Contracts for Difference (CFDs)
The definition of a Contract for Difference is an agreement (made between two parties) to exchange, at the closing of the contract, the difference between the opening and closing prices, multiplied by the number of shares detailed in the contract.
In practice this is much easier to understand because OMF operate direct market CFDs. This means that every trade is entered into the market. OMF does not act as a market maker, meaning that OMF does not take the opposite side of each position.
The buyer of a CFD pays interest on the borrowed funds, while short selling shares through a CFD contract benefits traders who receive interest on the short sold value.
Key Features
CFDs are geared or leveraged instruments. This means that a deposit from as little as 10% of the value of the CFD is required. Consequently, it is possible to hold a position 10 times greater than would be possible with a traditional investment. Clearly, this degree of gearing means that for a correctly anticipated price movement a greater profit will be generated. On the other hand, the risk of loss increases commensurately if the anticipated price movement proves to be ill founded. In the case of substantial and adverse market movements the potential exists to lose all of the money originally deposited and to remain liable to pay additional funds immediately to maintain the margin requirement.
The counterparty to the holder of a long CFD position will have had to borrow the stock in the market and in order to fully mirror the economics of the physical purchase interest will be charged. The margin deposit is held to secure the performance of the contract and is not available to be set-off against the Contract Value. Therefore, a long CFD holder will pay interest on the day-to-day Contract Value. Conversely, the holder of a short CFD position will receive interest also based on the day-to-day Contract Value. Interest is typically calculated at a margin above or below the relevant Inter-Bank Offered Rate for long and short positions respectively.
Other than shareholder privileges, a CFD reflects all corporate actions affecting the underlying stock or share. The net dividend declared by a company will be paid to the holder of a long CFD on the Stock Exchange ex-dividend date. This will be advantageous in cash flow terms as the dividend pay date will normally be several weeks after the ex-dividend date. Holders of short CFDs pay 100% of the gross dividend declared and this must also be paid on the ex-dividend date. These payments reflecting the dividend are made on the ex-dividend date as, all things being equal, the share would be expected to fall by the amount of the declared dividend per share. Similarly, bonus and rights issues and splits are replicated in the CFD on the corresponding 'ex-date'
Why trade CFDs?
CFDs offer a number of investment opportunities and strategies, some of which are unattainable in traditional share investing. They can be summarised as: -
- Immediate short selling
- Receiving interest for being short
- Providing access to the United States, Australian and New Zealand markets
- Providing a 100% hedge when index’s are not accurate
- Providing economic exposure to a company’s share performance without taking or making physical delivery
- Low execution cost
- No Stamp Duty is payable
- Delivering a geared return on the capital employed
- Freeing-up capital not required for margin for other uses
- Allowing you to close-out a position at any time
- Potentially positive daily cash flows
Points to remember when trading CFDs
- The margin or deposit is always 10%. In volatile conditions this can increase further.
- There is no interest payable on excess funds held in your CFD account.
- When long an Equity CFD you pay the interest rate of that country plus a margin – please contact OMF to discuss
- When short an Equity CFD you receive the interest rate of that country less a margin – please contact OMF to discuss.
- You receive the dividend when long a CFD on the ex dividend date.
- You have to pay the dividend when you are short an Equity CFD on the ex dividend date.
- From time to time CFDs are added or withdrawn from availability depending on the capitalisation and liquidity of the underlying share
- CFDs reflect all the corporate actions of the underlying share
- It is highly recommended that you place a stop loss at the time of entering a CFD trade.
- The gearing can work against you as well as for you.
- You should work out what maximum loss you are prepared for and place a stop at that level.
- All orders are “Good Till Cancelled” If they are not filled you need to cancel them
- The operation of your CFD account is highly electronic. This means that if your account gets close to requiring margin, you need to fund it straight away. The computer unless fed with a deposit will automatically close out some or all of your positions without reference to you if it comes close to deficit. As a general guide the risk management systems start getting activated once 40% of you deposit is left. It then starts closing out your position in increments until there is sufficient margin in the account to hold the remaining position.
- Unlike traditional shares your CFD account cannot work an order which asks for a certain price “or better”. There is NO discretion on the part of the operator executing your trades. Remember CFDs were designed for institutions who choose the price that they wish to deal at and expect that and no better. It is the same as the FX market.
- You may place a Limit Order which is either a Buy Order below the current market price or a Sell Order above the current market price.
- You may place a Buy Stop ABOVE the current market price and a Sell Stop BELOW the current market price.
- You may ask for one order to cancel the other and you can ask for an order to only become active if a first order if filled. This is called an “If Done” order
- Always ask the dealer to help with your order if you aren’t sure of the wording, you just need to explain what it is that you want to do.
Understand your market
Before trading, it is important to understand the market on which you are taking a position. Knowing the potential for each market to experience volatility and establishing the likelihood of share price move3ments is essential when considering the risk associated with each trade. For example, historically, some markets are less likely to make sudden discontinuous jumps, while others, such as shares (which can be subject to profit warnings and other news), may be more likely to make abrupt movements.
If the CFD Price is moving like the stock price, why would you trade a CFD on IBM instead of just trading the IBM stock itself?
Well, there are a number of reasons. Because it is a derivative, we will quote you a price that you can trade on immediately, so you do not have to wait for an execution over the stock exchange. This also means that you do not have to pay for the stock, nor worry about having it delivered to your custodian account. And that is where it gets interesting. You can buy (or sell, we will return to that later) stock for much more than the deposit you have invested with us. We only require a minimum security deposit, normally of around 10% of the combined face value of your stocks. In effect you can buy USD100,000 worth of IBM, although you only have USD10,000 deposited with us. This gives you much more opportunity to make quick profits, but of course the risks increase in the same way. Because the CFD is a derivative, you can sell it just as easily as you buy it. So, if you think that IBM is about to fall, sell and then buy back the stock later at a lower price. The difference in price will be your profit, just opposite of buying stocks when you expect a rally. If you have sold a CFD on IBM, you will of course lose money if the price of IBM goes up.
The advantages of CFDs are not for everyone.
Leveraging an investment up to 10 times - under normal conditions - is by no means a necessity for all investors. But for aggressive, risk-willing investors, this feature is probably the most important advantage of CFDs. Selling the market short is very easy using CFDs. There are no worries about borrowing stock or paying financing costs for selling, which makes it simple to short the market.
Instantly tradable prices for anything but the largest deals is another attractive feature. Hedging an existing portfolio is a popular use of CFDs. If you do not wish to liquidate your "real" stock portfolio for some reason, you can quickly and efficiently secure it by selling the appropriate CFDs for a short or long period, until you feel more confident about the market again.
The risks of CFDs
The power of leverage can work against you just as quickly as it can make you profits. So if you get the markets wrong, always remember to apply adequate risk management strategies. Both losses and profits may accumulate up to 10 times as fast when using the full leveraging of CFDs.
While we will always seek to provide tradeable quotes for you, just as the real market can get literally untradeable at times, we may not always be able to quote you a price, or the spread between bid and ask prices may widen substantially.
Financing costs on long positions may be substantial, just as they would be if you undertake traditional margin trading. So you should always keep an eye on the costs associated with maintaining a bought position for a longer period of time. Short positions incur no financing charge.
Instant trading for small and medium-sized trades.
If you are executing smaller trades, we aim to give you an instant trading quote. The dealers will confirm the trade for you, but they may not accept the trade if the market has moved. But then you will be able to receive a requote instantly. This means that you will - most of the time - be able to execute trades instantly. For larger trades, you will always have to ask the dealer for a firm price. This is due to the difficulty in executing some larger trades in the market. But once we quote you back, you will have a reliable price quote on which, in most cases, you can execute your trade.
Financing Cost
When trading CFDs you will have the opportunity of leveraging your investment. Although CFDs are a margined product, you will, however, be charged an interest rate which mirrors the financing rate of actually borrowing the funds to invest. This means that if you buy stocks, you will be charged the market interest plus 2% p.a. for the period you hold the position (minimum one day). If you hold a long position for a lengthy period, this financing cost will be substantial and CFDs are therefore mostly suited to short-term investors. If you short a stock, you will receive market interest less 2% p.a. This means that the length of the period you hold your position is of less importance, as you will be credited interest as long as you are short.
Order Types
The markets are constantly moving 24 hours a day, during the trading week. It is good practice to place a 'stop loss' on your open position. This allows you to control any potential losses should the market move against you. There are a number of order types that you can place that facilitate risk management when trading CFDs. By using these additional order types you have the ability to control potential profits as well as potential losses on your open positions.
Limit Orders
A limit order is used to place either a closing trade to take a profit on an open position at a predefined rate set by you, or as an opening trade at a more favourable rate than the then current price for that instrument.
GTC (Good 'Til Cancelled)
Conditional orders (i.e. Limits / Stops / OCO (one cancels the other) can be placed GTC, (Good 'Til Cancelled). A GTC order means that the order you place will remain in the market until it is either executed according to the terms of that order, or is cancelled by you.
Important Note: If you close a position, you must cancel any related orders you have placed against that position. Failure to do so will mean that the order remains in the market at risk of execution.
Stop Orders
A stop order is an order placed to limit the loss on an open position. It can also be used to enter the market at an inferior rate, allowing you to enter the market on a 'breakout' of the current trading range.
One Cancels the Other (O.C.O)
This is the combination of both a 'limit' and a 'stop' order. It is an order that can be used to take a profit if the market moves favourably to the open position or to limit the loss if the market moves against the open position. The execution of one order will automatically cancel the other order.
Two Way Quotes
Two-way quotes are available on request subject to account status and a minimum deal size.
Contingent Order
An order which is to be executed only if another order is executed first.