Making Sense of Contract for Differences 

Contracts for Differences or CFDs are leveraged instruments. Trading in leveraged products like CFDs potentially exposes a person to a higher risk of loss than if the product were unleveraged (e.g. with leveraged products, the investor may lose more than what he originally invested). Thus, trading CFDs may not be suitable for everyone. Find out more about the impact of leverage on CFDs and the benefits as well as the pitfalls to watch out for. For ease of illustration, the examples cited here refer to shares as the underlying asset class.

What is a Contract for Differences?

CFDs are leveraged trading instruments. In Singapore, they 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.

Simply put, a CFD allows a person to speculate on future market movements of the underlying assets, without actually owning or taking physical delivery of the underlying asset.

The CFD involves two trades: firstly, a person enters into an opening trade with a CFD provider at one price. The opening trade creates an open position which the individual later closes 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 the investor holds a long position in the CFD, the CFD provider pays the investor the difference between the opening and closing out prices of the CFD if the closing out price is higher. If the closing out price is lower, the investor will have to pay the CFD provider the difference, thereby suffering a loss. Conversely, where the investor has a short position in the CFD, the CFD provider pays the investor the difference between the opening and closing out prices if the closing out price is lower. The investor will have to pay the CFD provider if the closing out price is higher. The proceeds paid or received by the investor will be subject to commissions, financing charges, other charges or other adjustments made by the CFD provider.

CFDs are leveraged trading instruments, i.e. traded on margin. Instead of paying the full value for the underlying shares, an investor pays an initial margin to open the position and is required to maintain some minimum margin level for open positions at all times. Investors may be required to satisfy the margin calls at very short notice, especially in volatile markets. An investor who fails to top up his margin when required, risks having his position liquidated at a loss. Find out more about margins in the next section.

How does the Product Work?

Trade on Margin

CFDs are traded on margin. This means an individual pays 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. 

In summary, 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

Because of this leveraging effect, if the markets move in favour of or against Mr A’s position taken, Mr A’s respective profits or losses will be magnified. Here are some examples of how leverage impacts Mr A’s profits and losses.

Continuous Margin Adjustments

In a situation where the markets move against a person’s open position, the CFD provider will require him to top up his margin to cover the losses he incurs. 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 a potential investor before entering into the CFD). An investor will typically 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 and the person is liable for any resulting deficit.  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.

Individuals who want to trade CFDs must be financially prepared to top up margins at short notice, especially when markets are volatile.

CFDs and Short Selling

Various restrictions apply to short selling in the stock markets. CFDs, however, allow individuals 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.

Rights in Corporate Actions

Buyers of CFDs may be entitled to adjustments to their CFDs, if dividends on the underlying shares are paid by the respective companies. It is important to confirm this with the CFD provider as well as to check what other rights the CFD buyer will have.    

What are the costs involved?

Margins and Costs

As CFDs are traded onmargin, the CFD provider will require some minimum margin level for open positions to be maintained all the time. The profit and loss and margin requirements are calculated constantly throughout trading hours. Margin calls will be made whenever the amount of money deposited with the CFD provider falls below the minimum margin level. Failure to cover these margins within the required time may result in the CFD provider liquidating the positions. This may lead to losses for the CFD buyer or seller.

The 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.  These may be quoted in the form of a bid-offer spread on the CFD, or may be charged upfront or when the position is closed.  Do clarify this with the CFD provider before trading in CFDs.

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.

The commission charged by the dealer firm is subjected to Goods and Services Tax (GST).

What are the Key Risks?

Market Risk

Retail traders enter into CFDs when they 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 they take is that their 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. The loss is potentially unlimited and can be much more than the cost of the initial margin.

For loss-making open positions, the CFD provider may require the CFD buyer or seller to top-up the margin to finance the position. This could be at very short notice. If funds are not provided within the stipulated time, the CFD provider may close, i.e. liquidate, the positions at a loss for which the position holder is liable. If the positions are not closed, a CFD buyer or seller could be exposed to significant or potentially unlimited losses.

If a CFD position is closed out at a loss, the position holder will be required to pay the loss to the CFD provider. He should ensure that he has sufficient capital to do this even before he starts trading on CFDs. Individuals looking to trade CFDs need to make the time commitment to actively monitor and manage their positions at all times to avoid incurring losses they cannot sustain. Some CFD providers may offer stop loss or limit order measures which allow investors to limit losses by setting price triggers to close the open position.

Counterparty Risk

This is the risk that the CFD provider you have transacted with fails to meet a payment obligation due under a CFD. For example, if you have made a profit, the insolvency of the CFD provider you have dealt with may result in its inability to make this payment to you. A CFD buyer should note that he has no recourse to the underlying shares as he has not actually bought the underlying shares.

Pricing of CFDs

There are currently two CFD models in the market: the Direct Market Access (DMA) and Market Making (MM) models. In the MM model, it is the CFD provider which makes the bid-offer prices for the CFDs provided. The prices quoted by the CFD provider may or may not match the exchange traded price of the underlying share. The DMA model can be viewed as allowing the investor direct access to the exchange via the CFD. This means that when an order to buy or sell a CFD is given 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

The investor faces currency risk if the CFD is quoted in a currency which differs from the currency of the underlying share. If the currency of the CFD and the underlying share is the same, currency risk still arises if this differs from the investor’s base currency deposited with the CFD provider. This is regardless of whether he is in a buy or sell position.

Do CFDs expire? What happens then?

CFDs may or may not have expiry dates. It is decided by the CFD provider. It is important to clarify this directly with your CFD provider. For those with expiry dates, an individual who bought into the CFD will have to close out the position at expiry.  If an investor wishes to maintain his exposure to the underlying shares beyond the expiry of the CFD, he will then 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, the individual’s account may require adjustments to margin, as well as to reflect current profit and loss status.

Individuals need to be more vigilant about monitoring open positions where there is no expiry date.

What other instruments have similar features as a CFD? 

A key feature of a CFD is that it allows a person to speculate in market price movements without actually owning the underlying assets. A CFD also provides leverage to the investor. Other instruments such as futures also have the same characteristics. Do note however that as the instruments may be transacted on a margin basis, this exposes the investor to higher risks.

Is trading CFDs suitable for me?

Trading CFDs on leverage exposes an individual to higher risk than physical share trading. With leveraged margin trading, CFDs are capable of magnifying both profits and losses, potentially leading to unlimited losses.

If you are interested in trading CFDs, you should ensure that you are fully aware of how CFDs function, their features and risks. You should also be sure you 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.   You should also be able to actively monitor the performance of the CFDs you are exposed to at all times so that you are able to react to limit your losses when the market moves against your position as well as respond to margin calls when required to do so.