CFDs, Contracts For Difference

Contracts For Difference are professional level investment tools that are also available to retail customers.

They offer chances of profits 5-10 times what you could achieve using just your own money, but also losses on the same scale.

Getting Into CFDs By Accident

Whilst researching which share dealing service you wish to use you will probably run into offers of CFDs, Contracts For Difference.

These are often portrayed as the source of massive wealth along with a disclaimer which reads something like:

CFDs are leveraged products and can result in losses that exceed deposits.

Even though I regard myself as a well informed retail trader CFDs scare the hell out of me.

Even the FCA had concerns We have serious concerns that an increasing number of retail clients are trading in CFD products without an adequate understanding of the risks involved, and as a result can incur rapid, large and unexpected losses. and acted upon them.


What Are CFDS?

These sort of warning makes CFDs very interesting, what is it that can be offered but carry such warnings?

CFDs are legally binding contracts where you agree a pricing method for a Contract Unit (CU) and then "purchase" a specified number of CUs.

The pricing method is usually the public price with a few fudge factors such as a buy and sell spread.

A Contract Unit can be a share, a commodity or an index, I refer to them as Contract Units as you are not buying, and in many cases such as a index can not buy, the underlying item.

When you exit the contract you are owed or owe the difference between the "entry" and the "exit" prices.

The typical duration of a CFD will be for a day or a few days they are never medium or long term investments and 4-10 weeks is normally quoted as the upper limit. One provider did some research and apparently in the UK the average is 3 days but in Singapore it is 25 days.

You never own anything except a contractual obligation.

So far so good, I get it, I have got a possible profit or loss but don't actually own anything, so what's the point? I can buy shares directly or invest in funds that track indexes or commodities.

If you are asking this then you are on the first step in understanding the danger.

For most retail investors there would be no point but for very serious short term traders CFDs are a useful tool in reducing possible losses.

To make them attractive to retail investors CFDs are nearly always offered with Leverage, this is another way of saying they will lend you "money" to buy shares etc..

Because there are no assets actually being bought Leverage (credit) allows the CFD platform to offer to sell you more than you have the money for.

Just how many more depends upon how much risk they want to take and more recently what the regulators will allow.

Typically you may be able to buy 5-20 times the number of CUs than you could buy if you were actually buying the underlying object.


Danger Will Robinson - Are CFds Risky?

There are three big risks that many people new to CFD may not realise.

  1. You always need to have enough money in your account to cover the loss if the contract closed now, I mean right now, not tomorrow or 8 hours in the future, it does not matter that you do not want to close the contract now.

    Some providers might offer a grace period, a small amount of time for you to add funds to your account, but if they do it will be for a very short period of time something like 15-60 minutes, certainly not days.

    Repeating the point; If you don't have these funds then the CFD automatically closes.

  2. Contracts have financing costs if they are over one day long.

  3. Many CFDs simulate dividends, so you may receive or have to pay dividends if your CFD covers a time period where the real share pays a dividend.


CFDs - What Is Leverage?

Leverage is betting using credit.

There are lots of other ways of explaining it, but this is the core truth.

CFD Leverage Example

Imagine that you have £10,000 to invest in a company whose share price is £1.00 at the time of purchase and you sell for £1.50.

Ignoring stamp duty and trading fees your money would buy 10,000 shares which you could then sell them for £15,000 or a £5k/50% profit.

A bank or other organisation could lend you £40K and then you could buy 50,000 shares and make a £25k profit.

Unfortunately there is almost no chance of getting such a loan and of course the shares may go down by 50% losing you £25K.

CFDs and leverage are a way of solving this problem, as you are not actually buying shares it is possible to "lend" you imaginary money to buy those 50k shares.

The table below shows some examples.

Leverage Number Of Shares "bought" Buy Price Sell Price Profit/Loss
None 10,000 £10,000 £15,000 £5,000/£5,000
2 Times 20,000 £20,000 £30,000 £10,000/£10,000
5 Times 50,000 £50,000 £75,000 £25,000/£25,000
10 Times 100,000 £100,000 £150,000 £50,000/£50,000
20 Times 200,000 £200,000 £300,000 £100,000/£100,000


Depending upon your stomach and the T&Cs you can see that Leverage can offer a very nice profit when things go well.

Of course if things go badly and you sell at £0.50 the profit column becomes a loss. With no leverage it is bad you have lost £5K but with 10 times Leverage you would have to find £50K to pay of the loss.

Up until recently for most people this could mean selling the house or even bankruptcy as CFD losses are believed to be enforceable.

Regulatory changes in 2018/2019 are supposed to restrict the loss to the total funds in CFD account. Note that this is not as good as it sounds, in practice it means that as soon as the share drops to the level that your £10k is not enough to cover the loss the position will be closed.

Remember that with CFDs there is no or little grace period to see if the share recovers, your £50k purchase suffers a 20% drop on bad news and then recovers within a few hours could easily see your £10k gone.

During late 2018 new rules were brought in that restricted leverage on equities, prior to this I seem to remember seeing leverage as high as 40 times.





Another Reminder Of The Danger

Margin Calls, all CFD providers know that getting money owed to them and in excess of the amount already deposited will either be a problem or not allowed.

So when an open position starts to lose money the provider will ask you to deposit enough in your account to cover current loses and if you don't they will close your position forcing the paper loss into an actual real money loss.

Generally these margin calls have to be satisfied with minutes, maybe an hour.

This is unlike owning a share when you can just choose to wait for the share to naturally recover.

This alone negates many of the advantages of leverage, you need enough spare money to cover an unexpected big drop.

Time to stress the point again, CFDs are just contracts between two parties, you never own anything and you are the more inexperienced party.

The CFD you enter into is a standard contract drawn up by a company specialising in CFDs with experienced lawyers, do you really understand what you have signed up to?

Although not a great risk the collapse of the CFD provider is possible, do an Internet search for alpari swiss franc administration.

As you are not buying anything with CFDs you need to understand what protection, if any is offered by compensation schemes and insurances.


CFD Interest Costs

Having just said that CFDs don't involve an actual purchase of anything you might be surprised to find that you might be paying interest on your loan.

CFD Interest And Buy/Sell Fees

When purchasing a CFD you will run into two costs, buy and sell fees and interest on the amount notionally borrowed.

You are likely to find that instead of the fixed fee of say £10 to buy or a sell shares that you have with a normal share purchase, the buy and sell fee will be a percentage of the purchase price. Typically something like 0.1% which for a £100,000 purchase works out as £100!

Although this is all paper transactions and promises and you haven't actually bought anything you will probably be charged interest on the whole of the purchase price, not just the amount that you have borrowed if you keep a position open over night.

To calculate this interest I have used a slightly simplified version of calculation that the IG platform detailed in their help page.

This is number of shares times their price times a daily interest rate. This is actually a bit worse than it sounds as you pay interest on the shares that you did provide the funds for and the amount that you are paying interest on is not the purchase price but the current valuation.

One plus is that as there is no actual purchase of assets there is no stamp duty due.

So instead of paying stamp duty at 0.5% on the purchase plus small fixed buy and sell fees, you pay 0.1% on purchase and then 0.1% on sale and then interest on the borrowed amount.

Given that you are probably paying interest over the weekends on open positions the savings on Stamp Duty can be wiped out pretty quickly.

As the stamp duty on a £10K purchase is £50 and looking at the table below we see that saving disappears within a month or two.

Remember that the interest is payable regardless of whether you make a profit or loss.

There is a table breaking this down further but these details can't be reasonably displayed on a screen of this size.


Number Of Shares "bought" Annual Interest Rate 1 Months Interest 2 Months Interest 3 Months Interest 4 Months Interest 5 Months Interest 6 Months Interest 12 Months Interest
10,000 3.50 £29 £57.53 £86 £115.07 £144 £173 £345
20,000 3.50 £58 £115.07 £173 £230.14 £288 £345 £690
50,000 3.50 £144 £287.67 £432 £575.34 £719 £863 £1,726
100,000 3.50 £288 £575.34 £863 £1,150.68 £1,438 £1,726 £3,452
200,000 3.50 £575 £1,150.68 £1,726 £2,301.37 £2,877 £3,452 £6,904
10,000 6.00 £49 £98.63 £148 £197.26 £247 £296 £592
20,000 6.00 £99 £197.26 £296 £394.52 £493 £592 £1,184
50,000 6.00 £247 £493.15 £740 £986.30 £1,233 £1,479 £2,959
100,000 6.00 £493 £986.30 £1,479 £1,972.60 £2,466 £2,959 £5,918
200,000 6.00 £986 £1,972.60 £2,959 £3,945.21 £4,932 £5,918 £11,836


The amounts of money charged as interest does look quite small, but don't forget the leverage.

If we are sticking with the 10 times leverage the 10,000 shares column interest costs for 12 months of £342 or £592 need to be considered against the real £1,000 invested.

It is probably easy to see how positions can be kept open in the hope of gains that pay off the interest, and just how quickly the interest and leveraged loss turns a 5% loss into a total loss of funds.


Another Reminder Of The Danger

Margin Calls, all CFD providers know that getting money owed to them and in excess of the amount already deposited will either be a problem or not allowed.

So when an open position starts to lose money the provider will ask you to deposit enough in your account to cover current loses and if you don't they will close your position forcing the paper loss into an actual real money loss.

Generally these margin calls have to be satisfied with minutes, maybe an hour.

This is unlike owning a share when you can just choose to wait for the share to naturally recover.

This alone negates many of the advantages of leverage, you need enough spare money to cover an unexpected big drop. Time to stress the point again, CFDs are just contracts between two parties, you never own anything and you are the more inexperienced party.

The CFD you enter into is a standard contract drawn up by a company specialising in CFDs with experienced lawyers, do you really understand what you have signed up to?

Although not a great risk the collapse of the CFD provider is possible, do an Internet search for alpari swiss franc administration.

As you are not buying anything CFDs supplied by FCA regulated firms are covered by FSCS compensation scheme, the limit for investments is £85K.


CFDs - FCA Regulation

The regulators have stepped in and reduced the levels of leverage offered to retail customers.

They have also tried to protect the retail customer by restricting losses to the amount in the client's account.

Summary

The UK regulatory authority the FCA (Financial Conduct Authority) and the ESMA (European Securities and Markets Authority) have been looking at CFDs and Binary Options (Up/Down bets) for a while now.

Over the last year or so new rules have been introduced and the main players in the market are starting to file their trading updates for the periods affected by them.

The biggest change from my perspective is the limit of 5 times leverage on equities.

The general theme is a big drop in use of CFDs by retail client, these drops ranging from a 30% to a 65% drop in revenue.


FCA/ECMA Regulation - The Steps.

Dec 2016 - The UK's FCA says
We have serious concerns that an increasing number of retail clients are trading in CFD products without an adequate understanding of the risks involved, and as a result can incur rapid, large and unexpected losses.

Aug 2018 - ESMA Introduces temporary rules,
The main points being
  1. Leverage limits on the opening of a position by a retail client from 30:1 to 2:1, which vary according to the volatility of the underlying:
    1. 30:1 for major currency pairs;
    2. 20:1 for non-major currency pairs, gold and major indices;
    3. 10:1 for commodities other than gold and non-major equity indices;
    4. 5:1 for individual equities and other reference values;
    5. 2:1 for cryptocurrencies;

  2. A margin close out rule on a per account basis. This will standardise the percentage of margin (at 50% of minimum required margin) at which providers are required to close out one or more retail client’s open CFDs;
  3. Negative balance protection on a per account basis. This will provide an overall guaranteed limit on retail client losses;
  4. A restriction on the incentives offered to trade CFDs;
  5. A standardised risk warning, including the percentage of losses on a CFD provider’s retail investor accounts.
Dec 2018 - FCA
Issued discussion document on making the rules defined by the ESMA permanent in the UK but broaden the definition of CFDs to catch products that are similar such as Turbo Certificates.

Feb 2019 - ESMA
The temporary rules shown above are renewed for another three months.


CFD Regulation - The Consequences.

The restrictions imposed on retail clients have been in force long enough for their affects to be start being seen.

Mar 2019 - IG Group (IGG)
Reports for the 3 months up to end of Feb 2019 show a drop of from $278 million to $202 million or about 27% over the same period in 2018.

Apr 2019 - CMC Markets (CMCX)
Reports an expected drop for the whole of 2018-2019 of around 37% to £110 million for both CFD and spread betting.

Apr 2019 - Plus 500 (PLUS)
Reports for the 3 months up to end of Mar 2019 show a drop of from $298 million to $54 million or about 65% over the same period in 2018.

All three providers mentioned here have seen significant drops in CFD revenues and the one affected the most, Plus 500, is the one that in my experience has been the most aggressive in its marketing of CFDs to new customers.


CFD Regulation - Professional Trader.
Retail Clients can be exempted from these restrictions by contacting their CFD provider and asking to be treated as a Professional Investor.

During Q3 IGG reported 1,425 Retail clients applied to be classified as Professional but only 14% of these applications were accepted as the requirement for Professional Status are quite stringent.

These standards are the same across providers and you need to meet two of them.
  • Sufficient trading activity in last 12 months - You have performed an average of at least 10 transactions per quarter, of significant size, over the previous four quarters on the relevant market.

  • Financial instrument portfolio of over €500,000 - The size of your financial instrument portfolio exceeds €500,000.

  • Relevant experience in the financial services sector - You work/have worked in the financial sector, for at least one year in a professional position which requires knowledge of the related transactions or services.
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