The Essentials of CFDs

by on October 26, 2016

A Contract For Difference (CFD) is an Over The Counter (OTC) contract between two parties, where one party pays the other party an amount determined by the difference between the opening and closing price on the contract. The price at which a particular CFD contract is traded, and the price at which it is valued, depends on the underlying asset. The underlying asset could be a bond, currency, commodity, index, or equity.

Let’s look at an equity CFD trade on a platform such as CMC Markets in Europe. Company A is trading at 10 euros per share, the investment manager could buy 10,000 shares, which would cost him 10,000 euros, or he could open a CFD position. One of the advantages of trading CFDs, like many derivatives, is that they are traded on margin. In other words, you don’t have to pay the full cost of the underlying asset. You only have to pay what is called the initial margin to open the position. Thereafter, variation margin movements between the counterparties reflect changes in the value of open positions. Margin is basically collateral.

The investment manager thinks that Company A will appreciate in value over the coming days so he creates a long CFD position, by executing a buy to open, and he buys 10,000 CFDs. Let’s say the CFD broker requires a 10% initial margin payment, so the fund must pay the broker 10,000 euros. So the fund bought 10,000 CFDs at a price of 10 euros each. Ten days later the investment manager decides to close the position. Company A has increased significantly in the meantime. This share is trading at 12 euros, and the fund closes the CFD position at 12 euros. So the fund realises a gain of 20,000 euros. But there is an expense we need to consider. The fund is making a 100,000 euro notional investment, but is only paying margin of 10,000 euros, it is as if the CFD broker is financing the CFD investment. As you’d expect, the CFD broker charges the fund for financing, so there is an interest expense associated with a long position, such as 3%. The rate of interest is usually tied to the market rate. For our example we will assume an interest rate of 3%. This is calculated daily, based on the value of the open position. Also, for simplicity’s sake, we just have one calculation whereas in reality it is a daily calculation. Some brokers charge commission or stocking-lending fees, so watch out for additional fees on the statement.

That fund was bullish on Company A so created a long CFD position. The same investment manager puts a negative view on Company B, which is trading at 20 euros per share. Thinking that the price will fall, the fund executes a sell to open, and thus creates a short position. The fund sells 5000 CFDs. The fund sold 5000 Company B CFDs at a price of 20 euros. Five days later the investment manager decides to close the position. Company B is falling in value and the share is trading at 18 euros. The fund closes the CFD position at this price. So the fund realises a gain of 10,000 euros.

Remember the long position from earlier and the fact that it incurred interest expense? Well, a short position earns interest income. The rate here is 2%.

Let’s go back to the long position of Company A. The fund enjoys the benefits of owning Company A shares without actually owning the shares by simply taking a CFD position. Long equity CFD positions earn dividend income on ex date. So the CFD holder earns the dividend income. Similarly, a short position in Company B, if B goes to ex while the fund held that short CFD position, then the fund would incur a dividend expense.

In the previous examples, the fund kept the positions open for just 10 days and five days respectively. What would happen if the fund kept the positions open for much longer? Unlike futures contracts, CFDs do not have an expiry date. Unlike swaps, CFDs do not have a maturity date. CFD trading usually has a facility to allow the counterparties to reflect the gains made to date, or pay cash when losses are incurred.

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