Contracts for Difference or CFDs were originally stgeloped in the United Kingdom in the early 1990’s by Smith New Court, a London based trading firm. CFDs were mainly used by the firm’s hedge fund clients to short sell using the benefits of leverage and also to take advantage of the stamp duty exemptions, which were not available on share transactions.
In the late 1990’s,CFDs were introduced to the private client and retail market by Gerrard and National Intercommodities via its on-line trading arm GNI Touch. Individuals trading their own accounts and small fund managers were now able to trade directly into the London Stock Exchange for the first time. These clients were now on a level playing field with large institutions. They could take leverage long and short positions without having to take delivery of the underlying shares.
Now CFDs are one of the UK’s fastest growing products with estimates that CFD transactions account for about 33% of all trades on the London Stock Exchange.
CFDs were introduced to Australia in 2002 and their growth has been phenomenal. They are now about 20 CFD promoters in the market. However, the main providers are E*Trade, CommSec, Macquarie Bank, IG Markets, City Index, First Prudential and CMC Markets.
CFDs, a derivative product, are available on numerous instruments including equities (the most popular), stock indices, foreign exchange and commodities.
They are called contracts for difference because they are an agreement between two parties to exchange the difference between the entry and exit price of a contract over an underlying instrument, without owning the underlying instrument.
The main advantages are:
1. Leverage. CFDs are traded on margin where in order to open a CFD position you are only required to deposit a percentage of the face value of the trade. Therefore depending on the margin rates you can leverage or gear your available capital to open CFD positions of a greater value. For example if you trades were subject to a 10% margin then if purchased $100,000 of stock using CFDs you would only have to outlay $10,000. Leverage can enable a more efficient use of your capital. It can also allow you to much more diversified portfolio and therefore you have a greater chance of increasing your returns. However, leverage also requires a disciplined approach because it can also magnify your potential losses.
2. The ability to short sell. This allows investors to profit from falling markets or protect their existing share portfolio through hedging during a market down turn like we are currently experiencing.
3. The ability to participate in corporate actions like dividends, share splits or consolidations and share issues. The effect is the same as if you owned the shares. For example holders of long CFD positions would receive the benefits of a cash dividend. Conversely holders of short CFD positions may pay an amount equal to the value of any cash dividend.
4. The ability to trade international markets. Most major CFD providers offer access to UK, European, US, NZ and key Asian markets like Japan, Hong Kong and Singapore.
It is important to note that CFDs are for sophisticated investors and you need to decide whether they are appropriate for your financial circumstances. They are a highly leveraged product and therefore a potentially high level of risk.