Contract For Difference was developed in the early 1990s in London. The invention is the CFD, admittedly, belongs financiers Keelanu Brian and John Wood.
Contract For Difference were first used in hedge funds with institutional trading is a cost-effective way to hedge the position of its shares on the London Stock Exchange. CFD Efficiency was high due to the low margins and lack of need for the payment of tax collection, and at the same time, physical action did not pass into other hands.
In the late 1990s, CFD were first introduced for retail traders. contract for difference have become popular due to a number of British companies whose proposals are generally characterized by innovative online trading platforms that make it possible to track the price and trade in real time. The first company in this area has become a GNI. Soon GNI IG and joined CMC Markets, which have started to promote the product in 2000.
This year, retail traders had understood the real benefit in CFD trading, and it is not an exemption from tax collection, and the ability to trade with leverage on any underlying instrument. This was the beginning of the growth phase in the use of contracts for difference. CFD-providers rapidly expanded its range of products; Only on the London Stock Exchange (LSE) shares include the performance of many global stocks, commodities, bonds and currencies. Trading CFD code, as well as those that are based on the world’s major indices, for example, Dow Jones, NASDAQ, S & P 500, FTSE, DAX and CAC, became the most popular type of CFD, which have been sold.
Around 2001 CFD providers have realized that they have the same economic benefits as when trading currency pairs, and the tax regime was changed. CFD providers started to expand and enter overseas markets. In July 2002, the first CFD entered the Australian market, and then began to be traded in the financial capitals of the world.
Trading Contracts for Difference
CFD traded between individual traders and CFD-providers.
CFD trading is triggered by opening a specific tool supplier CFD. This creates a “position” in this document. No expiration date, so the position is closed when the reverse transaction conducted. At that time, the difference between trade opening and closing is paid as profit or loss.
CFD provider can make a number of charges of the trade or open position. These may include, application-offer spread, commission, overnight financing and account management fees.
Despite the fact that the CFD, does not expire at any positions that remain open throughout the night will be “rolled over. This usually means that any profit or loss made and credited or debited to the customer account and any financing calculated charges. Items that bears next day. the industry standard is that the process is carried out at 10 pm UK time.
CFD trading on margin, and the trader must maintain a minimum margin level at any time. A characteristic feature of CFD trading is that profits and losses and margin requirements are calculated continuously in real-time and displayed on the trader’s screen. If the amount of money deposited with the broker CFD falls below the minimum margin level, the margin can be done. Traders may need to cover these fields quickly otherwise the CFD provider can liquidate their position.
To see how CFDs in practice to see examples of typical CFD transactions. “Interest Margin” and “costs” may be different from provider to provider, but a typical CFD providers.
Example 1 – equity based CFD trading
In this example, we show the equality on the basis of trading CFD. Share price Apple Inc is $ 194.38. We believe that the share price will rise, and so we decided to take a long position CFD. Our CFD provider quotes a price of $ 194.36 and $ 194.42 bid proposal.
Step 1: Opening a position
Buy 100 Apple, contracts for difference in price offers 100 x $ 194.42 = $ 19,442.00
The margin requirement is open position x interest margin. Typical margins for equities is 3% -15%, depending on the liquidity of the underlying instrument. In our Apple example, CFDs require margin of 5%. $ 19,442.00 x 0.05 = $ 972.10
You get charged a fee of 0.1% of the transaction $ 19,442.00 x 0.001 = $ 19.44
Step 2: Night of funding
To hold this position financing charge is made every night. This is usually based on the rate of interest is LIBOR + margin percent broker / 365. For simplicity, we assume that the price of Apple’s stock remained the same until the market closes and is therefore not P & L was founded on this day. $ 19,442.00 x (0.0025 ± 0.02) / 365 = $ 1.20
Step 3. Closing the position
The next day, Apple’s stock price rose $ 6.15. Our trade has moved in our favor, and we decided to close the position and take profits.
Our CFD provider quoted $ 200.50 and $ 200.58 bid proposal.
Sale 100 Apple, contracts for difference in the purchase price 100 x 200.50 = $ 20,050.00
The position is now closed, and therefore the margin requirement is now zero $ 0.00
You get charged a fee of 0.1% of the transaction $ 20,050.00 x 0.001 = $ 20.05
Gross profit is the difference between the opening position and the closing position of $ 20,050.00 – $ 19,442.00 = $ 608
Net profit is gross profit less costs. The cost of the commission and financing the night. In this example, we commission twice, once to open the position and once to close it, and we were charged one day financing of the night. $ 19.44 + $ 20.05 + $ 1.20 = $ 40.69
Profit and loss shows the profit after expenses $ 608.00 – $ 40.69 = $ 567.31
As a result, we had to add $ 972.10 to cover the transaction margin and a profit of $ 567.31. If the price of Apple shares, but instead fell to $ 6.15, we would have suffered losses in the amount of $ 647.47 ($ 608 plus commissions).
Example 2 – Index CFD trading is based on the S & P 500 Index
In this example, we show an index based CFD. The S & P500 at 1093.9. We believe that the index will go down, and the decision to take “short” positions. Our CFD broker quotes 1093.7 1094.1 purchase and supply.
Step 1: Opening a position
Sale 10 S & P500 CFDs at the bid price x 10 = $ 1093.7 $ 10,937
The margin requirement is open position x interest margin. A typical value for the major indices by 0.5% 10,937 x 0,005 = $ 54.68
The Commission – as a rule, will not be charged commission on CFD on index
Step 2: Night of funding
To hold the position of finance paid, however, as we hold short positions, we instead get funding. The rate is usually based on the interest rate as LIBOR, this margin broker subtract and divide by 365 to get the daily fund. For simplicity, assume the rate of US interests in 4% and broker margin is 2%. $ 10,937 x (0.04 – 0.02) / 365 = $ 0.60 +
Step 3 Closing the position
The next day, S & P dropped 10 points to 1083.7 1084.1 purchase and supply
Our trade has moved in our favor, and we decided to take profits and close the position
Redemption of the position at a lower price 10 x 1084.1 = $ 10,841
The position is now closed, and therefore the margin requirement is now zero
Gross profit is the difference between the opening position and the closing position of $ 10937 – $ 10841 = $ 96.00
Net profit is gross profit less costs. In this example, the funding is actually positive, and no other expenses. So we get a credit of $ 0.60
The income statement shows a profit after costs $ 96.00 + 0.60 = $ 96.60
As a result, we had to add $ 54.68 to cover the transaction margin and a profit of $ 96.60. If the S & P 500 Index was up, and 10 points, we would have suffered losses in the amount of $ 95.40 (+ $ 96.00 cost). Note that the profit or loss amount was more than the margin requirements. In other words, you would have received or have lost more money than you deposit.
Contracts are subject to a daily financing charge is usually applied in the previously agreed rate linked to LIBOR or other interest rates of the test, for example, the rate of the Reserve Bank of Australia. Parties CFD pay to finance long positions and may receive funding on short positions instead of deferment of revenue. Contracts are settled for cash the difference between the opening price and closing deals.
Traditionally, equity based CFD are the subject of a commission that is a percentage of position size for each transaction. In addition, traders can choose to trade with the market maker, not waiting for the Commission due to a larger proposal / offer spread of the instrument.
Traders in CFDs are required to maintain a certain reserve, as defined in the broker or market maker (usually from 0.5% to 30%). One of the advantages traders do not have to suffer as ensure full par value of the CFD is that a certain amount of capital can control larger positions, increasing the potential profit or loss. On the other hand, leveraged position in a volatile CFD can expose the buyer margins during the recession, which often leads to the loss of a significant part of the assets.
CFDs allow traders to go short or long on any position using margin. There are always two types of margin with CFD Trading –
Initial Margin – (normally from 3% to 30% of shares / shares and 0.5% – 1% for indices, foreign exchange and commodities)
Variation Margin – (which is then “at current market prices).
Initial margin is set in the range of 0.5% to 30% depending on the product and the base is generally accepted in the market risk at the time. For example, during and after 9/11 initial margin walked en masse across the board to counter the explosion in volatility in world stock markets.
Many relate to the initial margin, as a deposit. For example, for large and highly liquid stocks such as Vodafone initial margin is closer than 3%, and depending on the broker and customer relations by field may be even lower. However, with less and less capitalized liquid stocks margin is likely to be at least 10%, if not much higher.
Variation margin is applied to the position if they move with the client. For example, if a trader CFD could buy 1,000 shares in ABC shares using CFD for 100 rubles, and the price went below to 90P broker will hold the £ 100 in the variation margin (1,000 shares x-10P) from the customer’s account. Please note that this is all done in real time, as the market moves lower, so-called “at current market prices. Conversely, if the stock price went up, 10p the broker credits the customer’s account with £ 100 in profit management.
The variation margin may have a positive or negative influence on the CFD trader’s cash balance. But the initial margin will always be deducted from the customer’s account and replace only covered trade.
One of the benefits (and risks) CFD trading that they are traded on margin, that is, with the trader from the shoulder. Using involves taking a small deposit and use it as a lever to borrow and gain access to a larger equivalent quantity of assets. Margin requirements for CFD are low values, that only a small amount of money necessary to take large positions.
Stop-loss can be set to trigger the exit point, as pre-determined by the trader for example, bought at $ 3.00 with a stop loss at $ 2.60. After the stop loss is triggered, a sell signal is activated and the CFD provider to act in accordance with their terms of business and taking into account the available liquidity of the request. DMA providers usually get the stop value of the loss by phone or on-line order and place an order for the market to be operating at a predetermined price in a limited price range, for example, no more than 6, in the future, and provided that compliance with liquidity. If the stop price losses triggered and prices and then quickly moves beyond 6c range in this example, or do not have enough liquidity to order and in relation to other people who have orders for this price point, your stop-loss orders to not sell It may be due and you stay in the position.
Market makers have the opportunity to manage the stop-loss, and when the order stop loss is triggered, they can close a position where they see that compliance with the price and quantity available. This increases your chance of reaching the position that goes against you, though potentially inferior to the price that you expect.
One of the problems with the stop-loss price is that it’s only the target price. It depends, if the market price actually trades at this level. If there are “gaps” in the underlying instrument it moves past the stop price in one step, a stop will be made at the next price that has been sold or not, depending on the CFD provider. As a rule, it is not a problem very actively traded products such as indices and currency, but it may be a question about the price of justice, especially in stocks that have low liquidity. He is also a problem when the stock markets are closed, and the difference between the closing price on the same day and the next day discovered significant (eg, if there has been news about actions that affect the company’s profitability night).
To alleviate this problem, some providers offer a “Guaranteed Stop Loss orders (GSLO), according to which a trader pays a premium for a price that is guaranteed to have to stop the price loss of work. Also, for an additional fee, it is usually more limited. The nearest the purpose of the guaranteed stop loss can be placed, as a rule, 5% from the current price and suppliers, as a rule, the specific terms and conditions on the orders but they can be effective, if the output is at a fixed price is very important.
CFDs, as a rule, are traded over-the-counter market by the manufacturer or the broker, known as CFD provider. CFD provider will determine the terms of the contract, the marginal rate and what are the main tools he is willing to trade. They trade in two different models that can have an impact on the price of the instrument traded:
Market Maker (MM) is the most common way, and where the CFD provider makes the price of the CFD’s underlying and takes orders for all his books. Most CFD providers will hedge these positions based on their own risk models, which can be as simple as buying or selling of the core, but can also be a means of hedging the portfolio or strengthening customer positions and compensate a customer for a long time with another client’s short position . It has no effect on CFD trading, as the matter that the provider does with your own CFD market risk, the contract is always between a trader and a CFD provider. The main impact is that the price may differ from the underlying physical market as a CFD provider may, for example, take into account other provisions of the client he is holding. It really allows CFD provider to be very flexible in the products and shopping time, he suggests, as it allows them to easily create hybrids, and hedging with alternative instruments, such as to trade after hours on the market. In practice, the price of the market-maker usually corresponds to the main instrument as a CFD provider would otherwise be subjected to arbitrageurs, but some vendors CFD add additional written guarantees in the contract that all CFD price will correspond to the underlying instrument.
Direct market access (DMA) was established in response to concerns that the prices in the market-maker model may be different from the underlying instrument. Supplier warrants, CFD DMA, what will he do physical trading on the main market in accordance with each CFD transactions at one to one. Contract still CFD between merchants and vendors, but by this method it ensures that the CFD price is the same as the base value, and that they are not again enclosed in quotes. They will also be able to see their order in the physical portfolio in the market. DMA is only where the underlying instrument can be easily bought and sold in quantities that match CFD and is most often used for CFD shares. DMA CFDs can be more expensive, as the CFD provider fee should cover the exchange transaction and can not get a grid-scale client savings orders together. DMA model is much more like a traditional brokerage model and prefer the professional and institutional traders, because it avoids a conflict of interest with the CFD provider.
Corporate events on the basis of equity CFDs
Corporate events such as the dividend payments can have an impact on the share price and, consequently, the price of capital is based CFD. However, a person who holds the position of CFD has no ownership of the underlying instrument and therefore do not receive dividend payments from the company issuing the shares.
In this case, the CFD provider will pay a dividend equivalent to anyone holding a long CFD position, and subtract the equivalent of someone holding a short position. This will be done on an ex-works, as the date when the economic benefits felt by the main share price. The general rule is that any economic benefit from the corporate action on the main should be reflected in the CFD. This includes dividends, stock splits, issuance of shares, etc. However, CFD owner will never have access to corporate non-economic activities, such as the right to vote.
The main risk is the market risk that the treaty is intended to cover the difference between the opening price and closing price of the underlying asset. CFD trading on margin, and using this effect increases the risk significantly. Margin is usually small and therefore a small amount of money can be used for a large position. It is this risk, which controls the use of the CFD, or to speculate on movements in the financial markets or to hedge existing positions elsewhere. One way to reduce the risk of the ego is to use stop-loss orders. Users typically make money from CFD provider to cover the margin and can lose much more than the deposit, if the market goes against them.
Elimination of risk
If prices move against CFD open positions additional variation margin required to maintain the margin level. CFD provider may request the party to make additional funds to cover it, and in fast-moving markets, it may be in the short term. If funds are not available in time, CFD provider may close / liquidate positions at a loss, for which the other party is responsible.
Another aspect of the CFD counterparty risk is the risk factor in the majority of over-the-counter (OTC) derivatives are traded. Counterparty risk is related to financial stability and solvency of the counterparty to the contract. In connection with the CFD contracts if the contract counterparty fails to meet its financial obligations, CFD, may have little or no value, regardless of the underlying instrument. This means that CFD trader could potentially incur significant losses, even if the underlying instrument is moving in the right direction. Although OTC CFD providers are obliged to allocate funds the client protection of clients in the event of default of the company balance sheet. Exchange-traded contracts are traded through the focal point, it is generally considered to have a lower risk of the counterparty. Ultimately, the degree of risk of the counterparty credit risk of the counterparty is determined, including the clearing house, if applicable.