CFD Bougainville Copper Limited
Warning established by the European Shareholders of Bougainville Copper (ESBC) to all members of the ESBC and to all other people interested in investment in Bougainville Copper Limited: Please KEEP OFF from Bougainville Copper based CFDs ! CFDs are high-risk financial instruments for gambling only. CFDs do not represent any value related to the ownership of the company they are based on. CFDs are simply bets on price differences.
Contract for difference
From Wikipedia, the free encyclopedia
In finance, a contract for difference (or CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time. (If the difference is negative, then the buyer pays instead to the seller.) In effect CFDs are financial derivatives that allow investors to take advantage of prices moving up (long positions) or prices moving down (short positions) on underlying financial instruments and are often used to speculate on those markets.
For example, when applied to equities, such a contract is an equity derivative that allows investors to speculate on share price movements, without the need for ownership of the underlying shares.
CFDs are currently available in the United Kingdom, The Netherlands, Poland, Portugal, Germany, Switzerland, Italy, Singapore, South Africa, Australia, Canada, New Zealand, Sweden, France, Ireland, Japan and Spain. Some other securities markets, such as Hong Kong, have plans to issue CFDs in the near future. CFDs are not permitted in the United States, due to restrictions by the U.S. Securities and Exchange Commission on over-the-counter (OTC) financial instruments.
CFDs were originally developed in the early 1990s in London. Based on equity swaps, they had the additional benefit of being traded on margin and being exempt of stamp duty, a UK tax. The invention of the CFD is widely credited to Brian Keelan and Jon Wood, both of UBS Warburg, on their Trafalgar House deal in the early 90s.
They were initially used by hedge funds and institutional investors to hedge their exposure to stocks on the London Stock Exchange in a cost-effective way.
In the late 1990s CFDs were first introduced to retail investors. They were popularised by a number of UK companies, whose offerings were typically characterised by innovative online trading platforms that made it easy to see live prices and trade in real time. The first company to do this was GNI (originally known as Gerrard & National Intercommodities); GNI touch is now owned by MF Global. They were soon followed by IG Markets and CMC Markets who started to popularise the product in 2000.
It was around 2000 that retail investors realised that the real benefit of trading CFDs was not the exemption from stamp tax but the ability to trade on leverage on any underlying instrument. This was the start of the growth phase in the use of CFDs. The CFD providers quickly responded and expanded their product offering from just London Stock Exchange (LSE) shares to include indices, many global stocks, commodities, bonds, and currencies. Trading index CFDs, such as the ones based on the major global indexes e.g. Dow Jones, NASDAQ, S&P 500, FTSE, DAX, and CAC, quickly became the most popular type of CFD that were traded.
Around 2001 a number of the CFD providers realised that CFDs have the same economic effect as financial spread betting except that the tax regime was different, making it in effect tax free for clients. Most CFD providers launched financial spread betting operations in parallel to their CFD offering. In the UK the CFD market mirrors the financial spread betting market and the products are in many ways the same. However unlike CFDs which have been exported to a number of different countries, spread betting relying on a country specific tax advantage has remained primarily a UK and Irish phenomenon.
The CFD providers started to expand to overseas markets with CFDs being first introduced to Australia in July 2002 by IG Markets, a subsidiary of IG Group, and CMC Markets. CFDs have since been introduced into a number of other countries, see list above.
Until 2007 CFDs had been traded exclusively over-the-counter (OTC); however, on 5 November 2007 the Australian Securities Exchange (ASX) listed exchange-traded CFDs on the top 50 Australian stocks, 8 FX pairs, key global indices and some commodities. There were originally 12 brokers offering ASX CFDs, but as of 2009 there are only five.
In June 2009, the UK regulator the Financial Services Authority (FSA) implemented a general disclosure regime for CFDs to avoid them being used in insider information cases. This was after a number of high profile cases where positions in CFDs were used instead of physical underlying stock to hide them from the normal disclosure rules related to insider information.
CFDs are traded between individual traders and CFD providers. There are no standard contract terms for CFDs, and each CFD provider can specify their own, but they tend to have a number of things in common.
The CFD is started by making an opening trade on a particular instrument with the CFD provider. This creates a ‘position’ in that instrument. There is no expiry date so the position is closed when a second reverse trade is done. At that point the difference between the opening trade and the closing trade is paid as profit or loss. The CFD provider may make a number of charges as part of the trading or the open position. These may include, bid-offer spread, commission, overnight financing and account management fees.
Even though the CFD does not expire, any positions that are left open overnight will be ‘rolled over’. This typically means that any profit and loss is realised and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. The industry norm is that this process is done at 10pm UK time.
CFDs are traded on margin, and the trader must maintain the minimum margin level at all times. A typical feature of CFD trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on screen. If the amount of money deposited with CFD broker drops below minimum margin level, margin calls can be made. Traders may need to cover these margins quickly otherwise the CFD provider may liquidate their positions.
To see how CFDs work in practice see the examples of typical CFD trades. The ‘margin percentage’, and ‘charges’ shown may vary from provider to provider, but are typical of CFD providers.
Example 1 - an Equity based CFD trade
In this example we show an equity based CFD trade. The share price of Apple Inc is $194.38. We believe that the share price will rise and so decide to take a long CFD position. Our CFD Provider is quoting a price of $194.34 bid and $194.42 offer.
Step 1 Opening a position
Buy 100 Apple CFDs at offer price
100 x $194.42 = $19,442.00
Margin requirement is open position x margin percentage. Typical margin for equities is 3%-15% depending on the liquidity of the underlying instrument. In our example Apple CFDs require margin of 5%.
$19,442.00 x 0.05 = $972.10
You get charged commission of 0.1% on this transaction
$19,442.00 x 0.001 = $19.44
Step 2 Overnight Financing
To hold this position a financing charge is made each night. This is normally based on a benchmark rate per cent like LIBOR + broker margin per cent / 365. For simplicity we will assume the price of Apple shares stayed the same until the market close and so no P&L was generated on this day.
$19,442.00 x (0.0025 + 0.02) / 365 = $1.20
Step 3 Closing the position
The next day Apple share price has risen by $6.15. Our trade has moved in our favour and we decide close the position and take profit.
Our CFD provider is quoting $200.50 bid and $200.58 offer.
Sell 100 Apple CFDs at bid price
100 x 200.50 = $20,050.00
The position is now closed and so margin requirement is now zero
You get charged commission of 0.1% on this transaction
$20,050.00 x 0.001 = $20.05
Gross profit is difference between opening position and closing the position
$20,050.00 - $19,442.00 = $608
Net profit is gross profit less costs. The costs are commissions and overnight financing. In this example we have been charged commission twice, once to open the position and once to close it, and we have been charged one day overnight financing.
$19.44 + $20.05 + $1.20 = $40.69
Profit & Loss shows a profit after costs
$608.00 – $40.69 = $567.31
In summary we have had to deposit $972.10 to cover margin on this trade and made a profit of $567.31. If the price of Apple shares had instead dropped by $6.15, we would have sustained a loss of $647.47 ($608 plus commissions).
Example 2 - An Index based CFD trade on the S&P 500 Index
In this example we show an index based CFD. The S&P500 Index is at 1093.9. We believe that the Index will go down and so decide to take a 'short' position. Our CFD broker is quoting 1093.7 bid and 1094.1 offer.
Step 1 Opening a position
Sell 10 S&P500 CFDs at bid price
10 x $1093.7 = $10,937
Margin requirement is open position x margin percentage. Typical value for major indices is 0.5%
10,937 x 0.005 = $54.68
Commission – typically no commission is charged on index CFDs
Step 2 Overnight Financing
To hold a position a financing charge is made, however as we are holding a short position we will instead receive the financing. The rate is normally based on a benchmark rate per cent like LIBOR, from this we subtract the broker margin and divide by 365 to get the daily financing. For simplicity lets assume the US interest rate is 4% and the broker margin is 2%.
$10,937 x (0.04 - 0.02) / 365 = +$0.60
Step 3 Closing the position
The next day the S&P has dropped by 10 points to 1083.7 bid and 1084.1 offer
Our trade has moved in our favour and we decide to take profit and close the position
Buy back the position at the lower price
10 x 1084.1 = $10,841
The position is now closed and so margin requirement is now zero
Gross profit is difference between opening position and closing the position
$10,937 - $10,841 = $96.00
Net profit is gross profit less costs. In this example financing is actually positive and there are no other costs. So we get a credit of
Profit and Loss shows a Profit after costs
$96.00 + 0.60 = $96.60
In summary we have had to deposit $54.68 to cover margin on this trade and made a profit of $96.60. If the S&P 500 Index had risen instead by 10 points we would have sustained a loss of $95.40 ($96.00 + Costs). Note that the amount of gain or loss was bigger than the margin requirement. In other words, you would have gained or lost more money than you deposited.
The contracts are subject to a daily financing charge, usually applied at a previously agreed rate linked to LIBOR or some other interest rate benchmark e.g. Reserve Bank rate in Australia. The parties to a CFD pay to finance long positions and may receive funding on short positions in lieu of deferring sale proceeds. The contracts are settled for the cash differential between the price of the opening and closing trades.
Traditionally, equity based CFDs are subject to a commission that is a percentage of the size of the position for each trade. Alternatively, an investor can opt to trade with a market maker, foregoing commissions at the expense of a larger bid/offer spread on the instrument.
Investors in CFDs are required to maintain a certain amount of margin as defined by the brokerage or market maker (usually ranging from 0.5% to 30%). One advantage to investors of not having to put up as collateral the full notional value of the CFD is that a given quantity of capital can control a larger position, amplifying the potential for profit or loss. On the other hand, a leveraged position in a volatile CFD can expose the buyer to a margin call in a downturn, which often leads to losing a substantial part of the assets.
CFDs allow a trader to go short or long on any position using margin. There are always two types of margin with a CFD trade -
- Initial Margin - (normally between 3% and 30% for shares/stocks and 0.5% - 1% for indices, foreign exchange and commodities)
- Variation Margin - (which is then 'marked to market').
Initial margin is fixed at between 0.5% and 30% depending on the underlying product and overall perceived risk in the market at that time. For example, during and after 9/11 initial margins were massively hiked across the board to counter the explosion in volatility in the world's stockmarkets.
Many refer to initial margin as a deposit. For example, for large and highly liquid stocks such as Vodafone the initial margin will be nearer 3%, and depending on the broker and the client's relationship with the firm the deposit maybe even lower. However, with a smaller capitalised and less liquid stock the margin is likely to be at least 10% if not a lot higher.
Variation margin is applied to positions if they move against a client. For example, if a CFD trader was to buy 1,000 shares in ABC stock using CFDs at 100p and the price moved lower to 90p the broker would deduct £100 in variation margin (1,000 shares x -10p) from the client's account. Note, this is all done in real-time as the market moves lower, so called 'marked to market'. Conversely, if the share price moved higher by 10p the broker would credit the client's account with £100 in running profits.
Variation margin can therefore have either a negative or positive effect on a CFD trader's cash balance. But initial margin will always be deducted from a customer's account and replaced once the trade is covered.
One of the benefits of trading CFDs is that they are traded on margin meaning that they provide the trader with leverage. Leverage involves taking a small deposit and using it as a lever to borrow and gain access to a larger equivalent quantity of assets. The margin requirements on CFDs are low meaning that only small amount of money is required to take large positions.
Stop loss orders
A stop loss order can be set to trigger an exit point as pre-determined by the trader e.g. Buy at $3.00 with a stop loss at $2.60. Once the stop loss is triggered, a sell signal is activated to the CFD provider and actioned in accordance with their terms of business and taking into account available liquidity to action the request. DMA providers typically receive the stop loss value via the phone or online ordering and will place the order in the market to be actioned at the pre-determined price to a limited price range e.g. to a maximum 6c further,and providing there is matching liquidity. If the stop loss price is triggered and the price then rapidly moves outside the 6c range in this example, or there is insufficient liquidity for your order and considering other people that have orders at that price point, your stop loss sell order may not be triggered and you remain in the position.
Market makers have the ability to manage the stop loss and when a stop loss order is triggered, they can close the position wherever they see that matching price and quantity are available. This increases your chances of getting out of a position that is going against you, albeit at a potentially inferior price to what you were expecting.
One of the problems with the price of a stop loss order is that it is only a target price. It depends if the market price actually trades at that level. If the underlying instrument price 'gaps' i.e. it moves past the stop price in one step, the stop will get executed at the next price that was traded or not at all depending on the CFD provider. This is normally not a problem on very actively traded products like indices and currencies, but can be an issue on equity prices, particularly for stocks that have low liquidity. It is also a problem when stock markets are closed, and the difference between the close on one day and the open on the next day is significant (for example: if there has been news about a stock overnight that impacts company profitability).
To mitigate this problem, some providers offer 'Guaranteed Stop Loss Orders' (GSLO) whereby the trader pays a premium for a price to be guaranteed should a stop loss price be triggered. As well as the additional charge, there are normally other restrictions. The closest a guaranteed stop loss order can be placed is typically 5% from the current price and providers usually have specific terms and conditions on the orders however they can be effective if exiting at a set price is important.
CFDs are typically traded over-the-counter with a broker or market maker, known as a CFD provider. The CFD provider will define the contract terms, the margin rates and what underlying instruments it is willing to trade. They trade under two different models which can have an impact on the price of the instrument traded;
Corporate Actions on Equity based CFDs
Corporate actions such as dividend payments can have an impact on the share price and hence the price of an equity based CFD. However, a person who holds a CFD position has no ownership of the underlying instrument and so would not receive the dividend payment from the company that issued the shares.
In this case the CFD provider would pay the equivalent of the dividend to anyone holding a long CFD position and deduct the equivalent from anyone holding a short position. This would be done on ex-div date as that is when the economic effect is felt on the underlying share price. The general rule is that any economic effect of a corporate action on the underlying must be reflected in the CFD. This includes dividends, stock splits, rights issues etc. However, a CFD holder will never have access to non economic corporate actions such as voting rights.
The main risk is market risk as the contract is designed to pay the difference between the opening price and the closing price of the underlying asset. CFDs are traded on margin, and the leveraging effect of this increases the risk significantly. Margin rates are typically small and therefore a small amount of money can be used to hold a large position. It is this very risk that drives the use of CFDs, either to speculate on movements in financial markets or to hedge existing positions elsewhere. One of the ways to mitigate this risk is the use of stop loss orders. Users typically deposit an amount of money with the CFD provider to cover the margin and can lose much more than this deposit if the market moves against them.
If prices move against open CFD position additional variation margin is required to maintain the margin level. The CFD provider may call upon the party to deposit additional sums to cover this, and in fast moving markets this may be at short notice. If funds are not provided in time, the CFD provider may close/liquidate the positions at a loss for which the other party is liable.
Another dimension of CFD risk is counterparty risk, a factor in most over-the-counter (OTC) traded derivatives. Counterparty risk is associated with the financial stability or solvency of the counterparty to a contract. In the context of CFD contracts, if the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This means that a CFD investor could potentially incur severe losses, even if the underlying instrument moves in the desired direction. Although OTC CFD providers are required to segregate client funds protecting client balances in event of company default. Exchange-traded contracts traded through a clearing house are generally believed to have less counterparty risk. Ultimately, the degree of counterparty risk is defined by the credit risk of the counterparty, including the clearing house if applicable.
CFDs compared to other products
There are a number of different financial products that have been used in the past to speculate on financial markets. These range from trading in physical shares either direct or via margin lending, to using derivatives such as futures, options or covered warrants. A number of brokers have been actively promoting CFDs as alternatives to all of these products.
Although no firm figures are available as trading is off-exchange, it is estimated that CFD related hedging accounts for somewhere between 20% and 40% the volume on the London Stock Exchange (LSE). A number of people in the industry back the view that a third of all LSE volume is CFD related. The LSE does not monitor the numbers but the original 25% estimate as quoted by many people, appears to have come from a LSE spokesperson.
The CFD market most resembles the futures and options market, the major differences being:
- There is no expiry date, so no price decay;
- Trading is done off-exchange with CFD brokers or market makers (note exception with ASX discussed below);
- CFD contract is normally one to one with the underlying instrument;
- CFDs are not available to US residents;
- Minimum contract sizes are small, so it’s possible to buy one share CFD, low entry threshold;
- Easy to create new instruments, not restricted to exchange definitions or jurisdictional boundaries, very wide selection of underlying instruments can be traded.
Futures are preferred by professionals for indices and interest rate trading over CFDs as they are a mature product and are exchange traded. The main advantages of CFDs, compared to Futures, is that contract sizes are smaller making it more accessible for small trader and pricing is more transparent for CFDs as it mirrors the underlying instrument. Futures contracts tend to see price decay near to the expiry date compared to the price of the underlying instrument.
Futures are often used by the CFD providers to hedge their own positions and many CFDs are written on of futures as pricing for futures is easily obtainable. As CFDs have no expiry date, for CFDs written on futures contract, the industry practice is for the CFD provider to 'roll' the CFD position to the next future period when the liquidity starts to dry in the last few days before expiry.
Options, like futures are an established product, exchange traded and centrally cleared and used by professionals. Options like futures can be used to hedge risk or to take on risk to speculate. CFDs are only comparable in the latter case, when options are used to speculate on markets. The main advantage of CFDs over options is the price simplicity and range of underlying instruments. Compared to CFDs, option pricing is complex and has price decay when nearing expiry while CFDs prices simply mirror the underlying instrument. CFDs cannot be used to reduce risk in the way that options can.
Similar to options trading, covered warrant have become popular in recent years as a way of speculating cheaply on market movements. CFDs costs tend to be lower for short periods and have a much wider range of underlying products. In markets like Singapore, some brokers have been heavily promoting CFDs as alternatives to covered warrants, which may have been partially responsible for the decline in volume of covered warrant there.
Exchange-traded funds (ETFs) like CFDs can been used for short term speculation, and are available over a wide variety of underlying products. In particular Indices, commodities and overseas markets, which have been seen as one of the strengths of CFDs. Also in the same way as CFDs there are ETF on customised groups of instruments such as sectors or baskets and an increasing number of ETFs are set up to use leverage. Compared to CFDs, ETFs are exchange traded product and have been around longer and are a more mature product. Like other exchange traded products the costs are higher and access is via a traditional broker.
Physical Shares, commodities and FX
This is the traditional way to trade financial markets, this requires a relationship with a broker in each country, require paying broker fees and commissions and dealing with settlement process for that product. With the advent of discount brokers, this has become easier and cheaper, but can still be challenging for retail traders particularly if trading in overseas markets. Without leverage this is capital intensive as all positions have to be fully funded. CFDs make it much easier to access global markets for much lower costs and much easier to move in and out of a position quickly. All forms of margin trading involve financing costs, in effect the cost of borrowing the money for the whole position. This is charged daily for all open positions and makes CFDs convenient if used under around 10 weeks, an estimated point where CFD financing charge exceeds financing charge for stocks, but more expensive for long term positions.
Margin Lending also known as margin buying or leveraged equities have all the same attributes as physical shares discussed earlier, but with the addition of leverage, which means like CFDs, futures, and options much less capital is required, but risks are increased. Since the advent of CFDs, many traders have moved from margin lending to CFD trading. The main benefits of CFD versus margin lending are that there are more underlying products, the margin rates are lower, and it is easy to go short. It can be difficult and expensive to short sell using physical shares and may not be possible at all, however it is just as easy to go short as to go long with a CFD. Even with the recent bans on short selling, CFD providers who have been able to hedge their book in other ways have allowed clients to continue to short sell those stocks.
Exchange traded CFDs in Australia
The majority of CFDs are traded OTC using the direct market access (DMA) or market maker model, but in 2007 the Australian Securities Exchange (ASX) introduced exchange traded CFDs. As a result a small percentage of CFDs are now traded through the Australian exchange.
The advantages and disadvantages of having an exchange traded CFD are similar for most financial products and mean reducing counterparty risk and increasing transparency but costs are higher.
- Market Independence; the exchange has to make sure markets are fair, orderly, and transparent. ASX is independent of the parties with whom a customer receives advice and deals through. This separation of responsibility between broker and exchange provides customers with choice as to whom they wish to execute their business through and also means there is one standard contract specification for all ASX CFDs.
- Transparency; ASX reports on all ASX CFDs transacted, open positions, bid, offers and their volumes and ASX CFDs are traded in the same way as other ASX traded contracts. ASX CFDs are offered on a separate market with a separate book to that of physical stock trading on the ASX. When trading ASX CFDs, the customer's order is entered directly via a Participant into the ASX CFD central market order book. This order book is available for the market to see. All orders are executed on a strict price/time priority.
- Higher costs; the exchange and the clearing house need to earn money and so charge fees as well as the broker. In addition the broker’s administration costs tend to be higher to comply with exchange and clearing requirements.
- Pricing; one side effect of the separate order book for CFDs on the exchange is that prices and spreads are based CFDs orders only. This means that the price and spread of an ASX CFD can be different from that of its underlying instrument. In some instances, while the underlying instrument is liquid and heavily traded with a tight spread the ASX CFD based on that instrument may have little or no liquidity and a wider spread. The viability of trading will depend on the ASX attracting enough participants to its CFD products to create a liquid market.
The current disadvantages of the ASX exchange traded CFDs and lack of liquidity means that most Australian traders still opt for over-the-counter CFD providers. As of 2010 no other exchange has followed the ASX in creating listed CFDs.
Some financial commentators and regulators have expressed concern about the way that CFDs are marketed at new and inexperienced traders by the CFD providers. In particular the way that the potential gains are advertised in a way that may not fully explain the risks involved. In anticipation and response to this concern most financial regulators that cover CFDs specify that risk warnings must be prominently displayed on all advertising, web sites and when new accounts are opened. For example the UK FSA rules for CFD providers include that they must assess the suitability of CFDs for each new client based on their experience and must provide a risk warning document to all new clients, based on a general template devised by the FSA. The Australian financial regulator ASIC on its investor information site suggests that trading CFDs is riskier than gambling on horses or going to a casino. It recommends that trading CFDs should be carried out by individuals who have extensive experience of trading, in particular during volatile markets and can afford losses that any trading system cannot avoid.
There has also been concern that CFDs are little more than gambling implying that most traders lose money trading CFDs. It is impossible to confirm what the average returns are from trading as no reliable statistics are available and CFD providers do not publish such information, however prices of CFDs are based on publicly available underlying instruments and odds are not stacked against traders as the CFD is simply the difference in underlying price.
There has also been some concern that CFD trading lacks transparency as it happens primarily over-the-counter and that there is no standard contract. This has led some to suggest that CFD providers could exploit their clients. This topic appears regularly on trading forums, in particular when it comes to rules around executing stops, and liquidating positions in margin call. Although the incidence of these types of discussions may be due to traders psychology where it is hard to internalise a losing trade and instead they try to find external source to blame. This is also something that the Australian Securities Exchange, promoting their Australian exchange traded CFD and some of the CFD providers, promoting Direct Market Access product, have used to support their particular offering. They argue that their offering reduces this particular risk in some way. The counter argument is that there are many CFD providers and the industry is very competitive with over twenty CFD providers in the UK alone. If there were issues with one provider clients could easily switch to another provider.
Some of the criticism surrounding CFD trading is connected with the CFD brokers' unwillingness to inform their users about the psychology involved in this kind of high-risk trading. Factors such as the fear of losing that translates into neutral and even losing positions and becomes a reality when the users change from the demonstration account to the real one, a fact not documented by the majority of CFD brokers.
Criticism has also been expressed about the way that some CFD providers hedge their own exposure and the conflict of interest that this could cause when they define the terms under which the CFD is traded. One article suggested that some CFD providers had been running positions against their clients based on client profiles, in the expectation that those clients would lose, and that this created a conflict of interest for the providers.
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