Forget Password?
  1. Indices
  2. Commodities
  3. Currencies
Straits Times 3,114.16 -11.98 -0.38%
Hang Seng 26,719.58 -128.91 -0.48%
Dow Jones 26,770.20 -255.68 -0.95%
Shanghai Composite 2,938.14 -39.19 -1.32%
Thinking Of Shorting The Market? Consider CFD
Education | 26 May 2010
By: jason.liew
Articles (66) Profile

As of 20 May 10, S&P 500 has dropped 12.2% and 12.0% from its 52 week intraday high and 52 week closing high of 1,219.80 and 1,217.28 respectively. I believe readers are being bombarded with a multitude of bad news coming from various fronts such as the European debt crisis; after effects of the European US$1t bailout package; increasing regulation from Europe and U.S; fear of property asset bubble in China; worries over potential war between North Korea and South Korea and the list continues. Generally, markets which drop more than 10% are said to be undergoing a correction. Readers who are thinking of capitalising on the downturn in the equity market can consider contract for difference, or CFDs.

What are CFDs?

According to Phillip Capital’s definition, a CFD is an agreement between a buyer and a seller to settle the difference between the opening price and the closing price of the contract multiplied by the number of shares specified. There is no actual transfer of shares. Thus, CFD offers both leverage and the ability to short sell. CFDs can be used to long or short equities and equities indices.

Below are the characteristics of CFDs, tabulated in Table 1.

Characteristics of CFDs (Source: Ernest )
Table 1: Characteristics of CFDs (Source: Ernest)

CFDs – important execution difference than stocks

Generally, the order execution of CFD differs from stocks. For example, with reference to Table 2A, Stock A is trading at S$1.01 with a bid of S$1.00 and an ask price of S$1.01. While I am keying in a CFD order to buy Stock A at 1.01, the screen changes to Table 2B where all the sellers at the ask price of S$1.01 are filled and the next ask price of S$1.02 appears on the screen. Readers will notice that firstly, after I key in a CFD order to buy Stock A at S$1.01, the buy order at S$1.01 will not appear in the bid price. Secondly, my CFD order will only be filled at the ask price of S$1.01 i.e. there have to be sellers who are willing to sell at S$1.01, else my CFD orders will not be filled.

Notwithstanding the above, there are some brokerage firms which are able to provide direct market access where traders can execute the CFDs, almost similar to the underlying shares. However, this typically comes at a higher cost. Depending on the traders, this may, or not be useful.

Table 2: Illustration of order fill for CFDs

Table 2A – Before keying in the CFD order (Source: Ernest)
Table 2A - Before keying in the CFD order (Source: Ernest)

Table 2B: - While keying in the CFD orders (Source: Ernest)
Table 2B - While keying in the CFD orders (Source: Ernest)

CFDs – as your shorting weapon

CFDs can be an effective weapon to short the market. I will illustrate with an example below. For example, a trader has S$6,000 and he short sells 15,000 shares of Stock B at S$2 via CFD which allows him to have up to 5x leverage. The trader closed his short position at S$1.85 per share. Stock B closed at S$1.90 on that day. Table 3 shows the calculation.

An example where CFDs are employed to short a stock (Source: Ernest & Phillip Capital)
Table 3: An example where CFDs are employed to short a stock (Source: Ernest & Phillip Capital)

There are no clearing and access fees whenever we trade CFDs. For simplicity, I assume that STI and non-STI stocks have the same finance and commission charges. However, these charges are arbitrary. Readers should check with their brokerage firms on the exact charges.

For the above example, it is noteworthy that the trader has maximized his leverage by shorting S$30,000 worth of stock. He will face the following margin call (Table 4) for his open short position, if Stock B closed at S$2.10 for the day.

A margin call situation (Source: Ernest & Phillip Capital)
Table 4: A margin call situation (Source: Ernest & Phillip Capital)

CFDs – a double edged sword

From the above examples, it is apparent that CFDs is a double edged sword. Although it can cut the trader both ways, with good risk management techniques, it is nevertheless a good weapon to wield in the onslaught of a market fallout.

Join The Conversation
The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

All Rights Reserved. Pioneers & Leaders (Publishers) Pte Ltd. Best viewed with Mozilla Firefox 3.5 and above.