Derivatives: introduction to Contracts for Difference: how does a Contract for Difference operate?
A Contract For Difference (CFD) is operated as a ‘margin’ trade. An investor is normally required to pay a minimum deposit or margin of 10 per cent of the overall contract value. A larger margin can translate into higher profits if the investment judgement is correct. Equally however, if the investor’s judgement is misconceived then higher losses will result. This process is commonly called ‘gearing’.
- An investor believes that a particular share price will rise. The investor takes out a CFD on 10,000 ABC Ltd shares valued at 200p per share (200p equates to the current market price). The total value of the contract will be £20,000, but the investor is only required to make an initial 10 per cent cash deposit (margin) of £2,000.
A few days later the shares have risen to 205p per share and the investor decides to close the contract. The investor will receive the initial cash deposit of £2,000 plus a gross profit of £500 (5p x 10,000 shares).
NOTE: If the investor had directly used the £2,000 deposit to buy the underlying shares at 200p each, his profit on selling 1,000 shares would only have been £50 on any subsequent sale at 205p per share.
- Alternatively, the investor may decide to continue with the CFD rather than close it in anticipation that share prices continue to rise. But the Market share price falls to 179p per share and to minimise the risk of increased losses, the investor decides to close the CFD. The investor has losses of £2,100 (21p x 10,000 shares) which means that the initial deposit is lost and a further £100 (i.e. £2,100 less the deposit of £2,000), has to be paid to the CFD provider.
- Conversely, an investor may believe that a share price will fall. A CFD is taken out to sell 10,000 ABC Ltd shares at 200p each. The total contract value will be £20,000, but again, the investor need only pay an initial 10 per cent deposit of £2,000.
- A few days later the shares have fallen to 195p per share and the investor decides to close the contract. The initial deposit of £2,000 is returned to the investor plus a gross profit of £500 (5p x 10,000).
The minimum amounts in which an investor can deal will vary from broker to broker. Some will set minimum trade sizes for all CFDs, while others may allow trading in just one share. An investor however, will be required to maintain a minimum deposit within their CFD trading account. Typically this will be around £5,000, although some providers require a minimum balance of as low as £250.
The opportunities offered by CFDs can bring high rewards in terms of profit for the investor. The danger, of course, is that in getting it wrong, high losses can quickly mount up for the investor and although contracts can be kept open indefinitely to rectify the situation, the investor’s cash position will change, reflecting the losses. Because investors are required to maintain a minimum deposit, should these losses eat into the initial deposit that the investor made to the broker, the investor may be asked to top up the deposit.
There are also the broker’s commission and daily interest charges to be taken into account by the investor in setting-up and maintaining a CFD contract and account. A CFD provider will charge daily interest where a CFD is kept open overnight. The reason for an interest charge is that a provider will normally minimise his exposure or risk in issuing a CFD by hedging the position and buying the underlying shares. This ties up the provider’s capital and he will want to be compensated for this.
A CFD holder’s rights
As no shares are acquired by the holder on issue of, or at closure of, the CFD, the CFD holder has no entitlement to the usual rights attaching to share ownership, such as voting or shareholder’s benefits. Although the contract makes the holder accountable for the movement in share price, it is the provider (such as the broker) who is beneficially entitled to any shares that are acquired as a hedge.