Understanding contracts for difference

Signing contract

29 Oct 2018 | 9 min. read

Find out how a contract for difference (CFD) works and things to look out for if you plan to trade

Key takeaways

  • You are exposed to the risk of the asset that the CFD is based on e.g. shares, currencies or commodities.
  • As a CFD buyer, you do not own the underlying asset.
  • A CFD is a Specified Investment Product.You need to complete a Customer Knowledge Assessment (CKA) before you can open a CFD account and begin trading.

What it is

A contract for difference (CFD) allows you to speculate on the future market movements of the underlying asset, without actually owning or taking physical delivery of the underlying asset.

CFDs are leveraged instruments. They tend to be traded over-the-counter with a securities firm, known as a CFD provider. A CFD is a Specified Investment Product (SIP).

CFDs are available for a range of underlying assets, e.g. shares, commodities and foreign exchange. In this guide, examples showing how they work will refer to shares as the underlying asset class.

How it works

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.

Holding a long position

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

Holding a short position

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.

Returns and losses

The CFD captures the price difference of the underlying asset between the opening trade and the closing-out trade.

What's the most you can lose?

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.

Note that:

  • 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

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 are the risks?

Common risks associated with CFDs include the following:

Market risk
  • You are taking a position on the future direction of the price of an underlying asset but your view turns out to be wrong.
  • 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. Check with your CFD provider if this is available to you. However, these measures may not be guaranteed, which means that the closing out price may be more unfavourable than indicated in the stop loss order.
Counterparty risk
  • The CFD provider may fail to meet a payment obligation due to you, e.g. if they become insolvent.
  • You don't have rights to the underlying assets as you have not actually bought them.
Foreign exchange risk
  • You face foreign exchange 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 foreign exchange risk if the currency is different from your own base currency.

Things to note

CFDs have certain features that you should take note of:

Trading prerequisites

In Singapore, CFDs are unlisted Specified Investment Products (SIP), so you need to complete a Customer Knowledge Assessment (CKA) before you can open a CFD account and begin trading.

You 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 20%, as 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 and Millie intends to buy 2,000 shares of XYZ Ltd as a CFD at the offer price of $2.

Assuming the CFD provider sets the margin of the CFD at 10%, the initial margin Millie puts up will be 10% x $2 x 2,000 = $400.

Millie will be able to open the position with $400 versus a payment of $4,000 for the underlying shares.

Leverage magnifies profits and losses

The leveraging effect means that if the markets move in favour of or against Millie’s position, her respective profits or losses will be magnified. Here are some examples of how leverage impacts Millie’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. Millie then decides to sell her CFD at $2.05:

  • She 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 she had invested directly in the underlying shares.

Millie will receive from the CFD provider $100, less any financing, transaction costs and commissions due from her.

Example 3: Example of a loss

Conversely, if the market moves against Millie’s position and the shares of XYZ Ltd are quoted at $1.95, Millie may choose to sell her shares at $1.95 to avoid incurring further loss:

  • She will incur a loss of $100 [($ 1.95 - $2.00) x 2000] from trading the CFD.
  • The ROI for investing in the CFD would be -25% (-100 ÷ 400), as compared to an ROI of -2.5% (-100 ÷ 4,000) if she had invested directly in the underlying shares.

However, Millie will end up paying more than $100 to the CFD provider, once financing, transaction costs and commissions are factored in.

In the worst case scenario, the shares of XYZ Ltd become worthless.

  • Millie will lose the full contract value of S$4,000 [(S$0 - S$2.00) X 2,000], similar to purchasing 2,000 shares at S$2 per share and losing the entire initial investment.
  • Millie will also be liable for additional charges, costs and fees incurred.

Margins can be called at short notice

At any time that the markets move against your open position, the CFD provider will require you to top up your margin with additional funds to cover your losses. This is known as a margin call.

In the above Example 3, if Millie intends to keep the position open, the $100 loss will be deducted from the initial margin and she will be required to top up her margin 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 1 day or as required by the CFD provider).

If you can't meet a margin call

If you can't meet a margin call within the required timeframe, the CFD provider can close your position without notifying you. The price at which your CFD is closed out will depend on the available price of the underlying share or asset at that point in time.

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.
  • Monitor your account closely to ensure that you deal with any margin calls promptly.

Risks of short selling

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 4: Short selling a CFD

Suppose Millie expects the shares of XYZ Ltd, quoted at $2, to fall. She can sell 2,000 shares at $2, as a CFD. The initial outlay to open the position will be $400 (10% x $2 x 2,000).

After 7 days, the shares of XYZ Ltd are quoted at $1.95:

  • Millie decides to close the position by buying 2,000 shares at $1.95 as a CFD.
  • The profit made will be $100 [2,000 x ($2 - $1.95)] or 25% ROI, although the actual amount received will be less once transaction and other costs are deducted.

However, here's what would happen if her view was wrong and the price had moved up instead:

If price rises Loss incurred What this means
By $0.05 $100 or –25% ROI The amount she has to pay the CFD provider will be $100 plus transaction and other costs
By $0.20 $400 [2,000 x ($2 - $2.20)] or -100% ROI She loses her entire initial investment of $400
Beyond $2.20 Further losses beyond initial investment She faces unlimited losses in this scenario.

Costs of trading CFDs

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. There could be a minimum commission per transaction. 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.
  • The commission is subjected to Goods and Services Tax (GST).
  • 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: Commission and GST charges

Suppose XYZ Ltd is quoted at $2 and Millie intends to buy 2,000 shares of XYZ Ltd as a CFD at $2. The commission, assuming a rate of 0.5% and no minimum commission, is $2 x 2,000 x 0.5% = $20.

GST (at 7% of $20) of $1.40 will be levied.

Example 6: Financing charges

If Millie holds 2,000 shares as a CFD overnight, she 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, the daily interest charge will be ($4,000 x 5% / 360 days) = $0.56.

When a CFD expires

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.

Note

Do be vigilant about monitoring open positions where there is no expiry date.

Your rights in corporate actions

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.

Checklist

Key questions to ask before trading CFDs

CFDs carry a higher level of risk because of their speculative and leveraged nature. Before you decide to trade CFDs, ask yourself the following:

Do you fully understand how CFDs work?

  • How is the derivative contract quoted? Can the trade be executed at a price that is different from my order price?
  • Does the CFD have an expiry date? If so, when? What if you wish to continue with the CFD after the expiry date?
  • What are the costs you have to pay? What margin, commission, transaction and financing charges are there? When are margin calls made?
  • Where are the margins and deposits that you have placed with the CFD provider kept and maintained? Will you be able to get back your margins and deposits if the CFD provider becomes insolvent? How long will the recovery of your monies take?

Do you fully understand the risks of investing in CFDs?

  • What is the maximum you can lose and how will this affect your financial plans? Losses can be much higher than the initial margin invested. If you are short selling, it may lead to unlimited losses.

Do you know what to watch out for when trading CFDs?

  • Do you have the time to monitor the underlying shares or index?
  • How do you limit losses?
    • Can you place stop loss and limit orders? How much do they cost?
    • If you place a stop-loss order, are you assured of the price that you set the stop-loss at?
  • What happens when a margin call is made?
    • What if you fail to meet a margin call? Can the company close your position?
  • As a buyer in a CFD, do you have rights in the underlying shares or index?
    • What if trading in the underlying asset is suspended or halted? Can you sell the CFD? How can you exit your position, and will you suffer losses?
  • Is the CFD provider authorised or licensed to deal in CFDs? Do check the MAS' Financial Institutions Directory for whether the firm has the requisite authorisation or licence.

Last updated on 07 Nov 2018