by Patrick Oberhaensli, on Nov 18, 2019 4:45:00 PM
Introduction
In this article, we will have a detailed discussion regarding one of the most common instruments on trading platforms, Contracts For Difference or CFDs. We will again start with the definition and an overview of the main characteristics of the CFDs which are not Exchange Traded Derivatives, followed by a comparative analysis with futures.
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What are CFDs?
CFDs are a derivative which simply allows the investor to gain very-close-to-identical exposure to the underlying market. In this case, the value (itself) is very similar to the cash market value - without having to own the (related) cash instrument when looking to go long or to sell it short when looking to go… short.
While CFDs, as with any derivative, derives its price from the underlying instrument but has no expiration, its liquidity is a function of the broker’s capacity and willingness. As for futures, the process is more extensive as it requires administrative tasks to be completed in order to start trading and there is a margin process, meaning a small(er) amount of money is needed in order to enter (the initial margin) and maintain (the maintenance margin) a position. In other words, CFDs allow the investor to leverage and, depending on the underlying, even to leverage a large amount. Let’s now take a detailed look at the main characteristics of CFDs.
The Main Characteristics of CFDs
The table below shows the main characteristics of CFDs independently from where (the specific broker) they are traded.
|
Characteristic |
Definition |
|
Format |
“Standardized” instruments |
|
Trading |
Over-The-Counter (OTC) and therefore not as Exchange Traded Derivatives (ETDs). The broker being the investor’s counterparty. |
|
Sectors |
In particular equity indices, (credit risk “free”) interest rates with short- & (very) long-term maturity, Foreign Exchange (FX) & commodities but with a larger offering. |
|
Retailization |
Very advanced and key for the CFDs success: it means that the minimum investment is (very) small. |
|
Clearing |
Via the broker. The credit risk is related to the broker used. |
|
Liquidity |
Often (very) high but it is a function of the underlying instrument and the broker. |
|
Direct transaction costs |
There is a quite larger bid-ask spread (when compared to futures) but typically no additional fees at transaction time. |
|
Risk control of the investor positions |
Via the broker’s own margining process, the initial margin depends on the underlying instrument. Margin requirements typically change quickly at the discretion of the broker. |
|
Settlement with potential fees |
Only financial settlement takes place. For an overnight position there are (financing) fees for a long position and potentially for a short position as well! Even though there should be a short position advantage for the investor. |
|
Passive investment |
As CFDs have no expiration, there is also no need for rolling the position in order to remain exposed but as mentioned, daily financing fees are charged which makes holding a position longer (very) expensive. In other words, it needs to be verified in advance (what interest rates are applied) |
|
Particular trading possibilities |
For example, some brokers may provide guaranteed limited stop-loss orders- This comes at a cost. |
|
Taxation |
Will vary with domicile and citizenship and the use of the CFDs. It needs to be individually checked |
|
Sensitivities |
The Delta (change in the CFD value for a change in its underlying) is in absolute essentially very close to 1. A short position in a CFD has a negative Delta. There is no Vega as the CFDs have no sensitivity to volatility but the margin is very likely a function of the volatility: more margin required if the volatility increases – at the broker’s discretion |
The broker is responsible for publishing on the trading platform / website the terms and conditions of the CFDs which allows the investors/traders to comprehensively understand what the particular CFDs represent. In addition, it provides transparency about the trading conditions and trading possibilities/constraints and how they are risk-controlled (before trading it).
Now, let’s discuss in more details the comparison between CFDs and futures.
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CFDs vs. Futures
CFDs provide very similar exposures when compared to futures but given the larger palette of underlying instruments and the very low minimum investment needed, CFDs are much more retail driven. Nevertheless, one must be careful of the bid-ask spread which is larger when compared to futures. And above all, investors should be aware of the high financing costs equaling several percentages (per annum) that affect non-intra day short- and long term trading respectively.
Conclusion
CFDs are in fact complementary to futures in terms of the retailization and the extension of the offering related to the new underlyings. But it is essential that the investor studies in detail the terms and conditions of his/her broker as they do vary (significantly) from one broker to the other. However, one key factor to consider is the transaction costs for strategies that require overnight positions. Because in this case, they may quickly accumulate and therefore a comparative analysis is necessary beforehand.
Written by: EVOLIDS FINANCE LLC, Disclaimer:
- This content is not intended to be a solicitation nor an offer
- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible
