What CFDs are, and how they work

The Weekend Australian - Review - - Wealth -

A CFD is a fi­nan­cial deriva­tive that rep­re­sents a the­o­ret­i­cal or­der to buy or sell a trade­able as­set — say, a cer­tain num­ber of shares, or amount of gold. The in­vestor sim­ply closes the trans­ac­tion by tak­ing the op­po­site ac­tion. The in­vestor’s profit or loss is the dif­fer­ence be­tween the open­ing and clos­ing price. It is paid at the close of the con­tract.

A sim­ple ex­am­ple of how the con­cept works is a CFD over shares. The price of a CFD is de­rived from the spread — the high­est buy­ing price ( bid) and low­est sell­ing price ( of­fer) that is quoted on the Aus­tralian Se­cu­ri­ties Ex­change ( ASX) — so the value of the CFD mir­rors the share price. ■ An in­vestor buy­ing a ‘‘ long’’ CFD ben­e­fits from a rise in the share price, while a ‘‘ short’’ CFD gives the ben­e­fit of a fall in the share price. The CFD moves iden­ti­cally with the un­der­ly­ing shares: if the share price rises one cent, the in­vestor is paid one cent. CFDs al­low traders to lever­age an in­vest­ment with a de­posit of as lit­tle as 3 per cent. ■ With a stop- loss — a pro­tec­tion mech­a­nism that au­to­mat­i­cally trig­gers a sell or­der at a pre- de­ter­mined price — in­vestors can limit their down­side us­ing CFDs.

CFDs com­pete mainly with ex­change­traded op­tions ( ETOs) and mar­gin lend­ing. CFDs give the same lever­aged spec­u­la­tion op­por­tu­ni­ties as op­tions, but it is much sim­pler — there is no ‘‘ time de­cay’’ and in­vestors do not need to trou­ble them­selves with op­tion- re­lated con­cepts such as delta, gamma and vega. ■ Com­pared to mar­gin lend­ing, CFDs work in a sim­i­lar but sim­pler way, and with more gear­ing: the in­vestor pays in­ter­est on a long ( buy­ing) po­si­tion, and re­ceives in­ter­est on a short ( sell­ing) po­si­tion. ■ On the debit side, in­vestors can’t use a buy- write strat­egy ( writ­ing, or sell­ing, op­tions over a share­hold­ing to bring in ex­tra in­come) as eas­ily us­ing CFDs. ■ In­vestors who be­lieve a stock in their port­fo­lio is go­ing to fall — but who don’t want to sell it — can ‘‘ short’’ it us­ing CFDs. When the share price drops, even though the value of their hold­ing falls, they make a profit on the CFDs and the two can off­set each other. ■ is that The holder of a short CFD is paid in­ter­est while the po­si­tion is open — whereas the holder of a short po­si­tion in ETOs ef­fec­tively pays time de­cay for that po­si­tion. Also, be­cause a CFD po­si­tion is in­de­pen­dent of the shares, the in­vestor can’t lose the shares.

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