columnists
Contract for Differences: A welcome addition to the markets
Wednesday March 16, 2022
Summary
- A CFD is a contract between two parties, the buyer and the seller, that provides that the seller will pay the buyer the difference between the current value of an asset or index and its value at a future date if the value at that date has increased contract was concluded.
Whenever the CFD acronym is mentioned, there are potentially a thousand and one combinations that can go through your mind.
Here are a few weird ones: Call for Discussion, Car-Free Day, Chinese Fire Brigade Exercise, Cubic Feet per Day, Child and Family Development, and Compulsive Referral Disorder.
I have to admit, the latter is the funniest. But a not-so-new addition to this long list is Contract For Differences. Today’s article is about these tradable instruments.
What are CFDs? A CFD is a contract between two parties, the buyer and the seller, that provides that the seller will pay the buyer the difference between the current value of an asset or index and its value at a future date if the value at that date has increased contract has been concluded.
Conversely, if the value goes down, the buyer pays the seller the difference. Let’s give an example. If you buy 100 CFDs on KCB at a price of Sh44.5 with a margin of 20 percent, your initial investment will be Sh890 (purchase price of Sh44.5 x 100 shares x 20 percent margin).
If the value of KCB stock moves to 50 and you decide to sell at that level – a rise of 5.5 points – your profit is Sh550 (5.5 point rise x 100 shares = Sh550) .
In this way, CFDs represent financial derivative instruments that allow traders to gain exposure without having to own the underlying asset. In fact, they offer similar economic benefits as an investment, but avoid certain costs and complexities associated with physical ownership.
But rewinding a little, speculating with leverage in the financial markets was never a retail affair. Trading on margin was limited to futures or options on derivatives exchanges that were out of reach for the retail crowd.
However, with the advent of CFDs and online trading platforms, retail clients are now able to easily trade on margin and gain access to a wide range of global financial markets and instruments (indices, shares, currencies, commodities).
To date, the CFD market is served by a range of players, large to small, including IG, CMC, Ingot Brokers, Scope Markets, EGM, Plus500 and Saxo to name a few.
Note that these instruments are highly speculative and trades are not typically made on any exchange – there are no clearinghouses for CFDs.
A key difference is that most brokers do not charge a commission, but rather a spread – that is, the buy price is always higher than the current underlying and the sell price is always lower. The difference between these prices is called the CFD spread.
Why use them? Not only can you trade on margin, CFDs also offer a low-cost way to trade on a variety of global financial markets. One can also choose to go short or long. Additionally, CFDs can be used to hedge an existing portfolio, apart from allowing the client to trade when the underlying market is closed.
All in all, CFDs are a welcome addition to the world of markets. And the next time your broker says the word, you now know it doesn’t stand for Chinese Fighting Ducks.
The author is MD, Canaan Capital
Comments are closed.