Welcome to the world of Contracts For Difference or CFDs.
A CFD is an agreement to exchange the difference between the opening and closing price of an asset. For example, if you buy (go long) a CFD on 100 shares of a stock that subsequently rises in price by $1, you have made $100 (excluding commissions); if you sell (go short) a CFD on 10 shares of a stock that subsequently falls in price by $1, you have lost $10.
CFDs are financial instruments that allow you to trade differences in the price of an underlying asset (stocks, indices, currencies and commodities). You do not have to own a stock to trade its derivative CFDs; for example, you can short CFDs without owning the underlying stock. CFDs are a kind of ‘betting order’ placed between a trader and an investment bank. Unlike for stocks, no exchanges are involved – CFDs are private, not exchange-traded instruments – and there is no stock-clearing fee.
There are several advantages to trading CFDs over trading stocks:
- CFDs allow us to set up both long and short positions (unlike for stocks on the Singapore Stock Exchange (SGX); we cannot short stocks in Singapore and hold the position overnight). For example, if we are bearish on Keppel Corp, we can short (sell) a Keppel Corp CFD. We can of course do this without owning a single share of Keppel Corp. This allows us to profit from both bull and bear markets.
- CFDs permit the more-efficient use of our capital (money) because of the leverage afforded by the use of margins. Margin or Leverage is the credit (borrowed money) provided by a broker or bank. A typical margin requirement for CFD trading in Singapore is 10% – this means that we need to provide only one-tenth of the amount required for the CFD trade; the CFD broker provides the other 90%. A margin requirement of 10% also implies that trading CFDs requires only one-tenth of the amount required for the equivalent stock trade. The use of margins magnifies our Return on Investment or ROI (both profits and losses!); for example, a margin of 10% provides a decupling (gain of 10%) of our ROI compared to trading without any margin.
In addition, while stock trading requires lot sizes of 1,000 shares, CFD trading can be done on less shares; we can open a CFD trade on just one (1) share (though, of course, commissions charges make trading very small CFD sizes unviable).
- Trading CFDs incurs lower commissions compared to trading stocks: 0.15-0.2% versus 0.18-0.28%, respectively, depending on brokerage house and the value of the contract. There are also no clearing fees for CFDs, since no stocks need to be cleared by an exchange.
- Finally, many CFD providers allow us, when opening our positions, to set up automatic profit targets and stop losses outside market hours. These order actions allow us (as CFD traders) to automatically exit our trade (close our positions) once a predefined profit target has been reached or a predefined loss has been made, thus helping us to instil discipline and remove emotions from our trading.
The fact that profit targets and stop losses can be placed outside market orders is important; this feature allows us to perform our analysis, place our trades and adjust our orders at our convenience and not just during market hours, allowing for more measured and less stressful trading.
There are also disadvantages to trading CFDs:
- As usual, margins can be a double-edged sword: they can magnify losses as well as profits. In addition, the use of margins means that the margin required for a CFD trade changes as the price of the underlying stock changes, so the CFD trader needs to maintain sufficient cash in her account to cover additional margin calls.
- CFDs are not traded on stock exchanges; they are therefore considered private instruments, and the difference between their Bid price (the price you can sell at) and Ask price (the price you can buy at), known as the Spread, can be a little wider than the spread for the underlying stock.
- A CFD trader that holds her long position overnight will be subject to interest charges. Interest rates range from 2-3% plus SIBOR (Singapore Interbank Offered Rate, the interest rate at which banks lend to one another), depending on CFD provider. For example, assume an interest rate of 3.75% for holding a long CFD position overnight. A CFD trader holding a long position of value $10,000 open for 30 days will be charged an interest of about $30.82 (10,000 x 0.0375 x 30/365 days).
The ability to profit from both bull and bear markets, the use of leverage (availability of margins) and their flexibility and simplicity compared to other derivatives, have resulted in CFDs becoming one of the hottest financial instruments on the Singapore, Sydney and London markets, for both retail and professional traders. By some rough estimates, CFDs account for about 30% of all equity trading volumes in Singapore, Australia and the United Kingdom.
However, as with other financial products and instruments, trading CFDs involves an element of risk. Trade only with money you can afford to lose, and spend sufficient time understanding both CFDs and the underlying assets you wish to trade.