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This section will discuss:
Definition of CFD and CFD comparison with stock trading
The usefulness of CFD in a diversified portfolio
Trading strategy to improve outcomes
Introduction to CFD
CFD means Contract for Difference that was first launched in the early 1990s in the UK at the request of several institutional traders and big hedge funds. This investment brokerage services corporation wants the stock can be sold without having to involve the borrowing of funds and huge costs.
CFD is a derivative product derived from other existing instruments. The characteristic that attract investors is the capital involvement that is much smaller, because the use of the concept of margin trading in CFDs. Through the use of this concept, the investor or trader can receive a gain or loss in an amount equal to the real stock trading. Only by using a smaller-scale capital.
As a type of trade that has no assets, CFD requires contract as well as other derivative products. Involvement makes CFD contracts can be traded with high liquidity and the ability to short sell.
Margin and Gearing
CFDs are traded on margin and transaction process can be carried out through the use of deposit funds. In general, the broker uses a margin of 10% of the contract value.
Here's an example of how CFDs work, you want to buy 10,000 shares of the company at a price of $ 19.30 for DELL. To be able to get the stock in real terms, you should prepare a capital of $ 193,000. While for CFD, you only need 10% of the contract value, which is $ 19.300 to perform the same transaction (see table 1)
Table 1: The Comparison of Capital Requirements for Stock and CFD
The thing to note is that you must be prepared to cover the entire value of the contract and other costs if prices do not move in line with expectations. You also must have the ability to keep funding requirements if necessary at certain times.
However, CFD has a great value as well. The main advantage of margin trading is that you do not need to spend the entire value of the contract, so you can do a bigger deal than usual. It is becoming more advantages compared to the real stock trading. How to trade using margin referred to as gearing.
The Similarities of stock and CFD
Buying a CFD is almost the same as having a stock. Meaning that you have been given an added value of stock ownership, but without having the shares. Various benefits are commonly obtained by stockholders that you will also be achieved, among other things, capital gains and dividends. In order to further expand the knowledge about these instruments, it is worth noting the similarities and differences between stock trading and CFD:
CFDs are traded in price movements with quotations and have the same performance with real stocks. For example: If the value of shares rose by 20 %, the value of the CFD will also rise by the same percentage.
The impact of a news ( positive or negative ) on the stock will be exactly the same on the CFD market, as both have similar price movements.
Action issuers ( including dividends ) that event made by companies that have implications for equity holders. Examples are: mergers, stock splits, dividends, and so forth. The impact of this action will also affect the issuer of the CFD price. That was with stocks, with CFDs you will receive all the benefits of the action of the issuer ( or equivalent ) that will be credited directly to your account. One exception if you are a CFD trader, you do not have the right to vote on the resolution or meeting of directors.
High liquidity by means of CFD trading that is done Over-The-Counter (OTC), so you can enter a new position or liquidate an existing position directly as is done in the shares (with the provision that have large-cap stocks).
The share price is almost the same price obtained from the relevant stock exchange. Because CFD does not have its own exchange, but a derivative of the stock, the stock price of the CFD has a close connection with the share price quoted on the exchange.
Tight spreads. The spreads of U.S. stocks varies but typically ranges from one to four points. For CFD the spreads are fixed, and can be as low as only two points.
There is no expiration. Others than futures, stocks and CFDs have no real expiration date, so you have the freedom to enter a new position or liquidate your position at the time anytime you want when markets open. You can also leave an open position as long as you want it.
The main components of CFD
There are several important differences between CFD and underlying stocks. You should understand these components before jumping on CFD trading. The differences are:
Margin. As already discussed, CFDs are traded on margin which can be as low as 10% of the trade value. In stock trading, you can take a margin facility with borrowing. However only 50% can be used as a loan. While in CFD, a position equal to 10 times the amount of margin can be taken.
Short Sell. CFDs can be bought or sold first, so there would be oppportunities either in bullish or bearish market. Short selling of some stocks are not allowed (eg Indonesia). While U.S. stocks, can be sold in advance, but limited to the regulation (uptick) and require high cost (due to the cost of borrowing).
Dividends are factors to consider when investing in stocks. For CFD, CFD buyer can receive the benefits of dividends if the stock was purchased. But the main difference is that for U.S. stocks, you are subject to the tax burden of 30% of the dividends received. It does not have implications for the CFD. For example if you are entitled to receive dividend of $ 0.50 / share for 10,000 shares, you will receive a $ 5,000 fully paid to your CFD position, but for real stock because 30 % tax is imposed, you will only receive a net amount of $ 3,500. Another advantage is the dividend distributed on the ex - dividend date to buy a CFD position. As for stocks, dividends received on Pay date specified by the issuer, which could take a month after the ex-dividend date. On the ownership of CFD short positions, the person will pay an amount equivalent to the ex - dividend date. Note : The position must be open before the ex - dividend date to receive the dividend benefits ( conditions are the same as stock ).
The cost of an overnight CFD. CFD buyer will have to pay the cost of the overnight interest rate based on U.S. LIBOR (London Inter-Bank Offered Rate) which currently apply. LIBOR is the interest rate used for interbank lending. In general, a difference of 2% for long positions. While CFD seller will accept LIBOR minus 2%.
CFD transaction queue, as an OTC product directly executed by your CFD broker. There is no central exchange so no queuing order, therefore, also no partial fills for CFD term as on the stock.
No ownership when buying a CFD, no element of ownership in the transaction. So no voting rights and there is also no charge to stamp duty as well as on certain stock trading countries (Examples are the UK).
As discussed, Table 2 below is a summary of the major differences in trade shares and CFDs.
Table 2: Comparison of Stocks and CFDs
Example of CFD trading
Assume you deposit $ 7.500 to your CFD broker. You buy $ 75,000 worth of CFD. Suppose you buy 5 lots of Morgan Stanley (MS) at a price of $ 15.00. MS then rose to $ 16.00, and you suspect the increase will continue, and maintain the positions overnight. The next day, you receive a dividend of $ 0.40/saham. MS also rose to a level of $ 16.10. You then liquidate an existing position at that price. Your balance sheet will be as follows:
Table 3: A complete example of CFD trading
As seen in the example above, the final balance is $ 14,614. When compared with the initial capital gain, the profit was 94% of the initial capital. Advantages compared to capital (the term ROI) is enlarged due to leverage, as well as any costs and losses. So use the appropriate leverage at your comfort level.
* Based on 0.5% commission to buy and sell.
U.S. LIBOR at 3% level
Benefits of CFD
CFD can be used for various functions. In general, there are two main objectives in the utilization by CFD traders. The purpose of hedging is diversification and hedging the existing positions.
CFD, as it can be used with high leverage, it can also be used to diversify risk . In stock, usually there is no element of leverage, so that capital employed ( usually purchase ) can only be purchased with capital worth. But with CFD, you can use the leverage of CFD to design a portfolio of 5-10 stocks with capital employed that is only equivalent to one share transactions ( 10:1 leverage ) .
Figure 1 illustrates that with a capital of $ 100,000, you can control the stock valued at $ 500,000, with an investment value per share of $ 100,000 and in the five sectors of the market, then you just use a fund of $ 50,000 and still have a $ 50,000 residual ( because it uses 10 % leverage ). In stock trading, the amount of $ 100,000 may only be invested into a sector that is worth $ 100,000.
Figure 1: Diversification using CFD
In this case, CFD offers the perfect opportunity for a portfolio to hedge your stock. There is a very close relationship both in terms of price and quantity between stocks and CFDs. At the time a correction occurs, you need to protect the opposite position and the value of shares is not affected at all over the fluctuations. When the market already has a clear direction of movement, you can then let go of hedging.
There are three main advantages to hedge shares through CFDs:
Capital required is much lower due to the use of leverage in CFD. Tax is not levied on capital gains derived from the CFD, while stocks are taxable. Not required liquidation of your stock position.
CFD trading strategy
Pairs trading can be determined as trading activity through two different instruments but has a high correlation. In many cases, for example on stock transactions, the trading is done on two stocks in the same sector or industry. When the temporary correlation between the two increases (or decreases), then the condition is considered as an opportunity and exploited by buying shares at once while at the same time selling another stock.
Shares of Exxon Mobil (XOM) and Conoco Philips (COP) are two stocks that are in the same sector of the energy industry. Both of the stocks have 1.65:1 correlation movements. That is, 1 point movement relative XOM shares equal to (•) 1.65 shares of COP.
On March 17, 2009, there was a widening of the correlations reached the level of 1.85. So that the XOM stock is at 1 equals to 1.85 shares of COP. This indicates that the overvalued relative to the shares of XOM-COP. XOM stock price at that time was at $ 67.50 and COP at the level of $ 36.50. These opportunities can be taken by way of selling shares at the same time of XOM and buying the COP shares, each with a volume of 1 lot.
On April 23, the correlation of both stocks back to its original level, 1.65. At this point, XOM share price traded at $ 65.30 while shares of COP at the price of $ 39.30. Therefore, both the previous position may be liquidated at the same time. If we assume that the opportunity has been taken, the results obtained are as follows:
Table 5: Example of pair trading
* Assume the LIBOR rate of 0.4% in Table 6.5: Examples of pairs trading
From Table 5, it is assumed LIBOR rate of 0.4%. So that the position of buying bears interest at 2.4% (LIBOR + 2%) and short position bears interest at 1.6% (LIBOR-2%). The second position was maintained for 25 days, resulting in a total cost of $ 140 ($ 75 COP and XOM $ 65).
Once the correlation having contractions again, both the stock moves as expected, and resulted in a net profit of $ 4.860.
The stocks offer a great level of dividends that can sometimes provide opportunities and good trading reasons, and in many cases their validity is high enough, because, in addition to the distribution of profits, dividends also provide an overview of the condition of a company's optimism.
Through CFD, there are two important advantages of dividend, the first is the dividends received are not taxed. Secondly, the amount of the dividend is not calculated based on margin or leverage, but is calculated based on the contract value or the value of the original shares. It also means you can double the amount of dividends you have through CFD, if using the same amount of capital stock transactions.
Table 6 provides a comparison of the distribution of dividends from the three companies that have strong fundamentals.
Table 6: Comparison of dividends output of 3 companies for CFDs and stocks
As can be seen from the table, shares of Microsoft (MSFT) traded at $ 20.00 and dividends per year is $ 0.52 / share, or a yield of 2.6% per year returned to shareholders, and 26% return for the holder of the CFD. In the case of AT & T shares resulted in a return of 6% while generating 60% of CFD.
It is really worth noting when holding a CFD position as a matter of interest financing. Therefore, more long CFD position is maintained, the greater the cost of the interest you have to pay.
From the use of the dividend strategy for example, we take the example of General Electric (GE) listed in the table 6.6 for consideration. GE Company distributed dividends per year in large numbers, $ 1.52 / share. Assume you have purchased GE stock CFDs as much as 1,000 shares at a price of $ 11.50 and you hold that position for one year, during which prices did not experience significant movement (think of it that way).
Table 7: Comparison of CFD results and the stock dividend, hold position * Assumption 1 year LIBOR at 0.4%
In Table 7 above, it can be seen that you have to pay an interest of $ 276 as a result of maintaining this position for one year, while in trading stocks you do not have to pay any interest.
Listed below are several websites that are generally used to obtain fundamental information and U.S. stock dividends;
www.dividend.com (Information on dividends) www.moneycentral.com (Fundamental stock) www.dividendinvestor.com (Information dividends) www.learncfds.com (Learning CFD)