Contracts for difference (CFDs) are similar to shares and share indices -
with the added benefit of leverage. CFDs are based on shares and share indices.
Whereas shares are actual certificates that show ownership in a company, CFDs are
simply contracts between two parties (you and your dealer, in most cases) that
designate how much money you will make, or owe, depending on where the price of
the underlying share or share index moves.
Whereas there are a limited number of shares available for each company, there
are no such limits on CFDs. Companies don't issue CFDs or determine how many are
available - traders do. As long as there are traders willing to buy or sell CFDs
and dealers or others willing to take the opposite side of the trade, there is
virtually no limit to the number of CFDs you can trade on each share or share index
CFDs and shares are like people and hot-air balloons. A person alone cannot fly.
A hot-air balloon, on the other hand, can fly by itself. However, when you put a person
inside a hot-air balloon, she can fly with the hot-air balloon. As the balloon floats
higher, the person inside the balloon also floats higher. As the balloon floats lower,
the person inside the balloon also floats lower.
CFDs and shares work in much the same way. A CFD by itself cannot move up or down in
price. A share, on the other hand, can move up or down in price all by itself. However,
when you attach a CFD to a share it can move up or down with the price of the share.
As the share price moves higher, the value of the CFD also moves. As the share price
moves lower, the value of the CFD also moves.
Every CFD has a specific underlying share or share index on which it is based.
For instance if you trade a CFD for the Nikkei 225 Index (an index of Japanese
shares that trade on the Tokyo Stock Exchange) the performance of your CFD is
going to be based on the price performance of the Nikkei 225. If you buy the Nikkei
225 CFD and the price of the Nikkei 225 moves higher then the value of your CFD
will also move higher. Conversely if you sell the Nikkei 225 CFD and the price
of the Nikkei 225 moves lower then the value of your CFD will also move higher.
The following table illustrates what will happen to the value of your CFDs
based on whether you bought or sold the CFD to enter your trade and the price movement of the underlying asset:
| |
Underlying Asset Price Goes DOWN |
Underlying Asset Price Goes UP |
| Buy a CFD |
Lose Money |
Make Money |
| Sell a CFD |
Make Money |
Lose Money |
CFD values fluctuate from day to day as the price of the underlying asset
moves up and down. Your job as a share trader is to determine which direction
you believe the underlying asset is going to move so you can place your CFD
trades accordingly. You will learn more about how to analyse these underlying
assets and project where the price is going to move in the future in later sections.
Along with being quite easy to trade, CFDs also enjoy another tremendous advantage over shares: leverage.
Leverage
CFDs have the added benefit of leverage. Leverage is probably the one
characteristic of CFDs that intrigues individual investors the most. Leverage
is the ability to convert a small amount of power into a larger amount through
the use of a tool. Imagine you are asked to move a large boulder from the spot
where it is currently resting. You could certainly try to push and move the boulder
with your bare hands, but your job will be much easier if you can use a tool -
such as a large pole - that you can place under the boulder to give you some leverage.
The same principle holds true when you are trading CFDs. You can make money
by investing just your own money, but you can make much more money if you can
use the tool of financial leverage by borrowing money from your dealer.
You can lever, or increase the investing power of, your CFD accounts by using
some of your own money to enter a trade and then borrowing the rest from your
dealer. For example, you can buy or sell a CFD on some heavily-traded shares
and indices using as little as 10 percent of your own money. You can borrow
the remaining 90 percent of the purchase price from your dealer.
The leverage you enjoy when trading CFDs is determined by the margin you
are required to post for each trade.
Margin
The CFD market is an exciting market because your dealer is willing
to lend you money so you increase your profit-generating potential in
all of your trades. Before your dealer lets you borrow money, however,
you have to show that you have some money to cover any losses you may
incur. Margin is the money you set aside with your dealer for safe keeping
to prove that you are able to cover your losses.
For example if you buy the Exxon Mobil CFD you will be required to set
aside 10 percent of the share price as margin. That means if the share price
is $90, you will be required to set aside the equivalent of $9 to
prove to your dealer that you can cover losses of at least $9 (a 10% loss) should your trade move against you.
Different CFDs have different margin requirements. CFDs covering
shares and indices that are actively traded have lower margin
requirements because their high levels of liquidity make it easier
to enter and exit your trades quickly - which gives your dealer added
confidence he will be able to close out your positions without incurring
unexpected losses. CFDs covering shares and indices that are not actively
traded have higher margin requirements because their low levels of
liquidity make it harder to enter and exit trades quickly.
Many novice CFD traders are often confused into thinking that the money
they set aside as margin actually goes toward purchasing shares or indices.
It does not. You borrow 100% of the purchase price from your dealer. Your
margin only shows your dealer you have money to cover any losses that you may incur.
CFD Financing credit/debit rates
As CFDs are a margined product, you finance the traded value through
an overnight credit/debit charge. Consider this as the price you pay
for access to the generous flexibility in lending that your dealer
provides you when you trade on margin. When you hold a CFD overnight
(i.e. you have an open CFD position at close of market, which is 17.00
New York time), your CFD position will be subject to the following credit or debit:
- When you hold a long CFD position overnight you pay interest,
meaning that you are subject to a debit calculated on the basis of
the relevant Inter-Bank Offer Rate for the currency in which the
underlying share is traded (e.g. LIBOR) plus a mark-up (times Actual
Days/360 or Actual Days/365).
- When you hold a short CFD position you receive interest, meaning
that you receive a credit calculated on the basis of the relevant
Inter-Bank Bid Rate for the currency in which the underlying share
is traded (e.g. LIBID) minus a mark-down (times Actual Days/360 or Actual Days/365).*
The credit/debit is calculated on the total nominal value of the
underlying share(s) at the time the CFD contract is established (whether long or short).
If you open and close a CFD position within one trading day you
are not subject to these credits/debits.
___________
* Please note that, depending on the jurisdiction of your account, you may not receive interest on short CFD positions.
CFD Traders
CFD traders who want to buy or sell a CFD also submit their
orders to Saxo, and Saxo takes care of the rest. With CFDs, however,
Saxo can fulfil your orders in one of two ways - by sending the order
to a centralized CFD exchange, or by acting as the counterparty to the trade.
When you submit an order for a CFD that trades on a centralized
exchange, Saxo will handle your order the same way it handles a share order. The following outlines the complete process:
- You submit an order to Saxo
- Saxo submits the order to the appropriate stock exchange
- The exchange fills the order by matching it with another order
- The exchange sends a confirmation to Saxo that the order has been filled
- Saxo updates the order in your account
When you submit an order for a CFD that does not trade on a centralized
exchange but will be fulfilled by Saxo instead, the order process is
slightly different. The following outlines the complete process:
- You submit an order to Saxo
- Saxo fills the order
- Saxo updates the order in your account
Regardless of which type of CFD you are buying or selling, the
entire process - just as with share trading - happens within a matter of seconds.
Short Selling CFDs
When short selling a CFD directly on an exchange (that Saxo
does not market-make), you will be affected by the rules for the
share market in that country. For example when trading Australian
CFDs you may experience limitations on the volume of CFDs you can
short trade in a single day due to limited borrowing availability in the underlying market.
You can also experience forced closure of a position if your
CFDs get recalled. The risk is particularly high if the share
becomes hard to borrow due to takeovers, dividends, rights offerings
(and other merger and acquisition activities), or due to increased hedge fund selling of the share.