What are CFD’s
• 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).
• For example, when applied to equities, such a contract
is an equity derivative that allows traders to speculate
on share price movements, without the need for
ownership of the underlying shares.
CFD’s continued…
• In effect CFD’s are financial derivatives, originally
known as Traded Options, that allow traders to take
advantage of prices moving up (long positions) or
prices moving down (short positions) on underlying
financial instruments and are often used to speculate
on those markets.
How CFD Trading Works?
The difference between where a trade is entered and
exited is the contract for difference (CFD).
A CFD is a tradable instrument that mirrors the
movements of the asset underlying it. It allows for profits
or losses to be realized when the underlying asset moves
in relation to the position taken, but the actual underlying
asset is never owned.
How CFD Trading Works
Continued…
Essentially, it is a contract between the client
and the broker. Trading CFD’s has several major
advantages, and these have increased the
popularity of the instruments over the last
several years.
Example of a Long Trade
A long trade is a position that is opened with a buy in
the expectation that the share price will rise.
Vodacom is currently trading at R127.
Investor A believes that Vodacom is going to rise and
places a trade to buy 500 shares as a CFD at R127.50.
The total value of the contract would be R63 750, but
they would only need to make an initial 10% deposit
(initial margin) R6 375.00.
Example of a Long Trade
Continued…
A week later Investor A's prediction was correct and
Vodacom rise to R127,50 – R136.50 and they decide
to close their position. By selling 500 Vodacom CFD’s
at R136,50.
The profit on the trade is calculated as follows:
Opening Level R127.50
Closing Level R136.50
Difference
R 9.00
Profit on trade - (R9.00 x 500) R4 500.00
Share CFD Example:
Short Trade
A short trade is a position that is opened with a sell
transaction in the expectation that the share price will
fall.
Barclays is currently trading at R155, 00
Investor B believes that Barclays is overvalued and is
going to fall and places a trade to SELL 500 shares as a
CFD at R154, 50. The total value of the contract would
be R77 250, 00. Even though they are selling short, they
would only need to make an initial 10% deposit (initial
margin) R7 725,00.
Short Trade continued…
A week later Investor B's prediction was correct and
Barclays falls to R154,50 – R146,50 and they decide to
close their position. By Buying 500 Barclays CFDs at
R146,50.
The profit on the trade is calculated as follows:
Opening Level R 154,50
Closing Level R 146,50
Difference R8
Profit on trade, (R8 x 500) = R4 000
What is a Margin?
Rather than pay the full value of a
transaction you only need to pay a
percentage when opening the position called
Initial Margin. The key point is that margin
allows leverage, so that you can access a
larger amount of shares than you would be
able to if buying or selling the shares
themselves.
Margin continued …
The margin on all open positions must be
maintained at the required level over and above
any marked to market profits or losses in order
keep the position open. If a position moves
against you and reduces your cash balance so that
you are below the required margin level on a
particular trade, you will be subject to a "Margin
Call" and will have to pay additional money into
your account to keep the position open or you
may be forced to close your position.
Advantage of CFD’s
•
Contracts For Difference (CFD’s) are traded on margin so
you can maximise your trading capital.
•
You can profit from falling or rising markets by trading
long or short.
•
A single account can give you access to far greater range
of financial markets.
•
You can limit & Manage your risk using a Stop Losses
and Limit orders.
•
No expiry date: CFDs don’t have a set expiry date and
interest is charged on a daily basis. The interest rate
could differ daily and for different clients.
Advantage of CFD’s
• No Rollover fees: As CFD’s do not expire into a physical
delivery, no rollover fees are payable.
• If a trader holds a long CFD on a stock during a
dividend payment period, they will receive payment
for that dividend on the ex-dividend date, from the
brokerage company.
• If a trader holds a short position on a stock, they will
be charged for the dividend on the ex-dividend date.
The purpose of these adjustments is to compensate
for the effects that dividends have on share price.
Risk of Trading CFD’s
• The geared nature if margin trading markets means
that both profits and losses can be magnified and
unless you place a stop loss you could incur very large
losses if your position moves against you.
• It is less suited to the long term investor, if you hold a
CFD open over a long period of time the costs
associated increase and it may be more beneficial to
have bought the underlying asset.
• You have no rights as an investor, including no voting
rights.