What exactly is a Contract for difference?
A CFD (Contract for Difference) is an agreement involving a buyer and a seller to swap the difference in value of a particular instrument between when the contract is opened and when it's closed. The difference is set by reference to an underlying instrument which is usually a stock, index, foreign exchange rate or commodity and the period over which the Contract for difference is held.
CFDs are geared financial products. This means that you will be fully exposed to price actions of the underlying instrument without needing to pay the full price for that instrument. Leverage means that Contracts for difference offer the possibility to make a higher return from a lower initial cost than investing directly in the underlying security.
Leverage, however, usually entails more risks than a direct investment in the underlying stock. It is imperative to understand that this effect may well work against as well as for traders. The use of leverage can lead to large losses and also large gains.
Benefits of trading CFDs
CFDs have been used by skilled investors for over twenty years and emerged initially as an over-the-counter (OTC) product. CFD related dealing and hedging is one of the fastest developing areas in the Australian and European derivatives markets. This popularity has arisen as a result of the following main features:
Leverage
CFDs permit you to attain full exposure to a share, commodity, FX cross or index for a fraction of the price of buying the underlying. CFDs require only a small initial margin to secure a position.
The capability to go ‘short’
CFDs permit traders to take advantage of falls in prices. This means that investors can benefit whilst prices are going down, not just up. CFDs are thus an excellent investing and hedging instrument.
Simplicity
Non-expiry: The majority of Contracts for difference do not have an expiry. They are perpetual in nature. For CFDs that do not expire, the only way to close a position is to trade the opposite side of the position.
The CFD mirrors the price of the underlying: Unlike other forms of derivatives (i.e. options and futures), cash flows such as carry costs and dividends are not reflected in the price of a CFD. Instead, cash flows are paid whilst the position is open, enabling CFD prices to follow the underlying instrument rather than trade at a discount or premium, as can be the case in other types of derivatives.
Advantages of ASX Listed CFDs
Market Independence
ASX is obliged in accordance with the Corporations Act to ensure that its markets are fair, orderly and transparent. ASX ensures a sound operational and front-line regulatory environment for its exchange-traded markets and clearing and settlement services, providing effective systems and infrastructure together with services designed to maintain and improve the integrity, efficiency and effectiveness of its trading, clearing and settlement facilities. For the ASX Listed CFD trader, this means being able to take part in the market with assurance.
As the predominant market operator, ASX is independent of the parties with whom you are receiving recommendations and dealing through enabling it to act fairly and impartially. This separation of responsibility between provider and exchange also provides customers with choice as to whom they wish to execute their business through.
Going through a central market also means there is one accepted contract specification for all ASX Listed CFDs, not a different product depending on who you execute through. It’s a fundamentally better Contract for difference market.
Transparency
Transparency is a major ingredient in a well educated market. ASX reports on all ASX Listed CFDs transacted, open positions, bid, offers and their volumes. In fact, all the market information you are used to seeing from the ASX. This means a better informed market.
ASX Listed CFDs are traded in the same way as other ASX traded contracts:
1. All prices are formed in a fully transparent way in the ASX’s CFD central market order book. Each trader’s order is pooled in the ASX Listed CFD central market order book with those from other market members, including market makers, and becomes an essential part of the price discovery process.
2. All deals are executed on a strict price/time priority. Price/time priority means the first person to enter the best price is traded against first. This results in each person in the central market order book being treated equally and consistently, no matter how big or small a trader you are.
3. Importantly, while prices are transparent, the individual trader remains anonymous, which minimizes market impact costs (especially those related to other people identifying an individual’s investing patterns and trading in front of him/her).
4. Anyone can place into the market a better bid or offer, as is the case in all exchange based markets. No-one is forced to agree to the price offered in the market. However, once an order is filled, you are committed to settle the trade. All prices in the market are firm in the volume indicated.
5. The ASX Listed Contract for difference central market order book incorporates orders from market makers. Their actions help ensure the ASX Listed CFD market has competitive prices and deep liquidity.
Risk Management
ASX Listed CFDs trade in a centrally cleared marketplace. The Clearing House offers central counter party clearing for the ASX Listed CFD market. This involves the Clearing House managing risks to make certain that the interests of its Participants and individuals are protected and that the integrity of the marketplace is maintained.
Through a process known as novation, the Clearing House becomes the principal to all trades and liable to perform against all contracts to which it is a party and effectively ‘guarantees’ performance to other Clearing Participants. Novation and thus the clearing guarantee become effective on registration of the contract connecting a buyer and seller.
This exposure is then handled and the clearing guarantee put in place in a variety of ways. Initially this is accomplished by the collection of the various margins. The collection of these moneys protects against extreme price movements and prevents members from accumulating considerable unpaid losses that might potentially impact on the financial position of other market users. This is a key component that differentiates exchange-traded markets from over-the-counter (OTC) markets, where such a strict margining regime is not in place.
The ASX Listed CFD market also has access to the Clearing Guarantee Fund meant for use in the event of default of one or more Clearing Participants.
Dealing in the ASX Listed CFD Market
When trading ASX Listed CFDs, your order is entered directly via a market member into the ASX Listed Contract for difference central market order book. This order book is accessible for the market to see. All orders are executed on a strict price/time priority. This means that the initial order with the best bid or offer price is always filled first. Dealing in the ASX Listed Contract for difference central market order book also ensures “client instructions” are always given precedence above a broker’s “house orders”.
In contrast, customers trading Contracts for difference through an OTC broker, do not have their orders in the ASX Listed CFD central market order book. Customer orders are transacted with the OTC CFD counterparty (generally described as a CFD Broker). The customer’s order is not protected by the ASX’s price/time precedence or client order precedence rules.
Author Resource:
John Masterton is a professional CFD trader trading with Australia's largest and most popular CFD provider , IC Markets. John has published a number of articles on CFD education including guides and ebooks which you can download for free.
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