Share Trading - CFDs, Contracts For Difference

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 up them.

What Are CFDs?

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. IG Group 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, so in order to be able to sell CFDs the platform will offer Leverage, this is another way of saying will 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 share.

Danger Will Robinson

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

  1. You always need to have enough money in you 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.

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

  2. Contracts have financing costs if the 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.

What Is Leverage?

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.

Actually buying the share would mean that you owned 10,000 shares.

As a CFD doesn't involve you actually buying the shares your CFD provider will offer to sell you more than you can afford.

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.

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.

Interest Costs

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 be charged interest on the whole of the purchase price, 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 details 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 fund 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 levarage 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.