Why Trade CFDs

How Contracts for Differences Pricing Works

The majority of equity CFD providers look to offer a relationship along the lines of a traditional stockbroker, acting as an agent on behalf of their clients. In other words, they are not risk-takers but instead look to hedge their CFD transactions in the underlying cash market.

So if a client was, for example, to submit an order to buy 10,000 CFDs in Vodafone, the provider would simultaneously enter the market, buy 10,000 shares in Vodafone as a hedge, and write a CFD to the client at the same price.

In this way, the client receives the position that he wants, namely long 10,000 Vodafone CFDs, while the provider has hedged his short CFD contract with the client by buying stock in the market. Although counterparties to the CFD transaction, the fact that the CFD provider is hedging means that any price improvement can be passed on to the client, who as a result pays the best cash market price.

The relationship between the client and CFD provider is crucial, as traders need transparent prices that track the cash market without any delays. Where a provider adopts the broker type model, always hedging and charging the true underlying market price, there is very little scope for a conflict of interest despite the fact that the client and provider are counterparties to each other.

With this type of approach the CFD provider makes his money from the overnight financing charge and by levying commission on each transaction. The amount varies slightly between providers and will typically range from 0.15% to 0.25% of the contract value. This will apply to both the opening and the closing trades, making a 0.3% to 0.5% charge for the two-way trip.

Fixed ticket, Direct Market Access or mark-up on bid-offer spread?

Some providers choose instead to offer a fixed-ticket commission of around £10 on the FTSE 100 constituents, which is extremely cost-effective for large orders.

The alternative adopted by those who charge no or low commission is to add a mark-up to the cash market bid-offer spread. This can work out good value, depending on how competitive the quote is, but has the effect of making the pricing less transparent.

The majority of equity CFD traders prefer the ease and cost effectiveness of a quote-driven service, where they are simply presented with their provider's bid and offer prices. The main limitation, other than having to accept the price as presented, is that those trading in large sizes can at times be subject to liquidity curbs that lead to dealing delays.

Sophisticated traders who are unhappy with these restrictions can instead sign up to one of the growing number of providers offering a direct market access (DMA) service. This technology effectively allows clients to execute directly into the London Stock Exchange's electronic order book. As a result, they can access the greater liquidity of the main market and can choose to enter their order at whatever price they wish.

A Direct Market Access service together with Level 2 market-depth data showing the full extent of the order book opens up some sophisticated trading opportunities. One of the main attractions is the greater transparency, since traders can see the full order book and know exactly where they are in the queue. This means they can either choose to trade on the bid or offer or can enter their price to get the fill they want, for example ahead of a large order. Seeing this information can also help to determine the size of the order by revealing the levels where it is likely to be filled. It also makes it possible to trade the opening, closing and intra-day auctions.

Index CFDs will be priced
according to the underlying index level or based on
the futures price as adjusted for fair value.

Fair value

Index CFDs will be priced according to the underlying index level or based on the futures price as adjusted for fair value. These products are generally traded commission-free, with the providers adding a fixed spread to their quotes - the most competitive being around 3-6 points on the most common indices.

They may be a point or two wider when traded outside normal market hours and the prices at such times would take their lead from the futures markets as the best indication of where the cash market would stand were it open.

Transparent trading

Being open-ended with the financing charged separately has the effect of making the CFD pricing more transparent by bringing it into line with the underlying cash market. Futures traders by comparison have to contend with a number of complications, such as 'basis risk' where the futures price is free to drift away from that of the underlying. Those holding a futures contract approaching its expiry date will also have to incur the cost and risk of trading the position if they want to maintain the exposure.

CFDs are quoted as seen in the underlying market, so for example UK equities are priced in pence and US stocks in cents, with the trades always executed in the base currency. The same principle also applies to stock indices, as these are quoted and traded in the base currency of the index, so the FTSE100 CFD is quoted in sterling and the S&P500 in dollars. Dealing hours are the same or better than those of the underlying exchange.

Most CFD providers support both online and telephone-based dealing. To ring through an order involves calling the trading desk and asking for a quote in the specific market in question. The dealer will quote the CFD price and it is then up to the trader to decide whether he wants to buy, sell or do nothing. In a fast-moving market, any delay in the decision may result in the dealer re-quoting the price. To go ahead and place a trade, the client will need to instruct the dealer on how many CFDs he wants to buy or sell and then give his name and account number. The trade will then be accepted once the necessary account checks had been completed.

Placing a trade online is slightly different. Having logged on, clients will have access to the full functionality of the trading platform. This gives them the chance to check their existing positions and to make sure that their margin balance is sufficient for the trade they have in mind. Usually they will also be able to refer to the latest news flow and the current chart position to help them decide whether to proceed with the trade.

Anonymity with CFDS

Not everyone is pleased with derivatives providers, though. Chief executives of quoted companies have been grumbling about the fact that, by using instruments such as CFDs, major players can build up substantial equity stakes under a cloak of anonymity. We've seen what happens recently in the market when big-hitting CFD traders build hefty positions in small-cap stocks and are then forced to liquidate them to meet margin calls. No wonder chief execs get annoyed when they can't see what's happening on their own share register and are calling for investors who build up such stakes to be forced to disclose holdings.

However, Steven Alexander, who heads Scottish-based CFD and spread-betting provider Direct Sharedeal Margin Products, takes exception to this view. He issued a press release this week in which he says forcing disclosure would run counter to the founding principles of a free market. Ultimately, says Alexander, a stock will only lose value if there are fundamental reasons for it to do so - 'such as poorer than expected trading results or an underperforming board of directors'. It's a false argument that investors buying and selling stock through CFDs affects the share price. 'In the shortterm there might well be movement in the stock, but there will be movement in any stock listed on the market. Ultimately, the value of the company will be reflected in the price of its stock.'

Alexander points out that CFD holders don't own the underlying asset and have no voting rights: all they are doing is speculating on possible price movements. I find this a little disingenuous: the CFD providers hedge trades in the underlying market so there is always going to be a direct impact on the shares, regardless of the fact that the customer doesn't actually own them. Logically, there is a strong case for the 3% disclosure rule that applies to equity ownership to be extended to exposure acquired through derivatives. But there is also a logical case for applying the same stamp duty regime across shares and derivatives.

Let's face it, saving stamp duty has probably been the biggest driver of CFD growth. I for one, though, am not anxious to encourage Gordon Brown down this route, so perhaps for the moment the least said the better.

 What is Level 2? Who needs it?

 Direct Market Access (DMA) & Market Makers (MM)

 Dealing Costs and Direct Market Access CFD Trading

 Comparing Direct Market Access to a Quote-Driven Service

 Advice/Tips on Level 2 and DMA