Contracts for Differences have hugely increased in popularity since first being adopted as a form of trading by private investors. This is because trading CFDs has many advantages over normal share/futures trading:
Contract for Differences, also commonly known as a CFD, is a derivative that allows investors to speculate on underlying asset price movements, without the need for ownership of the underlying asset. CFD is a margin product which enables you to have higher return by using so called gearing (leverage). This means that you do not have to pay the full value of the underlying asset.
Gearing (leverage) is the term used to describe margin requirements: the ratio between the collateral and deal size: 1:20, 1:40, 1:50, 1:100. Leverage 1:10 means then when you wish to open a new position, then you must have a deposit a tenth of the contract size. For example, to purchase $10,000 worth of Microsoft shares you only need to deposit $1,000. If you physically trade shares, a $1,000 profit in the underlying shares equates to a return of 10%. If instead, you trade these shares as a CFD, then this would equate to a return of 100%. Please note, that because of leverage, losses will be magnified as well.
Trading share CFDs can be described as opening a position on the proceeds of credit. If you buy share CFDs, you get all the benefits of the underlining share, including price rise and dividends, and pay off on-credit expenditures to the seller. It can be compared to a sort of a bank credit: you borrow money to buy shares and get the benefits of a shareholder would receive, and pay the bank interest.
If you trade CFDs you will not receive dividends in the same way that shareholders would. You will receive instead, a "Dividend Adjustment". This means that on the ex-dividend date, if you have open positions, your account will be credited or debited on the payment date to reflect those adjustments. If you have long position the adjusted amount is credited, if you have short position it is debited. Dividend adjustments are calculated on the same basis as share dividends.
Example:
On March, 8, 2004 (Declared Date) Board of Directors of Verizon Communications (VZ) announces a quarterly dividend payout of $ 0.385/per share; Ex-DateInvestors who purchase stocks before this day are eligible for the dividend payout. - 06.04.2004, Record DateThe date when the Board of Directors determines which shareholders are entitled to receive dividends. - 09.04.2004, Payment DateThe date on which dividend payments are made (by a bank transfer, cheque etc.). – 03.05.2004.
You decide to purchase Microsoft shares, which are quoted at 23.97/24.00, so you buy 100 shares at the offer price of $24.00:
| Price of Microsoft share | $24.00 | |
| Number of shares | 100 | |
| Number of lots (1.0 lot = 100 shares) | 1.0 | |
| Deal size | $2,400.00 | |
| Commission (0,1%) | - $2.40 | |
| Margin (10%) | $240.00 |
To fund this position you will need $242.40 (Margin + Commission).
Credit settlements are required when you leave your position open until the end of the trading session. Credit settlements are calculated based on FED funds rate (for US Stocks) and the closing price of the share.
For example: FED Funds rate is 1.75%, Alpari (UK)'s markup is 1.25% and the closing price of Microsoft shares is $25.00. Your credit settlement is calculated the following way:
| N_Stocks x P_Close x Interest / N_Days = | |
| = 100 x $25.00 x (1.75% + 1.25%) / 360 = | |
| = $0.21 |
When you leave your position open from Friday to Monday, the deducted amount will be three times higher.
Three days later Microsoft shares are quoted at $25.50/25.53, and you chose to close your position by selling at $25.50:
| Price of Microsoft share | $25.50 | |
| Number of shares | 100 | |
| Number of lots (1.0 lot = 100 shares) | 1.0 | |
| Deal size | $2,550.00 | |
| Profit | + $150.00 | |
| Commission (at closing there is no commission) | $0.00 | |
| Credit settlements (3 days) | - $0.63 | |
| Profit less commission and on-credit expenditures | +$146.97 (= + 150.00 - 2.40 - 0.63) |
So, you have a return of 60% on your initial investment.
This example shows a favourable outcome. If the share price had moved against you, you would have realised a loss, not a profit, and with leverage, this loss would be magnified. For example, if you closed the position at 22.50, your loss would be $ 153.03.
Let's assume that American Express (AXP) shares are overpriced and you decide to sell 200 American Express shares as a CFD. They are quoted at $3.90/33.94 and you sell 200 AXP shares at $33.90 as a CFD.
| Price of American Express share | $33.90 | |
| Number of shares | 200 | |
| Number of lots (1.0 lot = 100 shares) | 2.0 | |
| Deal size | $6,780.00 | |
| Commission (0,1%) | - $6.78 | |
| Margin (10%) | $678.00 |
To fund this position you will need $684.78.
Credit settlements are required when you leave your position open until the end of the trading session. Credit settlements are calculated with regard to FED funds rate (for US Stocks) and the closing price of the share.
For example: FED Funds rate is 1.75%, Alpari (UK)'s markup is 1.25% and the closing price of the AXP share is $33.10. So, your trading account will be credited as follows:
| N_Stocks x P_Close x Interest / N_Days = | |
| = 200 x $33.10 x (1.75% - 1.25%) / 360 = | |
| = $0.09 |
When you leave your position open from Friday to Monday, the credited amount will be three times higher.
Seven days later AXP shares are quoted at $33.36/33.40 and in the rising market you make a decision to close the position by buying 200 AXP shares at $33.40 as a CFD.
| Price of American Express share | $33.40 | |
| Number of shares | 200 | |
| Number of lots (1.0 lot = 100 shares) | 2.0 | |
| Deal size | $6,680.00 | |
| Profit | + $100.00 | |
| Commission (at closing there is no commission) | $0.00 | |
| Credit settlements (7 days) | + $0.63 | |
| Profit less commission and on-credit expenditures | + $93.85 |
So, you have a return of 14% on your initial investment.
This example shows a favourable outcome. If the share price had moved against you, you would have realised a loss, not a profit, and with leverage this loss would be magnified. For example, if you closed the position at 34.40, your loss would be $ 107.41.
Index-linked financial instruments have been growing in popularity among private investors because they allow you to have a diversified and low cost index investment.
Index investment means that you are able to track the price and yield performance of any index. You build your investment portfolio on the basis of the constituents of any index. For small private investors it's difficult to invest in NASDAQ 100 or S&P 500, because you have to have more than one share of any company listed in these indices. This has meant that until recently, only professional investors with large portfolios could invest in indices.
The first step in opening of this type of investment to small traders was made in 1993 when the S&P unit investment trust was introduced. Its shares are traded on the AMEX with the ticker SPY. Known as SPIDERS, each SPDR (Standard & Poor's Depositary ReceiptŪ) share represents 500 stocks of the Standard & Poor's 500 Composite Stock Price Index (S&P 500).
Further steps were made in 1997 with the introduction of DIAMONDS, an index product based on the Dow Jones Industrial Average, appeared (DIA, trade around 1/100th of the value of the Dow); and in 1999 the introduction of the Nasdaq-100 Trust (QQQ - Cubes, trade around 1/40 of the value of the Nasdaq 100). Nowadays ETFs are very popular among private and institutional investors. On December 14, 2005 their prices were:
Many investors prefer to trade Cubes, Diamonds and Spiders, as you don't have to be a market pro to use them. When you trade single shares you have to analyse both the company's weak and strong points and overall economic outlook. There is no need to make an in depth analysis of each corporation when you trade ETFs. ETFs price movements usually reflect macroeconomic factors and situation.
The main points you need to note are:
* under normal market conditions
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