These days, investors have a wide array of instruments to trade. Contracts for Differences or CFD, one of the newest instruments is fast gaining popularity.
A CFD is a contract between two parties, the buyer and seller, where the seller pays the buyer the difference between the opening and closing prices of the contract. Such a contract allows investors to take a view and make and investment on asset price movements, without the need for ownership of the underlying asset.
a. Underlying asset of the CFD, which can be a share, an index, a commodity, a currency, etc.
b. Price of the underlying asset of the CFD;
c. Number of units of the underlying asset specified in the CFD;
d. Expiry period, if any, of the CFD.
As trading in CFDs potentially entails a high risk of loss, investors should understand how CFDs work before investing in them. The following literature serves as an information guide on CFDs. For ease of illustration, the examples cited here refer to shares as the underlying asset class.
CFDs are leveraged products traded on margin, meaning the investor will only have to pay a fraction of the value of the underlying shares (typically between 10% and 30% set by the dealer) to open the position, as compared to paying the full value for the underlying shares. When trading in CFDs, the investor does not actually have ownership of the underlying shares.
| Example 1: Initial Margin
Suppose the shares of a particular company, XYZ Pte Ltd, are quoted in the market at an offer price of $2.00 and the investor intends to buy 2,000 shares of this company as a CFD at $2.00, the offer price. Assuming the dealer sets the margin of the CFD at 5%, the initial margin paid by the investor will be 5% x $2.00 x 2000 = $200.
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In other words, with CFD trading, the investor will be able to open the position with $200 versus a payment of $4,000 for physical share (traditional) trading. Because of this leveraging effect, if the markets move in or against the investor’s favour, his respective profits or losses will be magnified.
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Example 2: Example of a Profit
Suppose on the next day, the shares of XYZ Pte Ltd increase and are quoted in the market at a bid price of $2.05. The investor then decides to sell his CFD at $2.05. The investor will gain a profit of $100 [($2.05- $2.00) x 2000].
The return on investment (ROI) from the CFD works out to 50% (100 ÷ 200). This is comparatively higher than the ROI of about 2.5% (100 ÷ 4,000) from investing in the underlying shares.
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Example 3: Example of a Loss
Conversely, if the market moves against the investor’s position and the shares of XYZ Pte Ltd are quoted at $1.95, the investor may choose to sell his shares at $1.95 to avoid incurring further loss. The investor will incur a loss of $100 [($ 1.95 - $2.00) x 2000] from investing in the CFD.
In this example, the ROI for investing in the CFD would be -50% (-100 ÷ 200), as compared to an ROI of -2.5% (-100 ÷ 4,000) from investing in the underlying shares.
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Note: The above examples have not factored in other transaction costs of trading in CFDs, such as financing charges or commissions, which are explained in the later section on “Costs”. The net profit will be less after the various charges are factored in.
Because of trading on margin, CFDs are higher risk investments than physical share trading. In a situation where the markets move against the investor’s position, the dealer firm will require the investor to top up the margin to cover the losses incurred by the investor. In the above example 3, if the investor intends to keep the position, the $100 loss will be deducted from the initial margin. The investor will be required to top up his margin with additional funds (known as a margin call) to the initial amount of $200, or to a level prescribed by the dealer firm (the prescribed margin should be made known to a potential investor before entering into the CFD). Otherwise, the position may be closed at a loss and investor is liable for any resulting deficit. This daily process is called “marking to market”.
2. Ease of Going Short (or Selling)
In the physical stock markets, unless the investor hold the actual shares, he cannot go short, meaning to sell with the intent of profiting from falling share prices. CFDs, however, allow investors to take short positions, without having physical ownership of the underlying shares. Therefore, investors can profit from both rising and falling markets. But the risk of taking short positions is that it could lead to unlimited losses.
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Example 4
Suppose an investor expects the shares of XYZ Pte Ltd, quoted in the market at a price of $2.00, to fall. The investor can sell 2000 shares at $2.00, as a CFD. The initial outlay to open the position will be $200 (5% x $2.00 x 2000).
After 7 days, the shares of XYZ Pte Ltd are quoted in the market at $1.95. The investor 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 50% ROI, excluding transaction and other costs. However, if the price had moved in the opposite direction by $0.05, the investor would have incurred a loss of $100 or -50% ROI, exclusive of costs.
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3. Partake in Corporate Actions
Investors of CFDs are entitled to the dividends paid on the underlying shares by the respective companies. They can also participate in stock splits, where the quantity and price adjustment will be made to the CFD to reflect the market equivalent. However, unlike a shareholder, investors of CFDs are not entitled to any voting rights.
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Example 5
If an investor is in a long position of a CFD (i.e. investing with the expectation that the underlying shares will rise in value) in the shares of XYZ Pte Ltd, he will be entitled the dividend announced by XYZ Pte Ltd.
Conversely, if an investor is in a short position, the dividend amount would be debited from his trading account. Hence, it would reduce the profit margin or cause the investor to incur a greater loss, depending on the movement of the market against his speculation.
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Costs
Apart from the margin requirements and marking to market involved in CFDs, they are subject to other transaction costs, such as daily financing charges, commissions and Goods and Services Tax (GST).
1. Daily Financing Charge
Investors of CFDs may incur a financing cost or benefit if they hold their CFDs overnight. If they are in long positions, they may have to pay interest to the dealer. Because the price of buying the CFD is only a fraction of the total capital outlay, investors are essentially borrowing to enjoy the exposure of going long in the underlying shares. The interest charges that investors pay reflect the cost of borrowing and are usually applied at an agreed rate based on some interest rate benchmark. For short positions, the investors may receive interest in lieu of the deferring sale proceeds. However, some CFD brokers may charge interest in view of the borrowing costs incurred in allowing the ‘short’ transactions.
In contrast, a shareholder does not incur daily financing charges. However, the initial outlay will be the full value of the underlying shares acquired.
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Example 6
If a particular holder of a CFD holds 2000 shares overnight, he will incur a 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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2. Commission
Dealer firms may charge commission for the CFD transactions. The commission charge is usually a percentage of the total value of the underlying shares. In some dealer firms, the commission may be quoted in the form of a bid-offer spread on the CFD. Investors should find out from their dealers the commission rates before trading in CFDs.
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Example 7
Suppose XYZ Pte Ltd is quoted at $2.00 and an investor intends to buy 2,000 shares of this company as a CFD at $2.00. The commission, given that the rate is 0.5%, to be debited is $2.00 x 2000 x 0.5% = $20.00.
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3. Goods and Services Tax (GST)
The commission charged by the dealer firm is subjected to Goods and Services Tax (GST).
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Example 8
If the commission charged is $20.00, a GST (at 5% of $20.00) of $1.00 will be levied.
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Contract expiry period and its implications
A CFD may have an expiry date decided by the dealer firm. Upon expiry, an investor who bought into the CFD will have to close out (sell or buy back depending on the initial position) the position. If an investor wishes to maintain his exposure on the underlying shares after the expiry of the CFD, he will have to renew the contract. The profits and losses will be realized at the point of renewal. The renewed position will begin like any newly opened CFD, and commission fees may be chargeable by the dealer firm.
What other instruments in the market can give me similar benefits as a CFD?
Single-stock futures, also known as SSF, are futures contracts with an underlying of one particular stock. The contract is usually specified in 100 units of the underlying stock. It is another investment tool which offers some of the same benefits as CFD.
Like CFD, investors can trade SSF on margin, increasing the capabilities to leverage within the markets. Also, there is ease to go short. However, holders of SSF neither have voting rights nor are entitled to the dividends paid on the underlying shares.
How do the risks and costs of SSF compare with CFD?
SSFs are quoted and traded on the exchange markets, while CFDs tend to be traded in over-the-counter (OTC) markets. In so far as the exchanges operate as clearinghouses to guarantee the performance on the SSF contracts, the default risks of investing in SSFs are typically lower than that of CFDs, which are typically offered by smaller dealer firms.
In terms of financial risks, SSFs are generally comparable to CFDs on a single stock. However, as the universe of underlying assets with respect to CFDs is broader and more diverse, CFDs generally offer greater opportunities and flexibility for diversification of risks.
In terms of transaction costs, both CFDs and SSFs are similar. Like CFDs, SSFs are subjected to commission. And although SSFs do not have explicit financing charges, they are embedded in the quoted price of the SSFs.
How do I determine if a CFD is suitable for me?
Essentially, CFDs are higher risk investments than physical share trading. A potential investor should fully comprehend the high risks a leveraged product such as CFD entails. With leveraged margin trading, CFDs are capable of magnifying profits, as well as losses, sometimes leading to unlimited losses.
A potential investor should have an adequate and sound knowledge of the performance of the particular CFD he intends to invest. He should be able to monitor the performance of the underlying shares and the rates quoted by the dealer firm to make informed decisions pertaining to his investment.
The potential investor should have sufficient free equity for repayment in the event of loss, which can be much more than the initial outlay invested. There may be situations where the investor has to top-up the margin to finance the trading position upon the request of the dealer firm. Failing to fund the required margins before the given deadline, the trading position will be closed and the investor may sustain significant losses.
If the market movement is not in favour of the investment, certain dealer firms offer services to help limit potential losses of the investors. They have stop loss facilities that allow investors to set a price to trigger a sell order (for long positions) or buy order (for short positions) to close the trading position, controlling and minimizing the losses incurred. A potential investor may consider engaging such services to limit their losses, if any.
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Questions I should ask when considering whether to invest in a CFD:
1. Do I have adequate and sound knowledge of the performance of the particular CFD and the underlying asset which I have interest to invest?
2. Do I fully understand the risks of investing in a leveraged product like CFD? Am I comfortable with the risks?
3. Do I have the time to monitor the performance of the underlying shares and rates offered by the brokerage closely?
4. What are the costs I have to pay? Specifically, do find out what is the margin, commission and financing charge.
5. Do I have enough capital for repayment in the event that I suffer a loss from the CFD investment which can be significantly higher than the margin invested? In cases of short selling, it may lead to unlimited losses.
6. 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?
7. Is the dealer firm which I am going to engage authorized or licensed to deal in CFDs? Do check the Financial Institutions Directory on the MAS website (www.mas.gov.sg) whether the firm has the requisite authorization or license.
8. Do I have access to services such as risk exposure management and monitoring, charting and recommendations provided by the dealer firm? Do I have to pay for these services?
9. If I have bought a CFD on an underlying share, can I sell the CFD when the underlying is suspended?
10. When and how is the price and number of units specified in the CFD adjusted?
11. Does the CFD have an expiry date? If so, when? What if I wish to continue with the CFD after the expiry date?
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This information is provided by Securities Association of Singapore and Monetary Authority of Singapore as part of the MoneySENSE national financial education programme.
