CFDs can be your portfolio’s best friend or worst enemy depending on whether or not you know what you’re doing. Do not trade CFDs if you don’t know what they are or how much risk they carry – you’ll lose a lot of money (potentially more than you started with!)
In order to effectively utilise CFDs in your portfolio, it is vitally essential that you know exactly what a CFD is and how it works.
What is a CFD?
A CFD is simply an agreement to exchange whatever difference may exist between the value of a certain asset when a contract is opened and its value at the close of the contract. Investors open a position by either purchasing or selling a CFD: the former is often referred to as “going long,” the latter, “going short.”
When opening a position, investors do not have to provide the full value of the underlying shares: instead, they must only make an initial deposit on their position. The total amount of the deposit varies from share to share; most begin at 3% of the value of the underlying deposit but can reach upwards in cost. Whether an investor is going long or going short, they must pay their initial deposit.
After opening a position, movements in the value of the underlying securities change the value of the CFD contract. Every day, the value of a CFD is “marked to market”—that is, recalculated—and the investor’s account is credited or debited with changes in value. (Movements in favor of the investor, of course, result in credit; movements against, in debit.) Over time, the trader’s CFD balance represents their accumulation of loss and profit. CFDs have no expiry date, so account balances can reflect as great a time as the investor wishes.
(It is important to remember that CFDs give investors no right to acquire or deliver the assets underlying them.)
Availability of CFDs
Investors looking to go short or long with CFDs can do so over a range of underlying assets, such as:
- shares listed on the Australian Securities Exchange (ASX)
- share market indices
- internationally-traded shares
- commodities
- treasury instruments, and
- currencies.
After paying their initial deposit, investors can receive cash flow from their position through mark-to-market payments, interest payments, dividend adjustments, and shifts to their initial margin amount.
Favorable developments: mark-to-market payments
From day to day, changes in value of the underlying securities of a CFD occur. These, in turn, necessitate revaluation of a trader’s position. If—as any trader would hope—the position has moved favorably, then the account will be credited with the change in value. If, however, an investor has made an incorrect bet on where the market will head and the price of the underlying share moves unfavorably, the account will be debited. Just like futures and written option positions, CFDs are revalued day-by-day and margined accordingly. With CFDs, then, investors have the opportunity to earn credit on any favorable movements—and that is what can be called “mark-to-market payments.”
Interest payments and dividend adjustments
Before a position is closed, the trader’s account will either be charged or paid interest. If a trader chooses to hold a long position, interest will be charged to their account—but since only an initial deposit has been paid, the provider of the CFD is more or less lending the trader the value of their underlying shares. Typically, interest is charged at a benchmark rate: often the overnight cash rate plus a margin of around 2%. The exact interest rate depends, however, on the provider of the CFD.
On the other hand, if a trader has an open short position, then their account will be credited interest—similar to how a trader would receive interest for a short sale of the underlying shares. Like with a long position, interest paid to the trader is at the benchmark rate—but less a margin.
It may be useful to note that interest charged on long positions does not necessarily match up with interest paid on short positions. CFD providers tend to charge more interest than they pay—but this does not hold true for all providers.
CFD positions are adjusted when a stock goes ex-dividend. The position, then, must be open at the end of business on the day before the underlying security’s ex-dividend date. Traders going long will receive a credit equal to the amount of the cash dividend on the relevant security. Traders going short will have to pay in order to make up the amount of the cash adjustment.
It’s important to note that a trader holding a long CFD position will not receive any franking credits attached to dividends because franking credits are payable only to the beneficial owner of the stock. Investors holding short positions, though, will be debited both the dividend amount and any franking credits.
Shifts in initial margin amount
Small changes to the amount of the initial margin can occur as stock price shifts up or down. The initial margin percentage remains constant, but as a stock’s value increases or decreases, the margin will move slightly. Such shifts will be debited or credited to an investor’s CFD account.
CFDs vs. other derivatives
There are differences that exist between CFDs and other derivatives (as well as some notable similarities). These will be discussed below.
No right to acquire or deliver underlying securities
Whilst other derivatives might convey a right or obligation to acquire or deliver physical shares, CFDs do not. The trader, then, does not have the right to buy or sell the shares underlying their CFD. This is because a CFD is only a contract to exchange the difference between two values—not something like a share future, which are contracts to purchase or sell underlying shares that are deliverable or financially settled when they mature.
Thus, CFDs are closer to cash-settled contracts—like index options and futures—where no transfer of underlying assets takes place.
No expiration date
Most derivative contracts are limited in time and include an expiry or maturity date. CFDs, however, possess no such date. (That’s why they provide a cash flow of interest payments throughout the time they remain open.)
With options contracts or futures, interest costs are built into the price at which the derivative trades. Futures contracts often call this the “cost of carry.” Because CFDs are open-ended, they lack the certainty of total interest costs—they will vary depending upon the length the contract is held. Interest, then, is either paid or charged to the CFD holder regularly, so long as their contract remains open.
Counterparty risk
CFD contracts are between investors and the providers of the CFD. Since the former party is reliant upon the latter to fulfill its contractual obligation, there is a degree of risk involved that is not present in exchange-traded derivatives, such as options and futures. In an option or a future, the exchange is responsible for standardizing, managing, and settling contracts between counterparties. When a contract is traded, any direct link existing between the seller and buyer is dissolved, and the exchange acts as the counterparty to both parties involved in the contract. With CFDs, however, the trader is somewhat like a warrant holder, who is exposed to the credit risk of the one issuing the warrant.
Stop losses: the guardian angel of the CFD
The risk discussed above has been noted, and to counter it, many CFDs offer a “stop loss” feature that reduces risk of loss. Stop losses place a limit on the liability of the trader in the event that a sharp unfavorable movement in price in the underlying share occurs.
Guaranteed stop losses (GSLs) will close a position out at the specified price if the market falls past or rises above the stop. If share prices go far above or below the stop level, this stop loss can be of great benefit to traders. If for example, a dramatic move in the world market occurs while a national market (such as the ASX) is closed, the share price of the security underlying the CFD could move dramatically from the previous day’s close. GSLs give protection against such an event.
Not all stocks have GSLs available—and GSLs come at a cost. Stops expire after a specified period—most often, sometime between one to three months. After the end of the set time period, traders must pay to renew their stop.
Hedging exactly (or inexactly)
Investors looking to hedge a shareholding may have better (and easier) results achieving an exact hedge with CFDs, rather than options or futures.
This is because CFDs are able to be traded in any amount, but exchange-traded options and futures have set contract sizes that can often make formulating an exact hedge problematic. With inexpensive shares, this rounding off may not impact an investor much. With expensive shares, however, investors must choose whether to be unhedged or over-hedged (at an inflated price).
With CFDs, however, an investor can match exactly the size of their physical position. This relative advantage does not apply to warrants, though.
Transparency, or lack thereof
Not all CFD offerings are the same. Different providers use different models, and the transparency of pricing can vary.
Generally speaking, investors should look for providers who operate under the direct market access (DMA) model. With the DMA, the price of the CFD trade is determined by trades in the underlying security. The CFD, then, is done at the market price of the underlying shares.
The market maker model allows providers to quote another spread that results in a price disadvantage for traders. Providers using this method may advertise a low commission rate in order to keep attention off the extra cost a trader will pay thanks to the wider spread.
The unique risks and considerations with CFDs
As we have discussed, CFDs have their own set of risks and considerations, some of which are major.
Below is a list:
- The CFD’s leverage magnifies the losses possible with adverse price moment. Thanks to the high leverage gained by a low deposit to contract value ratio, investors can lose significantly more than their initial deposit.
- CFD providers lend the exposure to an underlying security when a trader takes a long position, and this bears a lending cost. Traders going short, however, receive interest income—but at an amount that is less than the amount long positions pay.
- Adverse market price movements can necessitate a variation margin call to maintain the prescribed margin percentage. Traders, then, must remain vigilant and ensure that their open positions are viable.
- Because CFD holders do not have actual (but rather synthetic) exposure to the underlying shares, CFD holders with long positions do not have voting rights for CFD’s underlying security.
- Though CFD holders with long positions do receive dividend payment values when the share goes ex-dividend, franking credits are not attached—because the underlying securities are not actually owned by the holder of the long position.
CFD trading strategies that can give your portfolio a boost
The addition of CFDs to a portfolio can have a markedly positive effect if executed well. The following is a list of strategies that can be applied using CFDs:
Hedging
CFDs make an excellent hedging tool because investors can take either long or short positions. Imagine that a savvy investor holds a large long position in the stock BHP. The investor wants to hold their position because the long term prospects for the stock seem positive.
The investor is worried, though, that the short-term price will be volatile—perhaps even falling significantly before recovering. In such a case, short selling a CFD in their stock provides a decent strategy for insuring against loss. If the price of BHP falls, the gain on the CFD will offset the loss of value in the portfolio. If the price rises instead of falling, the CFD can be closed out early—leaving the investor to enjoy the rise in the price of the shares they actually hold.
The investor, then, has used CFDs to hedge their position—without disturbing the asset allocation of their portfolio.
Let’s say that a different investor wants to diversify without actually holding a particular stock in their long-term portfolio. Through purchasing a CFD, that investor can put a small amount of money upfront into a new stock or sector and gain leveraged exposure. Through using a GSL, they can protect their position while taking a short-term exposure into their chosen security or sector. The investor is protected from under-performing the market and from excessive volatility in their portfolio—and is able to focus on their strategy for long-term asset allocation.
Speculating
It goes without saying that CFDs allow for speculation—which is not for everyone. If an experienced trader has free cash they wish to devote to something which will earn them better-than-average returns over a short period of time, CFDs can be an excellent option. Diversification and stop losses can help manage risks—but there is always the potential that better results could have been achieved.
Falling markets
CFDs can be appealing during times of falling markets when returns from long-term investments seem far-off. In such situations, a different strategy for investing needs to be employed, and using CFDs perfectly fits the bill for providing income in an economic slump.
Worldwide exposure
Even when trading locally, CFDs over foreign stocks or market indices give investors a means of diversifying their portfolio without the regulatory hurdles of global share ownership. This allows traders to skip over the complexities that come with international transactions and the many rules of investing and taxation in foreign jurisdictions.
Pairs trading
Similar to speculation is pair trading, where a long position is taken in one security and a short position in another. If one security looks like outperforming another, sophisticated investors can take a long position on one and a short on the other to exploit both conditions.
Summary
CFDs offer an exposure very like that of a futures contract if the unique stop loss feature of CFDs is ignored. A CFD buyer takes a position very similar to a long futures position, where a minuscule initial deposit gives leveraged exposure should the underlying asset rise in price. CFD sellers, on the other hand, can be compared to a short futures position, where a leveraged exposure to a fall in price for underlying shares is provided.
The variety of CFD offerings can make utilizing them less straightforward than plane vanilla equity ownership. An interested trader, then, must be sure to examine all relevant disclosure documents before investing. By being informed and aware, investors can use CFDs to provide a wonderful complement to a standard portfolio.