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Contracts for Difference (CFD)

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Let us imagine that we would like to invest upward in a Spanish action. Our broker considered you the order that bought us action "x" at a price "and". The only difference between the CFD and the normal trading is that with CFD we need not acquire titles but buy a CFD. If we get it right we will receive the differential won, and if we fail, we will have to pay for it, but it is not necessary that we physically own actions to obtain in our account the effect of their movement in the market. Therefore, a CFD is a contract between two parties to exchange the difference between the purchase price and the sale of stocks or other products. CFDs do not require the full disbursement of the nominal operation, run by a simple system of guarantees, which opens more possibilities in our operational stock, especially for intraday trading.

A little history about CFDs CFDs were created years ago by the Hedge Funds to gain access to the negotiation of operations with much leverage. It is a product that has belatedly offered to small investors, and in Spain only has been distributed so far to large customers. Nobody had transferred their benefits to the private sector. However, in the United Kingdom, where the distribution to the particular client has been running for 4-5 years, its popularity today is unquestionable. Use these data to the London Stock Exchange as an illustration: 1. The hiring of CFDs has grown in recent years 57% annual. 2. 35% of the current total procurement of the London Stock Exchange has its origin in contracts of CFDs, being the small inverter protagonist of 20% of the transaccionados CFDs.

How do CFDs work? CFDs (i.e. the financial intermediary) emitter is paying to bag the full amount of the purchase of shares, and at the same moment in which the product is bought emits CFD contract in favour of the investor. Thus becoming the movement of action daily settlements for differences in your account. If at the end of the session the investor does not sell your CFD, the financial intermediary will apply an interest rate that generally tends to be (Euribor + differential) / 365. As the intermediary who actually possesses the actions, it is money that has immobilized and cannot get any performance, that is why for each day that the inverter not band your CFD shall apply these interests.

There are two types of CFD:

  1. CFD with spread of contracting set by the issuer. The issuer sets the buying and selling price range and customer have to accept if you want to open a position. There is no depth of market, only a bid price and a price of demand with a differential between the two always superior to the stock exchange. The issuer gets their benefit from the differential between the price of your fork and the real price of the bag that can be covered instantly. The investor pays more than in the stock market if you want to buy, and get less if you want to sell. In most cases the brokers that offer this type of CFDs give misleading message saying they do not charge commissions. True, but because they get their benefit with execution prices.
  2. CFD with direct access to the market (transparent). An operation of this type causes an actual operation in the bag and the depth of the market that is used for hire, is the same as for the trading on shares, the stock exchange order book. The inverter can see their orders and executions in the ticker of the bag. When entering an order of CFD, this will go directly to the market on behalf of the issuer, making operation in settlements for differences.

These two types of CFD with a practical example, we see that the inverter when hiring this product can discern extent to which one is more beneficial than the other. Not complicating too much the example we should be our operation on a transaction of purchase of shares in the hope that will rise in the short term. Let us imagine that we want to hire a CFD on 100 shares of Acciona that traded at 197 euros and then sell them when they traded at 202 euros.

The two contracting options explained before give different results:

  1. The first Broker does not charge commissions, but applies a fork with a higher purchase price and one a price lower of sales. We buy 197,50 EUR each action and sell them to 201,50. We have a net profit of 400 euros.
  2. The other intermediary offers direct access to the market and apply us commissions buying and selling (0.2% of the amount). Therefore, we buy at market price of 197 euros and sell them to 202 euros. This gives us a gross profit of 500 euros (20,200-19.700). Now we must subtract the commissions and net benefit. The Commission's purchase would be 39,40 euros, while the Commission of sale would be 40,40 EUR. Then subtracting we get a net profit of 420,20 euros.

  In this case, we observe that it is better to operate through the second intermediary. But not always a choice is better than the other. We must examine the specific circumstances of each offer and which may be more beneficial for investors. For example, what if instead of a Commission of 0.2% a 0.5% applies us? With the above data, we would pay a Commission of 98.5 euros purchase. While the Commission on serious sale of 101 euros. Consequently net earnings would be only 300,50 euros. In this second case the offer of the first intermediary would be much better for us. These examples are not mentioned the daily interest which are settled to maintain an open position, this will be explained later.

Has it expiration a CFD?

  • CFDs have no expiration date, unlike what happens with the future on actions or operations of credit market. The absence of expiration simplifies operations for the following reasons:
  • The price of the CFD is not influenced by the calculation of the expiration value, as in the case of a futures contract. The price is the same as the action, during the life of the operation.
  • It is not necessary therefore "rolar" one expiration to other positions should want to have a stable position open.

What are the advantages of CFDs? There are five main advantages that you can find on the trading with CFDs:

  • They allow leverage, allowing you to get much more profitability to their investments in stock market. The CFD trading is not required to pay the full value of the shares that are buying or selling, but only the amount required as a guarantee. CFDs generally require 10% of the value of effective operation as a deposit guarantee (leverage 10 to 1 ratio). But eye, it is very important to keep in mind that when operated with a leveraged product the leverage ratio is obtained also with losses in the case that the result of the operation is negative. The use of these products is only suitable for investors who have a deep knowledge of the operation of markets and the risks involved in such operations.
  • They have the same liquidity actions since buying and selling operations on the forks of cash.
  • As in the future have daily settlements. A daily settlement means that at the end of each session they paid it or be loaded into your account the profits or losses of your open position. To put it another way we "will update" with the official closing of the market price.
  • Open short positions, obtaining benefits in the bearish market trends.
  • They have no expiration, therefore not needed renovations to maintain your investment.

What are the disadvantages of CFDs? Leverage and Liquidations daily are double-edged. Before a sudden drop in the bags may cause that we pay much more money than actually have causing that we should assume costs our pockets may not be allowed to have leveraged. Or it may cause the inverter stays without liquidity, therefore, they would force him out of the market and probably at the worst time. In addition without any possibility of being able to remain until his actions were returning to rise. Other disadvantages are the daily interest that must be paid for maintaining our position open. This can cause that interests are higher than earnings or are very similar, causing in this way, our net investment to be lower than expected. As a final piece of advice to highlight that this type of product is a derivative and is intended for investors who have a deep knowledge of the market, since if the purchase or sale goes wrong the investor may lose lots of money.   Contributions to http://rankia.wikispaces.com/ are licensed under a Creative Commons Attribution Share-Alike 2.5 License.

Erick Gálvez
Author: Erick GálvezWebsite: http://www.asdforex..comEmail: This email address is being protected from spambots. You need JavaScript enabled to view it.
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ASDForex manager and professional trader since 2008. I am also Aleforex.com manager where you can view the services that I give
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