In its recent regulation enforcement presentation and report, the Financial Sector Conduct Authority (FSCA) raised concerns, among other issues, about CFD trading in South Africa. It was worried about scam sites posing as legitimate CFD trading operations and about illegal share-price manipulation practices involving CFDs.
CFD stands for Contract for Difference. It is a derivative instrument which, in common with other types of derivatives, is a financial contract that allows you to take a position on the movement in the price of an asset without actually owning the asset.
Although derivatives were originally intended to mitigate risk, they have become a favoured tool for speculation. Be warned: when things go wrong, they can go horribly wrong.
The earliest derivatives were simple forward contracts between farmers and the buyers of their produce. Some time before the crop was harvested, the farmer and the buyer would agree on a price per unit. This would protect the farmer if the prevailing price of the commodity, such as wheat, dropped in the intervening period. It would protect the buyer if the price went up.
Similarly, in today’s markets, mining companies can protect themselves – or “hedge” – against a drop in the price of the commodity they are mining and pension funds can protect their members by hedging against a drop in the value of their investments. This type of contract, which is governed by a future outcome, forms the basis of the most common types of derivatives: forwards, futures, options, warrants and CFDs.
Forwards
A forward contract locks a buyer and seller of an asset into a price that is payable on a specified date in the future, the expiry date. The transaction may be removed from the assets themselves: neither party needs to hold any shares at all, they can simply settle the difference in cash on the expiry date. In this way, even intangibles such as market indices can form the basis of a forward contract.
Futures
Futures are standardised forward contracts traded on public exchanges where the exchange provides protection against counterparty risk (the risk of either party not honouring the contract). If you take a “long” position on the underlying asset, you expect its price to rise. Conversely, if you take a “short” position, you expect the price to fall. To ensure you honour your commitment, the exchange requires a deposit, known as the initial margin.
A widely used instrument is the single stock future (SSF), which lets traders buy or sell a block of shares of a listed company at a fixed price on a future date.
The danger of trading futures is that your investment is “geared”, like a small cog turning a large cog. You can make or lose a large amount of money by committing a small amount of money (the margin). A relatively small change in the share price can have a big effect on your investment, and you can lose more than your original capital.
Options and warrants
Options differ from futures in that you are not locked in. They give you the option to buy or sell an asset on a certain date for a certain price. You can then exercise the option or not, depending on whether or not the price of the asset has gone your way.
There are two types of options: a “put” option is where you can sell the asset on a certain date and a “call” option is.where you can buy the asset on a certain date.
There’s a catch, and it’s called a premium. Instead of depositing a margin, as with a futures contract, you pay the party offering the option a premium. This is not refunded; in fact, it’s much like an insurance premium.
A warrant is a form of option offered by an issuer, such as a bank. Warrants are generally more accessible to smaller investors because the value of the contracts is smaller.
CFDs
A CFD is an agreement on the difference in price of a share between the opening and closing of the contract. It is not a standardised product traded on an exchange; rather, it is traded over the counter directly with a broker. The counterparty is the broker itself. As with futures, you put down an initial margin, resulting in the same gearing risk that can cause you to lose more than your capital.
CFD trading sites have proliferated in recent years. While many are legitimate and operate under a licence from the FSCA, there are dozens of scam offshore sites which simply swallow your money. Even the approved sites may be risky. Compounding the risks are the gearing referred to above and the volatility of the markets.
Interestingly, CFDs are banned in the US, which only allows retail investors access to derivative instruments traded on public exchanges.
References:
“Futures Contracts: Definition, Types, Mechanics, and Trading Use” (Investopedia)
“Understanding Stock Warrants and Options: Key Differences and Similarities” (Investopedia)
“Understanding Contracts for Difference” (Investopedia)
