Contracts For Differences

CFD is a financial instrument linked to the underlying share price. Consequently, no rights are acquired or obligations incurred relating to the underlying share and, depending on your view of a company’s share price, you can buy (go long) or sell (go short). The ability to go short is one of the principal attractions of CFD's as other methods of going short are both expensive and inconvenient.

Contracts for Difference (CFD's) are growing rapidly in popularity and, for the experienced investor, are proving an attractive means of gaining exposure to the economic performance and cash flows of individual equities without the need to invest in the physical share. CFD's are geared or leveraged instruments. This means that a deposit from as little as 10% of the value of the CFD is required. Consequently, it is possible to hold a position 10 times greater than would be possiblewith a traditional investment.

Clearly, this degree of gearing means that for a correctly anticipated price movement a greater profit will be generated. On the other hand, the risk of loss increases commensurately if the anticipated price movement proves to be ill founded. If the case of substantial and adverse market movements the potential exists to lose all of the money originally deposited and to remain liable to pay additional funds immediately to maintain the margin requirement. CFD's are available on the stocks or shares of companies comprising the FTSE 350, in the UK, the S & P 500, Dow Jones and NASDAQ 100 in the USA and most of the major continental European companies.

The counterparty to the holder of a long CFD position will have had to borrow the stock in the market and in order to fully mirror the economics of physical purchase interest will charged. The margin deposit is held to secure the performance of the contract and is not available to be set-off against the Contract Value. Therefore, a long CFD holder will pay interest on the day-to-day Contract Value. Conversely, the holder of a short CFD position will receive interest also based on the day-to-day Contract Value. Interest is typically calculated at a margin above or below the relevant Inter-Bank Offered Rate for long and short positions respectively.

Other than shareholder privileges, a CFD reflects all corporate actions affecting the underlying stock or share. The net dividend declared by a company will be paid to the holder of a long CFD on the Stock Exchange ex-dividend date. This will be advantageous in cash flow terms as the dividend pay date will normally be several weeks after the ex-dividend date. Holders of short CFD's pay 100% of the gross dividend declared and this must also be paid on the ex-dividend date. These payments reflecting the dividend are made on the ex-dividend date as, all things being equal, the share would be expected to fall by the amount of the declared dividend per share. Similarly, bonus and rights issues and splits are replicated in the CFD on the corresponding 'ex-date'. CFD's offer a number of investment opportunities and strategies, some of which are unattainable in traditional share investing. They can be summarized as: - 
An alternative to traditional share trading 
Providing economic exposure to a company's share performance without taking or making physical delivery 
Counterbalancing economic exposure on an existing physical share holding, i.e. as a hedging or risk management tool 
Affording access to a wide geographical range of markets and exchanges 
Delivering a geared return on the capital employed 
Freeing-up capital not required for margin for other uses 
Allowing you to close-out a position at any time
Potentially positive daily cash flows

Pairs trading- If you believe that one company is undervalued compared to another company (e.g. Microsoft against Google) you can buy the cheaper share whilst selling the expensive one. This strategy reduces your exposure to market movements (because you trade on a cash neutral basis) but allows you to take advantage of perceived short-term anomalies.

Although there are no time limits on CFD's, most investors will use them for either short to medium term speculation or for hedging of physical stock portfolios. In practice, most CFD'sare closed within three months and the average time is six weeks. If you want to maintain your exposure in the stock market but would like to release most of the cash in your portfolio, then converting your physical stockholdings into CFD's is the answer. While reducing overall market risk it is possible to obtain the out-performance of one share versus another by going long a CFD while going short a CFD, with a matching Contract Value.

Going long: - This is the simplest and most straightforward strategy. A long CFD will profit from an upward price movement in the underlying and has the benefit that no tax is payable. There is no limit for the holding of a long position but, as explained below, there comes a point in time where a long CFD may become uneconomic.

Going short: - Also a simple and straightforward strategy and one of the principal attractions of CFD trading. By entering into a short CFD position a profit will be seen if the price of the underlying falls. Such a position can be maintained indefinitely without the need or the associated costs of having to continually roll the position over. Additionally, short positions generate an interest income but dividends are paid gross.

Hedging: - It is possible to offset an existing stock position so as to reduce market risk particularly in terms of a different time horizon to an underlying position. In other words, a trader may want to reduce exposure temporarily to a company but without effecting a sale of the physical holding.

Most CFD trading revolves around short-term trading so any comparison is best made by comparing the savings achieved by not incurring Any taxes with the financing cost of a long CFD. For ease of illustration, all commission costs are ignored and effective interest rate is taken as 6.5% (say LIBOR at 4% plus a 2.5% margin).

The additional cost of holding a long CFD position over a traditional purchase is only the interest cost. The interest charged on a long CFD is 6.5% of the Contract Value. The 10% lodged by way of margin is held to secure the performance of the contract and in not available to be set-off against the Contract Value.

Conversely, a traditional share purchase incurs Any taxes at 0.5%. The crossover will occur at the time that the interest charged on the long CFD match the saving made on Any taxes. This point is reached in 28 days  ((0.5/1.0) x (365/6.5)). However, this needs adjusting to allow for the fact that the Any taxes on the traditional purchase will be payable 3 days after the bargain date. Accordingly, the crossover occurs on day 25. Consequently, for trades outstanding for less than 25 days it is economically more viable to trade the CFD rather than the underlying stock.

The crossover point will occur earlier if interest rates rise above the 6.5% used in the example and be later in the event of a reduction in the interest rate. This is, of course, a basic calculation as there are other costs but for short-term or intra-day trading (and in the latter case there are no interest costs) the argument is undeniable