A CFD allows you to speculate on future market movements of the underlying asset, without actually owning or taking physical delivery of the underlying asset.
CFDs are leveraged instruments. CFDs tend to be traded over-the-counter with a securities firm, known as a CFD provider. CFDs are available for a range of underlying assets, e.g. shares, commodities and currencies. In this guide, examples showing how they work will refer to shares as the underlying asset class.
A CFD involves two trades:
- Firstly, you enter into an opening trade with a CFD provider at one price. This creates an open position which you later close out with a reverse trade with the CFD provider at another price.
- If the first trade is a buy or long position, the second trade which closes the open position is a sell. Conversely, if the opening trade was a sell or short position, the closing trade would be a buy.
The CFD captures the price difference of the underlying asset between the opening trade and the closing-out trade.
- Where you hold a long position in the CFD:
| If closing out price > opening price | CFD provider pays you the difference between the opening and closing out prices of the CFD |
| If closing out price < opening price | You pay the CFD provider the difference between the opening and closing out prices of the CFD |
- Where you hold a short position in the CFD:
| If closing out price < opening price | CFD provider pays you the difference between the opening and closing out prices of the CFD |
| If closing out price > opening price | You pay the CFD provider the difference between the opening and closing out prices of the CFD |
- The proceeds you pay or receive will be subject to commissions, financing charges, other charges or other adjustments made by the CFD provider.
CFDs are leveraged trading instruments; they are traded on margin. Instead of paying the full value for the underlying shares, you pay an initial margin to open the position and are required to maintain some minimum margin level for open positions at all times. You may be required to satisfy the margin calls at very short notice, especially in volatile markets. If you fail to top up your margin when required, you risk having your position liquidated at a loss.
What is the return?
The CFD captures the price difference of the underlying asset between the opening trade and the closing-out trade.
Why trade CFDs?
A CFD allows you to speculate on the future market movements of an underlying asset, without actually owning or taking physical delivery of the underlying asset.
What is the maximum amount you can lose? What is the worst that can happen?
Trading in leveraged products like CFDs potentially exposes you to a higher risk of loss than if the products were not leveraged. With leveraged products, you may lose more than what you originally invested depending on the positions you take.
As an investor, you pay an initial margin to open the position and are required to maintain some minimum margin level for open positions at all times. You may be required to satisfy the margin calls at very short notice, especially in volatile markets. If you fail to top up your margin when required, you risk having your position liquidated at a loss.
Are CFDs suitable for everyone?
Not everyone should trade CFDs. Do not consider CFDs if you:
- Want potentially higher returns BUT are not prepared for volatile returns which include the risk of suffering unlimited losses beyond your original investment amount;
- Do not understand or are unclear about the factors and scenarios that can affect CFD prices;
- Do not understand the risks associated with CFDs.
- Do not have the time and resources to monitor the markets, and respond to margin calls to cover your losses at short notice or risk having your position closed at a loss.
- Do not have the appetite and financial capacity to withstand the losses that may arise if your view on the future price direction of the CFD’s underlying share proves wrong.
What should you watch out for? What are the key risks involved?
Market risk
You are likely to enter into a CFD when you have an opinion of the future direction of the price of an underlying asset and want to take a position reflecting this view. The risk you take is that your view turns out to be wrong. Given that CFDs are bought or sold on margin, the leverage will have the effect of magnifying the loss. In some cases, the loss is potentially unlimited and can be much more than the cost of the initial margin.
Some CFD providers may offer stop loss or limit order measures which allow you to limit losses by setting price triggers to close the open position. Do check with your CFD provider if this is available to you.
Counterparty risk
This is the risk that the CFD provider fails to meet a payment obligation due to you, for example, if your CFD provider becomes insolvent. As a CFD buyer, you have no recourse to the underlying shares as you have not actually bought the underlying shares.
Pricing of CFDs
There are currently two CFD models in the market:
i. Market Making model: The CFD provider makes bid-offer prices for the CFDs provided. Prices quoted by the CFD provider may or may not match the exchange traded price of the underlying share.
ii. Direct Market Access: When you give an order to buy or sell a CFD to the CFD provider, the CFD provider sends a corresponding order on the underlying share to the exchange for execution. The DMA model should mean that CFD prices more closely match the exchange traded price of the underlying share. You may wish to clarify this directly with your CFD provider.
i. Market Making model: The CFD provider makes bid-offer prices for the CFDs provided. Prices quoted by the CFD provider may or may not match the exchange traded price of the underlying share.
ii. Direct Market Access: When you give an order to buy or sell a CFD to the CFD provider, the CFD provider sends a corresponding order on the underlying share to the exchange for execution. The DMA model should mean that CFD prices more closely match the exchange traded price of the underlying share. You may wish to clarify this directly with your CFD provider.
Currency risk
You face currency risk if the CFD is quoted in a currency which differs from the currency of the underlying share. Even if the currency of the CFD and the underlying share is the same, you are still exposed to currency risk if the currency is different from your own base currency.
How does the product work?
Trade on margin
CFDs are traded on margin. This means you pay a small proportion of the value of the underlying shares (typically between 10% and 30% set by the CFD provider) to open the position, instead of paying the full value for the underlying shares.
Example 1: Initial Margin
Suppose the shares of XYZ Ltd, are quoted at an offer price of $2.00 and Mr A intends to buy 2,000 shares of XYZ Ltd as a CFD at the offer price of $2.00. Assuming the CFD provider sets the margin of the CFD at 10%, the initial margin Mr A puts up will be 10% x $2.00 x 2000 = $400.
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Mr A will be able to open the position with $400 versus a payment of $4,000 for the underlying shares.
How leverage magnifies profits and losses
The leveraging effect means that if the markets move in favour of or against Mr A’s position, Mr A’s respective profits or losses will be magnified. Here are some examples of how leverage impacts Mr A’s profits and losses.
Example 2: Example of a Profit
Suppose on the next day, the shares of XYZ Ltd have risen and are quoted at a bid price of $2.05. Mr A then decides to sell his CFD at $2.05. He will gain a profit of $100 [($2.05- $2.00) x 2000].
The return on investment (ROI) from the CFD works out to 25% (100 ÷ 400). This compares to an ROI of about 2.5% (100 ÷ 4,000) if he had invested directly in the underlying shares.
Mr A will receive from the CFD provider $100 less any financing and transaction costs and commissions due from him.
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Example 3: Example of a Loss
Conversely, if the market moves against Mr A’s position and the shares of XYZ Ltd are quoted at $1.95, Mr A may choose to sell his shares at $1.95 to avoid incurring further loss. Mr A will incur a loss of $100 [($ 1.95 - $2.00) x 2000] from trading the CFD.
In this example, the ROI for investing in the CFD would be -25% (-100 ÷ 400), as compared to an ROI of -2.5% (-100 ÷ 4,000) if he had invested directly in the underlying shares.
However, Mr A will end up paying more than $100 to the CFD provider, once margins, financing and transaction costs and commissions are factored in.
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Continuous margin adjustments
At any time that the markets move against your open position, the CFD provider will require you to top up your margin to cover your losses.
In the above Example 3, if Mr A intends to keep the position open, the $100 loss will be deducted from the initial margin and he will be required to top up his margin with additional funds (known as a margin call) to the initial amount of $400, or to a level prescribed by the CFD provider.
The prescribed margin should be made known to you before entering into the CFD. You will usually be required to make the top up within a short period of time (e.g. within 2 days or less as required by the CFD provider). Otherwise, the position may be closed at a loss to you. This process of valuing the profit and loss of open positions is called "marking to market". This, coupled with managing margin requirements, is a continuous process.
If you want to trade CFDs, you must be financially prepared to top up margins at short notice, especially when markets are volatile.
What are the costs involved?
Costs relating to CFD trades may include bid-offer spreads, commissions, daily financing costs, account management fees and Goods and Services Tax (GST).
The commission charge is usually a percentage of the total value of the underlying shares and paid on a per transaction basis. The cost of the trading services may also be quoted in the form of a bid-offer spread on the CFD. Do clarify this with the CFD provider before trading in CFDs.
Example 4
Suppose XYZ Ltd is quoted at $2.00 and Mr A intends to buy 2,000 shares of XYZ Ltd as a CFD at $2.00. The commission, assuming that the rate is 0.5%, to be debited is $2.00 x 2000 x 0.5% = $20.00.
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Financing charges may be calculated on the total value of the underlying shares of the CFD. Some providers may however charge based on mark to market value instead of the opening or initial contract value.
Example 5
If Mr A holds 2000 shares as a CFD overnight, he will incur daily financing interest which may be set at say 5% of the initiated contract value. If the opening CFD price of the shares is $2.00, the daily interest charge will be ($4,000 x 5% / 360 days) = $0.56.
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The commission charged by the CFD provider is subjected to Goods and Services Tax (GST).
Example 6
If the commission charged is $20.00, GST (at 7% of $20.00) of $1.40 will be levied.
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Is short selling allowed?
Various restrictions apply to short selling in the stock markets. CFDs, however, allow you to take short positions, without having to first own the underlying shares. But taking short positions can be very risky and can potentially lead to unlimited losses.
Example 7 Suppose Mr A expects the shares of XYZ Ltd, quoted at $2.00, to fall. He can sell 2000 shares at $2.00, as a CFD. The initial outlay to open the position will be $400 (10% x $2.00 x 2000).
After 7 days, the shares of XYZ Ltd are quoted at $1.95. Mr A decides to close the position by buying 2000 shares at $1.95 as a CFD. The profit made will be $100 [2000 x ($2.00 - $1.95)] or 25% ROI, although the actual amount received will be less once transaction and other costs are deducted.
However, if his view had turned out to be wrong and the price had moved in the opposite direction by $0.05, the investor would have incurred a loss of $100 or -25% ROI. In this case, the amount he has to pay the CFD provider will be $100 plus transaction and other costs.
If his view had turned out to be very wrong and the price had moved up by $0.20, the investor’s loss would be $400 [2000 x ($2.00 - $2.20)] or -100% ROI. In this situation, he would have lost his entire initial investment of $400. Any further gain in price beyond $2.20 would result in further losses to the investor. In other words, he faces unlimited losses in this scenario.
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Do CFDs expire? What happens then?
CFDs may or may not have expiry dates. It is decided by the CFD provider. Do clarify this with your CFD provider. For those with expiry dates, you will have to close out your position at expiry. If you wish to maintain your exposure to the underlying shares beyond the expiry of the CFD, you will have to initiate a new position by entering into a new CFD. The position is said to be "rolled over" and the profits or losses are realised when the original position is closed. The new CFD position may be subject to commissions and financing charges. Meanwhile, your account may require adjustments to margin, as well as to reflect current profit and loss status.
Do be vigilant about monitoring open positions where there is no expiry date.
What are my rights in corporate actions as a CFD buyer?
As a CFD buyer, you will not have bought the underlying shares. Do check with your CFD provider as well as check what rights you have as a CFD buyer. Buyers of CFDs may be entitled to adjustments to their CFDs, if dividends on the underlying shares are paid by the respective companies.
Key questions to ask before trading CFDs:
- Do I fully understand how CFDs function, their features and risks? Do I fully understand the risks of investing in a leveraged product like CFD? Am I comfortable with the risks? How does leverage affect my losses?
- Do I have the appetite and financial capacity to withstand the losses that may arise if my view on the future direction of the CFD’s underlying share proves wrong? Such losses can be significantly higher than the initial margin invested. In cases of short selling, it may lead to unlimited losses. Can I afford to lose some or all of my financial capital when trading CFDs without endangering my overall financial plan and goals?
- Do I have the time to monitor the performance of the underlying shares and rates offered by the brokerage closely? Will I be able to react quickly enough to limit any losses I may suffer? When will a margin call be issued, and what can the company do if I fail to meet margin call? Under what circumstances can the company close my position?
- Can I place stop loss and limit orders, which will help to limit my losses? Will I be charged to place or change these orders? What additional services will be provided by the CFD provider? Do I have to pay extra for these services? If I place a stop-loss order, am I assured of the price that I set the stop-loss at?
- As a buyer in a CFD, what rights do I have? Are these rights different from those of a shareholder of the underlying shares? Can I sell the CFD when the underlying share is suspended? What happens when trading in the underlying asset is suspended or halted? How can I exit my position and will I suffer losses?
- Does the CFD have an expiry date? If so, when? What if I wish to continue with the CFD after the expiry date?
- What are the costs I have to pay? What margin, commission, transaction and financing charges are there?
- Where are the margins and deposits that I have placed with the CFD provider kept and maintained? Will I be able to get back my margins and deposits if the CFD provider becomes insolvent? How long will the recovery of my moneys take?
- How is the derivative contract quoted? Can the trade be executed at a price that is different from my order price?
- Is the CFD provider I am going to engage authorised or licensed to deal in CFDs? Do check the Financial Institutions Directory on the MAS website whether the firm has the requisite authorisation or licence.
The above information is prepared in collaboration with the Securities Association of Singapore.
Source: http://www.moneysense.gov.sg/Understanding-Financial-Products/Investments/Types-of-Investments/Contract-for-Differences.aspx
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