TD Direct Investing
A Guide
to CFDs
CFD eGuide
Introduction
This Contracts For Difference (CFD) eGuide will help you to
understand more about CFDs and how they can be traded by
experienced share traders who already have a good understanding
of the stock market.
CFDs are derivative financial instruments which derive their value
from an underlying asset, index, commodity, currency, exchange
or interest rate. It used to be that they were only available to
professional investors and financial institutions. However, during the
past decade specialist derivatives providers have popularised these
with individual traders.
There are five main types of derivatives that are available to the
individual investor to trade in, however in this eGuide we will focus
on Contracts for Difference (CFDs). CFDs are regulated products in
the UK and Europe and are primarily designed to take advantage of
relatively short-term market fluctuations.
CFDs are derivative products which are aimed at experienced traders
rather than long-term investors. Derivatives are a niche financial
instrument that will be unsuitable for many investors. Before you
read on you should note the Risks highlighted to the right.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
This eGuide is intended for educational purposes only and as such
should not be treated as investment advice or a solicitation to make an
investment decision based on the content of this eGuide.
Investors should be aware that the value of an investment can go down
as well as up. You may not get back all the money that you invest.
Please remember that derivatives are designed for active traders.
Derivatives trading involves leveraged transactions, which means that
you only deposit a fraction of the full value of the deal. Consequently
profits or losses can quickly and substantially exceed your initial deposit
and will require you to make further, possibly intraday, payments.
Derivatives should only be considered if you have significant investing
experience and knowledge, a thorough understanding of the risks
involved and if you are dealing with money that you can afford to lose.
If you have any doubt over the suitability of a particular investment for
you then you should seek independent financial advice.
The tax treatment of derivatives depends on the individual
circumstances of each client and Taxation Law and may be subject to
change in the future.
The information within this eGuide is based on our understanding at
the time of writing.
Version 0.1 February 2014
CFD eGuide
What are derivatives?
Derivatives were created as a way of trading on the
price movement of a specific asset such as stocks, bonds,
currencies, indices and commodities without ever owning
the underlying asset.
They are a ‘synthetic’ financial instrument which means that they
are frequently created by the derivatives provider and traded
directly with them. They replicate the price movements of the
underlying asset and are quoted in a similar way to it.
Exchange traded derivatives contracts are standardised to fixed
quantity, quality and end dates, making Over the Counter (OTC)
contracts, provided by specialist derivative providers, more
attractive to individual investors.
For that reason your account will be owned and operated by a
derivatives provider even when they are offered by a well-known
brokerage like TD Direct Investing. Because financial markets
and instruments can experience rapid price movements and
derivatives are made and offered by specialists, your access to
derivatives is usually via a specialist account. This uses a dedicated
online dealing platform that has sophisticated order types for risk
management, plus comprehensive tools and research. There are
usually demonstration facilities as well as live accounts.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
CFD eGuide
What are derivatives?
Experienced traders use derivatives to maximise their trading
capital. This is because they only pay an initial deposit for the
full value of the deal, which is known as Trading on Margin,
or leverage. This method of funding substantially increases
buying power. In most cases, derivatives also offer the ability
of shorting, in other words they have the potential to profit
from falling market prices as well as from market price rises.
Derivatives also offer a very wide range of global markets and
instruments, including those that would be difficult to access by
other means. They have relatively low trading costs and, subject
to individual circumstances and applicable tax laws, these
instruments can also offer tax-efficiency.
The benefits and potential rewards from trading derivatives
come with a high degree of risk. Because they require only
a small initial percentage of the trade value as deposit, this
magnifies the volatility of profits and losses. This means that if
markets move against you, losses can quickly exceed your initial
deposit and require you to make further payments. These are
known as Margin calls and may be made to you at any time,
including intraday while the markets are open. If a margin call is
not satisfied your position will be closed.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
This eGuide will explain the risks involved with derivatives in
more detail and it is important that you understand and are
comfortable with the risks involved before starting to trade them.
To help you understand whether derivatives are right for
you, you will always be required to pass what is known as
an ‘Appropriateness Test’ as part of the derivatives account
opening process.
Regulation and Financial Services Compensation Schemes
Derivatives are regulated financial instruments. In the UK they are
regulated by the FCA and have the protection of the Financial
Services Compensation Scheme (FSCS). They are also offered
and regulated in Europe, hence a European derivatives house
operating in the UK market may instead be regulated by its host
country and the relevant terms of its financial compensation
scheme will apply. You should understand this and the Terms of
Service that will apply before opening an account.
CFD eGuide
Contracts for Difference (CFDs)
Contracts for Difference (CFDs) are a derivative instrument
which is popular in the UK because of their simplicity. They are
defined as an “agreement between two parties to exchange the
difference in value of a particular market or instrument, between
the time at which the contract is opened and the time at which
it is closed.” In other words, when you open a new CFD position
you are entering into a contract directly with the CFD provider to
exchange the difference between the opening and closing prices,
which will either be your profit or your loss. You are therefore
speculating on the price movements of financial instruments
such as shares and indices without owning the underlying asset.
CFDs are usually not traded on an exchange, they are frequently
traded OTC with the Derivatives House.
“As with share trading, you decide how
long you want to keep your position
open and real-time prices constantly
show your exact position and valuation.”
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
CFDs are made and traded on many thousands of different
UK, European, US and Asia Pacific stocks, indices, commodities
and currencies. One CFD is usually equivalent in value to one
share or one point, and has a bid/offer price spread similar to
that offered on the underlying asset. As with share dealing, you
undertake to buy or sell a number of CFDs, deciding either that
the market will rise (go long), or fall (go short). If you predict
correctly and the market moves in your favour, you will make a
profit. That profit will be your CFD size multiplied by each point
that the market has moved in your favour. If you are wrong you
will make a loss of your CFD size multiplied by each point that
the market moved against you.
As with share trading, you decide how long you want to keep
your position open and real-time prices constantly show your
exact position and valuation. Most CFDs do not have an expiry
date, so you may decide to trade intra-day, overnight (subject to
additional financing) or for longer as part of a hedging strategy.
Because you are trading on Margin, your initial deposit required
to open the CFD is substantially less than the full opening value.
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CFD eGuide
Contracts for Difference (CFDs)
Trading on Margin
When you buy shares on the stock market, you are normally required to pay for them in
full. Your broker will quote you the price and you must pay for them by settlement day.
So if you bought £10,000 worth of shares you will need to pay for the full £10,000 value.
However, because CFDs are margined, you pay for them in a different way. In this
example you might only be expected to pay 10% of the value of the shares as an initial
deposit, i.e. £1,000.
This deposit has given you exposure to the price movement of £10,000 worth of shares for
initially just £1,000, which is known as ‘leverage.’ If you think the shares will rise in value,
your opening deal will be a buy and you will go long. If on the other hand you believe that
the shares will fall in value, your opening deal would be a sell and you will go short.
Leverage magnifies your profits, but it can also equally magnify your losses. Let’s assume
that your CFD was a buy that was anticipating a rise in value and that you are correct.
With the value of the shares increasing by 10% they are now worth £11,000 and you
decide to close the deal by selling. If you had bought the actual shares, you would have
made a 10% profit (£1,000). However, since you bought the CFD instead and only had
to set aside £1,000 to make the trade, you made a 100% profit (£1,000) when you sold.
However, the same principle can work against you in reverse. In this example, if the
shares had declined 10% in value instead, your loss on your initial CFD deposit would
have been 100%.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
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ENLARGE
CFD eGuide
Contracts for Difference (CFDs)
This simplified example doesn’t include commissions and any
daily financing, but illustrates two things. The first is the power
and risks involved with using margin trading, particularly when
markets are volatile and price fluctuations up or down can
be large and rapid. For this reason you should monitor your
positions closely. It is good practice to deposit more than the
initial margin requirement to allow for any margin calls should
the market go against your initial position, including intraday.
The second is that CFDs allow you to trade ‘long’ or ‘short’
which opens up a new trading opportunity, unlike with
equities you have the potential to profit in both rising and
falling markets, providing the market moves in the way you
anticipated. You can go some way to controlling your risk of loss
if the market moves against you by employing various forms of
risk management, which are explained below.
“For this reason you should
monitor your positions closely.”
Margin Calls
Although you have only been required to put up an initial
margin deposit, you should be prepared to further fund
your account to cover any potential losses.
If price movements mean that you no longer have the margin
required to sustain the positions on your account then this is
known as a margin call. How this call is made will differ with the
provider, though it is usually electronic rather than a phone call.
You should fully understand the procedure used before placing
a trade as markets can move quickly and additional money may
be required immediately. Alternatively, the position will be closed
and this will crystallise your loss. Besides margin calls, most
Derivatives Providers also operate automated maximum limits
to restrict losses from becoming unlimited. Again, these limits
vary but are designed to protect both parties. It is always your
responsibility to monitor the margin in your account and make
further payments in sufficient time. In some situations, such as
markets gapping which is explained below, you may not have
time to fund your account and your positions will be closed,
crystalising a loss which you will be required to pay.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
CFD eGuide
Contracts for Difference (CFDs)
Market Gapping
Limit orders
In its simplest terms, market gapping is a break between prices
that occurs when the price of a stock makes a sharp move up or
down with no trading occurring in between.
These can enable you to take profit or make a purchase
automatically if an order reaches a target market price. You can
usually set these as being Good for the Day (GFD), Good until
Cancelled (GTC) and some providers allow you to name an exact
date the order is valid until.
Gapping can create significant quick gains, but also quick
infinite losses.
Direction of position
Gapping up in share price
Gapping down share price
Long
Infinite profit as share could rise
substantially
Price could fall to zero which would mean
losing an amount which equals the total
size of the position (not just the margin)
Short
Price could rise to infinite which
Price can only fall as far as zero, therefore
would mean losing an amount which the maximum profit is gained when the
equals the total size of the new
share price falls to zero
position (not just the margin)
Order types
Derivative platforms usually offer a range of order types when
opening a position that can be used to help you reduce the
risks of financial losses, particularly when you may be unable
to monitor your position. They are best seen as optional risk
management tools.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
(NOTE TO REDWALL – CAN WE MAKE THE ABOVE TEXT IN
Stop
Loss
REALLY PROMINENT – AGAIN REALLY IMPORTANT FOR CLIENTS
This
is anTHIS)
order that closes out your position if it is going against you
TO GET
once a certain chosen price has been breached. It is good practice to
set one every time you open a position. You can also add one to an
existing open position and it can be adjusted or cancelled by you as
prices change. Stop Losses are particularly beneficial where a position
is left unmonitored because the Stop Loss will be triggered if the CFD
trades at the price set. However, it will not account for those instances
where a market price ‘gaps’ (jumps from one level to another without
trading in between), which can happen under unusually volatile
conditions or overnight. When the market recommences trading it is
at a price below the stop loss level set. If this happens, the stop loss
would not be effective and instead your position would close at the
next available price and your loss could be bigger than anticipated –
and crucially, could be bigger than your initial deposit. This is why
Guaranteed Stop Losses (explained on the following page) act as a
Gapping/slippage tool.
CFD eGuide
Contracts for Difference (CFDs)
Guaranteed Stop Loss
Trailing Stop Loss
This order type works like a Stop Loss but crucially also gives
complete protection against market gapping/slippage in return
for an additional payment and therefore brings additional peace
of mind. View these as an insurance policy. Some derivative
accounts offered are only available with Guaranteed Stop Losses
made compulsory for every trade - though investors should
remember that derivatives are still only suitable for experienced
traders. A Guaranteed Stop loss will still only limit the size of
your losses, not prevent them.
These act in a similar way to a Stop Loss but move in tandem
with the market price to protect profits as prices move up
and down. The trailing stop allows investors to set an agreed
distance between the current price, and the point at which
they intend to exit the trade. If the current price should fall by
this ‘distance’, the position will automatically be sold. If the
current price rises, the percentage level will be recalculated from
the new high. Using a trailing stop is an excellent method for
potentially minimising loss, whilst locking in profits in the event
that the markets move against a position.
“The trailing stop allows investors to
set an agreed distance between the
current price, and the point at which
they intend to exit the trade.”
Buy Stop
This has the opposite effect to a limit order. Placing this opens a
position at the point you set, anticipating a price rise when your
position is long.
Sell Stop
This opens a position at the point you set, anticipating a price
fall when your position is short.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
CFD eGuide
Contracts for Difference (CFDs)
Linking order types
Other combinations of linking order types include;
Some Derivative providers allow you to combine order types to
create a more comprehensive order management strategy.
n
Limit or Market on Close (MOC) – will be executed at the
stipulated price during the day, or else it will be executed at
the best available price towards the end of the day, usually
within the last five or ten minutes of trading. It is guaranteed
to be filled.
n
Market If Touched (MIT) – a combination of a limit order
and a market order. Initially, the trade specifies a limit. If the
market trades at or through the price, the order becomes a
market order and will be executed at the best prevailing price.
n
Fill or Kill (FOK) – this means execute the whole quantity of
the order if market conditions permit, otherwise cancel the
whole order if the former cannot be achieved. They are often
referred to as immediate or cancel orders.”
A popular order type is a One Cancels Other (OCO) order.
This allows you to place a limit and stop order either side of
your position at the same time. Once the limit or order stop is
triggered, the other order is cancelled. Some brokers may let
you place ‘If Done OCO’ orders. This allows you to combine a
limit order, which once triggered, means you will automatically
have a stop and limit order either side of your new position.
“This allows you to place a limit
and stop order either side of
your position at the same time.”
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
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CFD eGuide
Contracts for Difference (CFDs)
CFD Choices
CFDs offer thousands of diverse trading choices on Equities,
Indices, Commodities and Currencies.
n
n
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Equity CFDs can be traded on a wide range of UK, US,
European and Asian markets. Non-UK shares will be traded in
their underlying currency and so require a foreign exchange
conversion. As well as trading the underlying equity, some
investors use derivatives for hedging. This is where a
derivative’s short position is taken out with the intention of
offsetting any potential short-term losses incurred by the
long-term ownership of the underlying equity, so the investor
does not need to sell and ownership and shareholder rights
are protected. This is a complex technique that you must fully
understand before attempting.
Index CFDs. Indices are popular if you would prefer to trade
a market index rather than an individual share. Popular
examples include the FTSE in the UK to Dow Jones, NASDAQ
and S&P in the USA, or the Japanese Nikkei and Hong Hong
Hang Seng. Sector CFDs work in a similar way, where you can
take positions on individual market sectors such as Banks,
Pharmaceuticals or Technology.
Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
n
Commodity CFDs give direct exposure to commodity
markets, ranging from oil and energies through to base and
precious metals to a wide range of agricultural products
n
Currency CFDs allow you to speculate on currency
price movements in Foreign Exchange Markets and are
characterised by low initial margin requirements. Popular
examples include the US Dollar, Euro, UK Sterling and
Japanese Yen, but there are many others.
Most CFDs will allow long and short positions, subject to any
requirements that may be set by a regulator from time to time
that may restrict short positions in times of particular economic
crisis. These restrictions will be clearly shown by the Derivatives
House while in force.
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CFD eGuide
Contracts for Difference (CFDs)
Costs to look out for
Corporate Actions
As with any financial instrument it is important to understand
the costs involved when trading CFDs and what you will be
expected to pay along with the Margin requirement.
With derivatives you do not own the underlying shares but you
are entitled to the rights. Hence when companies pay dividends
this is reflected as a credit or debit to your account made by the
Derivatives house. Similarly with Corporate Actions the Derivatives
House will seek to replicate the action. This may be by the
adjustment of your position or cash balance. In some situations
the derivatives provider will terminate the existing position.
Commission
Just like equity share trading, a transaction commission per trade
is usually charged on both the opening position and closing
deal. This charge varies according to the Derivatives Provider and
is usually a percentage of the overall transaction, though fixed
rates can apply.
Taxation
Another reason for the popularity of CFDs is their tax
treatment*. Unlike equities, CFDs do not currently incur UK
Stamp Duty on buys. This is because CFDs are synthetic and you
do not own the underlying shares. Any profits you make on a
CFD are, however, subject to Capital Gains Tax.
This may be because it determines that the CFD is no longer an
adequate representation of the economics of the underlying
instrument. This may occur in the case of certain corporate
actions as but it could also terminate in other circumstances, for
example in case of illiquidity in the underlying asset, absence
of sufficient borrowing ability in the underlying asset and
insolvency, dissolution or delisting of the underlying security.
*tax treatment depends on the individual circumstances of each client and maybe subject to change in the future. It is recommended
that specific tax advice, where required, is obtained from HMRC (or other taxation authority) or a qualified tax adviser.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
CFD eGuide
Contracts for Difference (CFDs)
Overnight Financing
Dividends
CFDs are traded on margin and therefore when you buy a CFD
there will be a financing charge because you are effectively
borrowing money to finance the purchase. This will be
calculated daily on your account. The opposite occurs when
you sell a CFD short; in this instance you are loaning money so
any interest is payable to you and will appear as a credit. For Uk
shares these charges are usually based on LIBOR** or LIBID***
and applied to the full value of your position, not the margin
amount. As these are accrued daily they are only charged if
your position remains open overnight. If LIBOR is low, overnight
financing on a short position could result in a charge. Be aware
that these costs can quickly build on positions kept open for
long periods. Alternatively, some providers offer quarterly CFDs
for longer-term positions where the overnight financing is built
in. This can still be cheaper than buying the underlying share on
extended settlement terms if available.
Generally, an equity CFD will seek to replicate any dividend
payments that occur on the underlying share on its ex-dividend
date. If you hold a long CFD position then the net dividend will
be credited to your account. Conversely, the gross dividend will
be debited from an open short CFD position.
**London Inter-Bank Offered Rate.
***London Inter-Bank Bid Rate.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
Guaranteed Stop Losses
As explained previously, these usually incur an additional
‘insurance’ premium to pay for the guarantee that prevents
exposure to market slippage/gapping.
CFD eGuide
Choosing a Provider
There are a large number of Derivatives providers in UK, so it is
worth reflecting on how to choose one. Naturally, you will want
your provider to offer competitive costs and attractive margin
limits as well as the markets/instruments on which you wish to
trade. The providers might be derivatives specialists or they in
turn may operate the service on behalf of well-known equity
brokerages. It is wise to check that the provider is regulated by
the FCA and that your money is protected through the Financial
Services Compensation Scheme (FSCS).
When choosing a provider you should also consider the
stability, security, speed of execution and ease of use of the
internet based trading platform. You may also want a mobile
trading option to be able to deal on the go. Customer service,
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
reputation and the financial strength of the provider should not
be ignored. The tools and educational materials offered to help
you make decisions are important too: such features as real-time
pricing, stop-losses, sophisticated charting, analysis and market
news are all essential ways of helping you make informed
trading decisions to manage your risks.
Many providers offer online educational programmes, tutorials
and seminars. Some offer telephone access as well as online
trading. One reason to opt for a brokerage service such as
that provided by TD Direct Investing is because the broker has
researched and chosen to partner with a specialist who is a tried
and trusted Derivatives provider who continuously prove their
standards and reputation.
CFD eGuide
In summary
In summary, it is worth restating that derivatives offer individual
experienced investors considerable opportunities to trade. The
rewards can be substantial but that potential means that these
are high-risk instruments that are not suitable for everyone. Only
experienced traders will pass the Appropriateness Test, which
is designed to demonstrate that they not only understand the
instruments and their risks but also are comfortable with taking
the level of risks involved.
It is good practice to only ever trade with money that you can
afford to lose and be aware that unlike equities, losses can
potentially be unlimited and mount up quickly. Successful
derivatives traders are disciplined in their approach and also are
aware of the psychology and emotion that can influence their
trading decisions. Never underestimate the emotions that can be
involved with this level of risk and reward.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
Choosing a Provider | In summary | Legal Disclosure
Experienced traders do not usually trade up to their Margin Limit
and ensure that their open positions are covered by Stop Losses
or Guaranteed Stop Losses. They use tools and research to help
form their judgement, rather than trade on a hunch, and they
monitor their open positions closely. They will close a position
and take a smaller loss rather than ‘bet the farm’ on a single
trade and have losses escalate beyond their resources.
Derivatives Providers invariably offer demonstration accounts
and it is wise to familiarise yourself with the technology and
instruments available and practice trading before embarking on
placing live trades.
If you would like to continue your derivatives fact-finding
journey, please visit www.tddirectinvesting.co.uk for
more information.
CFD eGuide
Legal Disclosure
Brokerage Services provided by TD Direct Investing (Europe) Limited (a subsidiary of The Toronto-Dominion Bank). Incorporated in
England and Wales under registration number 2101863. Registered office: Exchange Court, Duncombe Street, Leeds, LS1 4AX,
United Kingdom. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London,
E14 5HS, United Kingdom (Financial Services Register Firm Reference Number 141282), member of the London Stock Exchange and
the ICAP Securities and Derivatives Exchange. VAT Registration No. 397103051. www.tddirectinvesting.co.uk
Banking Services provided by TD Bank N.V. Incorporated in the Netherlands and registered as a branch in England and Wales under
branch registration number BR006780. Authorised by the Dutch Central Bank (De Nederlandsche Bank – DNB Institution Number
481) and subject to limited regulation by the Financial Conduct Authority and Prudential Regulation Authority (Financial Services
Register Firm Reference Number 216791). Details about the extent of our regulation by the Financial Conduct Authority and
Prudential Regulation Authority are available from us on request.
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Introduction | What are derivatives? | Contracts for Difference (CFDs)
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Reduce