Equity CFDs

Equity generally means anything of value in its common meaning. For instance, it is customary for a home owner to think about the “equity” in his home, by which he means the difference between the value of the home and the amount that he owes on mortgage. If the house is worth $250,000 and he owes $100,000, then the equity is $150,000.

In the trading world, the term equity is much more limited in its connotation. Equity refers simply to ordinary stocks and shares. Equity CFDs have become a very popular way of trading, echoing as they do the performance of the underlying stocks and shares without needing to take ownership of them. There are several advantages to profiting from share price movements using CFDs rather than buying the actual shares.

The most obvious advantage of using CFDs for trading is that they are a margin product, which means that you do not have to invest as much money as you would when buying the shares. Typically, you will only have to pay 10% of the share value in order to participate in the price gains.

In addition, equity CFDs are available that permit you to trade on many markets, including London and other major European markets and the US markets.

Another advantage for the UK trader is that no stamp duty is required on the transaction, as equity CFDs do not involve actually owning the shares. This will save 0.5% at current rates.

However, trading with equity CFDs is very similar in other ways to owning the shares. For instance, if a dividend is due then the trader with a long CFD position will receive a credit to his account. Sometimes there are tax and administration charges to be deducted, so typically you will receive about 90% of the declared dividend.

The major difference to holding actual shares is that you do not receive the benefit of being able to vote at the shareholder meeting. Ownership of the shares does not change hands when trading equity CFDs. This also means that CFDs can be used for anonymous trading, as the stock exchange disclosure rules do not apply and the trades do not need to be published.

The trader who suspects that the share is going to fall in value can also go short easily with CFDs, and this does not involve owning or borrowing the underlying shares, as it does in stock trading. The CFD trader with a short position will have the dividend value debited from his account, however.

Because of the leverage enjoyed, equity derivatives are regarded as a higher risk financial product, as any losses are multiplied in a similar way to the gains. As CFDs are “marked to market” you will find any losses or gains in the share prices are reflected every day in your account, which may result in your broker executing a margin call and requiring you to deposit further funds, even while you’re still holding the CFDs.

One disadvantage with using equity CFDs rather than owning the stocks is that you are charged daily while you hold the long position. This is effectively an interest charge for the margin that you are enjoying. If you intend to hold any position in a stock for the long-term, you would not use equity CFDs because of this. In fact, if you anticipate wanting the exposure to the stock for a month or more, then CFDs would typically not be worthwhile.

Interestingly, because margin is used with CFDs, if you hold a short position you are paid interest on the daily value.

While many of the aspects of equity contracts for differences are similar to trading in single stock futures, there are some notable differences. For instance, there is no set date or time limit on a CFD. Futures always have a set settlement date, and this affects their value as the date approaches.

CFDs are also more flexible than futures in other ways. The minimum transaction size for a CFD may be as little as one share, depending on your broker, whereas single stock futures involve lots of 100 shares.

Provided that you read the market correctly, you can benefit from the mark to market pricing of contracts for difference. As your account is credited daily with the change in value, you do not have to sell your CFDs in the middle of a good run in order to use your gains to date. This means that you can continue to let your winners run and also use the profit you have made to date for another trade, which is a very efficient way of using your money.

There is another use of CFDs for the long-term investor who is concerned in protecting his position on his shareholdings. CFDs can be used as a hedging tool, protecting profits while maintaining a shareholding for the long-term.

For instance, you may hold some shares which you believe will continue to increase in value over the coming years, but you anticipate that the price will fall temporarily in the short term. You want to maintain ownership of the shares for the long-term, so selling them now is not a good option. You may also not want to realize any capital gains that you have made and on which you would be taxed.

The answer to this situation is to select short CFDs in the stocks right now. You maintain continued ownership, including voting rights, in the original shares. However, if as expected the price falls in the short term, having a short CFD will ensure that you receive some compensation which balances the loss in value of your shareholding, negating the disadvantage of holding on to the original shares.

CFD Examples

Trading CFDs isn’t complicated but for many investors it is a new concept, hopefully the examples below should help.

Example 1 Long Position (Purchaser)

Client A believes that the shares in XYZ are going to move higher and has a sum he wishes to invest to seek to profit to any possible rise in the price of underlying stock – i.e. ‘go long’.

Sequence of Events

8th November, the underlying stock is trading at $4.00 per share:

  • Client A decides to buy 5000 shares as a CFD at $4.00 per share which equals $20,000
  • Initial margin required (deposit) is calculated at 5% of contract value.
  • Actual initial margin requirement – i.e. funds required to cover the deposit at the opening of the position – is $1,000

12th November, price of the underlying stock has risen to $4.75 per share and investor chooses to close the position by selling the CFDs.

When the position is closed, the gross profit made by Client A can be calculated as follows:

  • 8th November purchased 5,000 CFDs at $4.00 per share
  • 12th November sold 5,000 CFDs at $4.75 per share
  • Gross profit on transaction = 0.75c per share x 5,000 CFDs = $3,750

Example 2 Short Position (Seller)

Client B believes that the price of shares in XYZ are going to fall and has a sum he wishes to invest to profit from any possible fall in the price of underlying stock – i.e. ‘go short’.

Sequence of Events

4th December, the underlying stock is trading at $5.00 per share.

  • Client B decides to sell 2000 shares as a CFD at $5.00 per share which equals $10,000
  • Initial margin required (deposit) is calculated at 5% of contract value
  • Actual initial margin requirement – i.e. funds required to cover the deposit at the opening of the position is $500

15th December, price of the underlying stock has fallen to $4.50 per share and investor chooses to close the position by purchasing the CFDs.

When the position is closed, the gross profit made by Client B can be calculated as follows:

  • 4th December sold 2,000 CFDs at $5.00 per share
  • 15th December purchased 2,000 CFDs at $4.50 per share
  • Gross profit on transaction = 50c per share x 2,000 CFDs = $1,000

The above examples obviously have shown positive trades where a profit was realised in both. Please take into consideration that any profitable trades could quite have easily been loss making and please conduct proper research before entering into any CFD position.