set stop loss then the order will be executed at the next available price at the time of dealing. This may mean the order is executed at less than the stop loss price in the case of a long position or more than the stop loss price in the case of a short position. However, the use of a guaranteed stop loss overcomes this. As it suggests this is a stop loss order that is guaranteed to be executed at the price the trader specifies, even if the price of the underlying share or index makes a sudden movement and never actually trades at the price that specified, the position will still be closed at the chosen price. This may not be the case with a simple stop loss.

Risk Profile

Every traders risk profile is different as is every stocks risk profile. The more speculative the stock, the higher the inherent risk associated. As such, those CFD traders with a more aggressive risk profile trading these more risk-prone shares suggests a GSL is mandatory.

Risk Management

We strongly suggest that all CFD traders implement risk management tools when Trading CFDs.

Other Risk Management tools for the CFD Trader

Ideally the CFD trader would not exceed 8 different CFD suggestions at any one time and normally aim to have between 4-6 positions in settled market conditions. This is aimed at diversifying your suggestions to form a portfolio of positions to ensure that losses incurred on any one trade does not substantially impact upon on the overall trading bank. In determining the amount to place on each trade, we suggest maintaining a constant dollar value exposure on the underlying position. This means that whatever the collateral level, your trading results are all equally weighted towards the movement of the underlying stock. This eliminates the risk of one bad highly leveraged CFD trade eliminating more than one 'good' lower leveraged CFD trade.

Example:

Assuming you wanted to trade (borrow) $10,000 of CFDs, then at;

  • 5% collateral (20:1 leverage) - $500 is required
  • 10% collateral (10:1 leverage) - $1,000 is required
  • 15% collateral (6.66:1 leverage) - $1,500 is required
  • 17.5% collateral (5.71:1 leverage) - $1,750 is required

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