In this week’s article we continue our series on derivatives by looking at a very popular and widely used derivative, especially in South Africa, known as a Contract for Difference (CFD). Although this type of derivative can be used to hedge against downside risk, investors commonly use it to increase their exposure in the market, and therefore also their potential gains or losses.
Just as with all derivatives, CFDs also derive their value from the movement of an underlying asset. They allow traders to trade price movements without actually owning the underlying asset. CFDs are offered by brokers for instruments like equity, forex, indices and commodities to name a few.
How does a CFD work?
A CFD contract allows the investor to make a bet on whether the price of the underlying will rise (in which case the investor will “go long”) or fall (in which case the investor will go short). The investor will put down a deposit for trading a CFD, which is known as the deposit margin and is usually a percentage of between 5% and 20% of the position taken, depending on the broker. Margins serve as collateral for the broker since the remaining portion of the position is effectively borrowed from the broker to fund the position. In effect the CFD gives the investor a leveraged position, meaning they have exposure to an underlying asset, but without having to fund it in full.
If the price of the underlying moves in favour of the investor, meaning that the price of the underlying increases while the investor holds a long position, the seller of the CFD, usually the broker, will pay the investor the difference between the initial buy price and the new value of the asset. On the flip side, if the price of the underlying asset moves against the investor, they will be expected to pay the difference to the seller of the CFD contract.
In reality, the investor might not want to close the position immediately when the underlying asset’s price doesn’t move in their favour. In such a case the broker will give the investor a call asking them to pay a maintenance margin, which is commonly known as a margin call. If the investor can’t pay this margin the broker has the right to close the position on behalf of the trader.
Although many investors trade CFDs as a daily short-term instrument, it does not have an expiry date and as such the position can be held indefinitely. When the investor keeps a CFD position open past the daily cut-off time they will be charged an overnight funding charge. This cost reflects the cost of the capital the broker has in effect lent the investor in order to open a leveraged trade and can be thought of as interest.
Advantages of CFDs
- CFDs provide the investor with all of the benefits and risks of owning the underlying asset without actually owning it or having to take any physical delivery of the asset.
- CFDs are traded on margin meaning the broker allows investors to borrow money to increase leverage or the size of the position which means their potential profit is increased (but also their potential losses).
- CFD accounts can be opened for as little as R100, allowing an investor to start trading without the capital commitment that may be needed when buying the underlying.
- CFDs can be traded on different asset classes such as indices, commodities, forex and bonds, depending on the offering of the broker.
- There is no stamp duty on CFDs as the investor is not purchasing the underlying assets. Normal share purchases attract a stamp duty of 0,25%.
- CFDs can also be used as a hedging tool.
- The investor does benefit from the dividend received by the underlying asset.
Why it might not be beneficial to trade CFDs
- Leveraging through margin also means the investor can lose money at a higher rate, if not all and even more of their capital invested.
- Finance costs can result in trades that are not cost effective if the position is held for too long.
- CFD owners do not have voting rights.
- Availability – CFD trading is not legal in the United States.
As with any investment it is important to ensure you fully understand the product and risks before investing money and CFDs are no different. Only invest in these products if you know you can afford the risk of losing all, if not more than the capital invested.
