Contracts for difference (CFDs) are a near-perfect route into the markets for those who wish to trade financial assets rather than own them. Each CFD is, as the name suggests, a contract between the trader and CFD provider, usually, a broker.
The trader takes a view on whether the asset in question – a share, a currency, an index or anything else – will rise or fall in value over a certain period. The broker, essentially, stands on the other side of the trade. At the end of the contract period, one party – whichever made the best judgment as to the direction of the price – will receive from the other the difference between the opening and closing price.
As the trader never owned the capital asset, how can any gain be taxed? But less well-understood is how CFD trading is paid for. Are there fees. Are there commissions? What should a novice CFD trader look out for?
Spreads and fees
The first thing to bear in mind is that the answers to these questions vary enormously, across brokers, across different markets and in relation to different assets.
In some cases, there are no charges at all for day trading, with the broker making its profit solely on the difference between the buying and selling price - the “spread”.
More on that in a moment.
The most obvious is a commission or fee on the value of the underlying security being traded. The size of this can vary a lot, from 0.1% to perhaps 0.3%, or more. Fortunately, this is a very competitive market, so the ability of brokers to charge steep commissions is severely limited.
If a commission is charged, it will usually apply to all instruments, including the trading of indices.
The second way in which traders pay a broker is through the spread, as mentioned earlier. This difference between buying and selling prices means, in effect, that a trader’s position has to move a number of points in what is, from the trader’s point of view, the “right” direction before they could even sell the contract back for the price they had paid.
When a broker both charges commission and operates a spread, the trader needs to take full account of both because it is in the interplay of the two that most of the real cost of the trade will be found. Low commission may disguise wide spreads, and vice versa. The total cost is the important figure.
One charge common to all CFD brokers comes into play when a position is left open overnight, even if it is opened a few minutes before midnight and closed a few minutes after. This “overnight premium” usually varies from one asset to another and is normally set at a pre-agreed level above a benchmark such as the London Inter Bank Offered Rate (LIBOR), typically about 2%.
As to why this overnight premium is levied, the answer is that a CFD, being a derivative, allows traders to take a position while paying only a small fraction of the value of the underlying security. In effect, the CFD trader is trading on margin, thus an interest rate is payable.
Obviously, this premium is not charged when the trader closes out their position by the end of the day’s trading.
One of the less well-known benefits of CFD trading is that, while it does not give the trader the voting rights enjoyed by a shareholder, it does usually entitle them to enjoy a benefit when the underlying share pays a dividend.
Thus, most CFD providers will make a “dividend adjustment” to the trader’s account. For those holding a long position in the stock concerned, this is good news, because the adjustment will, typically, be equivalent to about 90% of the value of the dividend.
Unfortunately, for those taking a short position, their account will be adjusted downwards, usually to the value of 100% of the dividend.
This is, in effect, another charge, but only for those of a bearish disposition!
A transparent charging structure
What other costs may there be? Sometimes, the broker’s bank may charge a small fee when the broker despatches funds to the client’s account. Furthermore, the trader’s credit-card issuer may make charges for the deposits required of CFD traders when they open a trading account.
Earlier, we mentioned that some CFD brokers charge no commission at all, making their money solely from the spread between the buy and sell price. CFD providers that do charge commission may object that charging by spread alone may disguise a higher cost of trading than charging by commission, as the width of the spread may be less obvious than the upfront charge, certainly to a novice trader.
This argument does not really stand up. CFD providers will give details of both any commission and any spreads. Traders, even fledgling ones, will need to take account of either or both.
Which takes us to one final point. CFD trading costs are not merely transparent, they are sometimes lower than those that would be faced by someone trading the actual underlying instruments. However, for larger orders it would normally make more sense to trade the actual instrument in question.
To sum up, in order to make sure that CFD traders are choosing the right trading platform for their needs they should look at all costs in the round and select their CFD provider accordingly.