Contract For Difference (CFD)
Contract for Difference (CFD) is a financial instrument that has been gaining popularity in Asia over the last few years. Conceived in the early 80's and termed an 'equity swap', CFDs are an agreement between the buyer and the seller that the seller will pay the buyer any difference between the value of the asset at the time of entering into the contract and the value at the end of the contract. (Or receive money if the difference is negative.) This may sound misleading when in fact the CFDs are marked to market every day and they don't have a fixed expiration like an option.
There is no time value or volatility premium in a CFD. It is simply a one for one equity swap. You don't deliver the underlying and like any share is only settled in cash when you are ready to flatten your position. Also, like the equity swap the CFDs are OTC which means the contracts can be tailored to an individuals needs and they also avoid the exchange fees too. Of course, selling may be difficult if you can't find a seller for your custom CFD.
If you can't price a CFD like an option or deliver (or receive) the underlying instrument the CFD is based on what's the point of trading CFDs? One of the strengths of CFD trading is that you can trade on margin (why it has gained popularity with retail investors) and use very little money to get started. Singapore Exchange allows 1:20 gearing for example.
One of the other advantages to investors is the ability to enjoy downward moving markets emulating a short position. Of course, they aren't actually short as there has been nothing borrowed. The brokerage community likes the prospects of the CFD business. They earn commission from trades, financing charges are paid to them and due to the daily marking to market default risk is minimized.
In fact, CFDs are so popular amongst the brokerage community that the Australian Stock Exchange is getting into the game by listing exchange traded CFDs. Further diversifying their product offering and earning the exchange fee for each trade too. The launch date for ASX CFDs has yet to be determined but is widely expected to begin November 2007.
As I mentioned before CFDs are marginable. With all margin trading there are two types of margin; variable and initial margin. Here's an example. Variable margin is commonly set at a specific percentage with stocks however with CFDs and marking-to-market a fixed percentage is not necessary.
For example, if a CFD trader bought 100 shares of DBS Holdings using CFDs at S$100 and the price moved down to S$90 the broker would decrease the account by S$1000 in variable margin (100 shares x S$10). Of course conversely, if the share price moved up to S$110 the broker would credit the CFD traders account by S$1000 in positive variable margin. Generally, at the end of the day but are able to increase this without notice to intra-day if markets are volatile.
Initial margin on the other hand is always debited from a client account up front and credited after the trade is flattened. In this case the buyer would have only had to put up 5% of S$100 x 100 or S$500 and borrow the remaining S$9500. You can see why the brokerage community is happy to finance AND earn a commission on these products too. Again citing the sample above if DBS rose S$10 and the customer sold they would earn S$1000 (S$11,000 - S$10,000) from a S$500 investment or 200%. Minus, of course, brokerage and financing. Not bad for your average punter.
Who knows maybe this product will be over exploited and cause a global financial crisis too.
Visit AsiaStockTips.com forum to learn more about CFDs
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