The Product
The contract for difference (CFD) is a contract between
two parties to exchange the difference between the
opening and closing price of a contract, as at the
contract’s close, multiplied by the specified
number of shares. It is a neat way to get exposure
to the price movement in, among other things, a stock
or index without ever owning the underlying instrument.
If the share price goes up or down, you will make
or lose money on the difference.
Like spread betting, this is an over-the-counter market,
which means the counterparty is the product issuer.
A guaranteed stop loss is similarly available at a
premium. But unlike spread bets, the CFD aims to replicate
all the financial benefits of share ownership except
for voting rights. You will be entitled to dividend
payments and, depending on your broker, will have
full access to corporate actions, including rights
issues and takeover activity. There are CFDs based
on indices, currencies and commodities.
The CFD market now accounts for more than 20 per cent
of trading by volume on the London Stock Exchange,
and the product is now commonly offered by spread
betting firms, CFD market makers, specialist brokers
and online dealers. Since the first edition of this
book was published in 2002, CFDs have expanded their
coverage to include almost any market or any kind
of asset. You can typically trade CFDs in all UK stocks
with a market capitalization (share price ×
number of shares in issue) of over £50 million,
in many US and European stocks, and in all major world
indices.
The Market
The market attracts institutional investors, particularly
the hedge funds - those freewheeling spirits that
trade using sophisticated techniques in pursuit of
absolute returns. The CFD enables them to take a position
in equities without revealing their identities. By
direct market access (DMA) through brokers you can,
as a trader, obtain often keener prices than through
spread betting firms acting as market makers, provided
somebody on the other side is prepared to meet the
trade, but your deals will have to be of a specified
minimum size.
Not everybody has an appetite for DMA, where a commission
must be paid and there is not the added liquidity
which a market maker can bring. But unless you use
DMA, you are often just as well off doing spread betting.
In recent years, private investors have become increasingly
involved in CFDs, but, unlike on spread bets, CFDs
are open only to intermediate customers under current
FSA classifications, which means that to trade this
product, you must have some experience and knowledge.
Trading
As with other derivatives, you will trade the CFD
on margin. At the start of the trade, you will put
up initial margin, which is often at least 10 per
cent of the value of the underlying instrument. The
smaller the stock size, the greater the initial margin
required. The margin is on the high side for stocks
outside the FTSE-100, and on the low side for indices.
If you have a long position in a stock, you will have
to pay a financing charge. This may be, for instance,
LIBOR (London Interbank Offered Rate), defined on
Day 16, plus 1.5 per cent - for the outstanding amount
above the margin. The rate payable is pro rata to
the annual rate. If you have a short position, you
will similarly be paid financing (perhaps LIBOR -
2.5 per cent) for this. If you close out your CFD
intraday, financing payments will not apply, as for
rolling online spread bets.
The CFD has no settlement date, unlike for futures
and spread betting where the contract on expiry must
be rolled over to the next one. As in spread betting,
you will pay no stamp duty on your CFD purchase but,
after you have held it for about 60 days, the amount
that you saved this way compared with on shares is
cancelled by your interest payments. From this time,
it makes no economic sense to continue holding your
CFD unless it is significantly increasing in value.
Unlike in spread betting, you are liable for capital
gains tax on profits beyond your annual exemption
level (£8,500 in 2006-7), and you may offset
losses against future liabilities.
