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CONTRACTS FOR DIFFERENCE (CFDs)

CFDs are a derivative instrument of sorts, with their value being derived from the underlying instrument that any given contract represents. As such, when the contracts entered into relate to certain stocks, they can be referred to as a type of equity derivative.

A CFD is a contract, or agreement, entered into by two parties to exchange the difference between the entry price and the exit price of a given contract (hence the name contract for difference). If you want to invest in a particular stock because you believe it is going to go up, you can buy CFDs in that stock, whereby you are essentially entering into a contract with a CFD provider. The same applies if you want to short a particular stock as you believe it is going to fall, the only difference being that you sell CFDs in that stock rather than buy them.

Unlike shares, there isn’t another investor as such on the other side of the trade. It is essentially you placing a bet on the direction of a stock, and the CFD provider is the party taking the bet. The CFD provider may then choose to hedge their position by taking the same position in the physical market (ASX).

It is important to understand that when trading CFDs, you are at no time buying or owning actual shares. CFD trading can be thought of as a kind of virtual trading. And so there is essentially a CFD marketplace (provided by your CFD provider) that mirrors the ASX exactly; hence, stocks in this virtual market move identically to stocks on the physical market. And when you buy CFDs, you are buying virtual shares essentially, meaning you don’t have the rights that an ordinary shareholder would have (e.g. voting rights etc). Whilst your account is credited the equivalent amount of a dividend if a stock goes ex dividend whilst you are long (you bought) a CFD, you do not receive franking credits.

So how does all this differ from buying and selling shares on the ASX? The major difference, and the big reason behind CFDs’ popularity, is leverage (being a form of derivative, this is logical). CFDs operate on margin, which means the following. If a given CFD provider has a 10% margin requirement for TLS, this means that you need to put 10% down (effectively as a margin deposit) of the amount you want to invest. So if you want to buy $10,000 worth of TLS, using CFDs, you only require $1000 to make that purchase.

Other benefits of CFDs include slightly cheaper brokerage than ASX trading and the ease with which one can short sell. Short selling in the physical market is not as flexible, in that fewer stocks can be shorted and not all brokers offer such a service. In terms of brokerage, obviously this varies with CFD providers, but trades can be executed for as little as $10.

So should one use CFDs? That’s a difficult question. Obviously they have their place and suit some people, but on the whole, one should be wary of recommending services to beginner/intermediate investors that operate on margin. Whilst the ability to gain a large exposure with a minimal investment does increase the potential return, so too it increases the potential risk. When a position moves against you and margin calls are made by the CFD provider, things can get nerve-wracking. If you do not fully understand the high-risk nature of leveraged positions, you should avoid using debt and debt instruments such as CFDs.

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