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WestCap
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West Capital Markets
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Financial Derivatives
Alternative Investments
Contracts For Difference (CFD's)
 Contracts for Difference (CFDs) were launched in the late 1990s, since then usage of these contracts by
both retail and institutional investors has grown to around 50 per cent of total share trading.
This phenomenal growth is hardly surprising given the considerable attractions of CFDs, including the lack
of stamp duty in some parts of the world, the facility to gear up, and the anonymity that they provide in that share ownership
via CFDs does not have to be declared.
What is a Contract for Difference?
A contract for difference (CFD) is a contract to buy or sell a share, or sometimes other investment type,
at a future date. When you enter into a CFD you can either go ‘long’ or ‘short.’ If you believe the
stock is going to rise you pay an amount at the end of the contract that equates to the asset's price at the time you entered
the contract, minus the price when the contract ends. If the price rises, as you expect, then the difference will be negative,
and when you close the contract you will make a profit.
Typically, a CFD requires an upfront payment of 10-20 per cent of the market price of the asset at the time
of purchase. Because this initial payment represents a small percentage of the value of the contract, a CFD is known as a
‘margin’ product, and the investor who takes out a CFD is said to be trading ‘on the margin.’
How it works
Assume you are an optimist, and you have heard a whisper that "Ghana Oil Company Limited" is likely to see
its share price rise in value, and that acting on this rumour you take on a CFD, and ‘go long.’
When you agree to such a contract, you buy a certain number of units. Because you are trading at the margin,
the money you pay up front is effectively a deposit. If you make a profit, this is refundable, and profit is in addition to
this. If you make a loss, your initial outlay will go towards the cost of this loss.
The amount you pay up front is normally 10-20 per cent of the investment’s initial value. So for example,
assume your initial deposit is 10 per cent of the asset's value. When the contract ends your profit will be price at the time
the contract was signed, minus the price when it ends, times the number of units.
So, if you agree to buy 1,000 units, with a unit price at outset of the contract of £10, you will fork out
10 per cent of 10 times 1,000, which equates to £1,000.
Assume that when the contract ends, the unit price of the asset is £12, so that the initial price, minus the
final price, equates to - £2. 1,000 units were bought, so your profit is £2,000, minus dealing charges. So, in the case of
this example, (and ignoring dealing charges,) you will have made a £2,000 profit, from an initial outlay of £1,000.
As the above example shows, the profits can be dramatic, but the losses can be too. If you get it wrong, and
the share price falls, you could end up seriously out of pocket. So, taking the example above, assuming instead that the share
prices falls to £8. Your loss will be £2,000 and you will have to pay out £1,000, on top of the £1,000 you paid upfront.
Open ended CFDs
One of the more interesting features of CFDs is that these contracts are open ended. You can choose to end
the contract, as and when you feel the time is right.
So if the asset moves in the opposite direction from what you had expected, you can hang on to the asset,
and wait for the price to move in the direction you had anticipated before you close the contract.
However, your broker will usually charge on a daily basis for this facility, so the longer you leave the contract
open, the higher the charges. The danger is that the asset falls in price when you had expected it to rise, and so you wait.
While doing so, the charges continue rise.
If the price falls very low, your broker may want you to deposit more money, so that he has greater cover
for the potential loss. For you, it's difficult to know when to get out and the temptation is to wait, even though the danger
is that by doing so you simply compound your loss.
Margin Trading
Another point to remember is this. If you have taken out a CFD, it is always wise to ensure you have cash
set aside in case you make a substantial loss. So while you may typically only invest 10 to 20 per cent of the asset's value,
you really need to set aside a lot more than that, in case the worst happens.
But a CFD can also work the other way. If you have a pessimistic view on the likely movement of a share, you
can enter into a CFD to sell a stock, or ‘go short.’ In this case, you pay the difference between the asset's
price at the time the contract ends, and the asset's price at the time the contract was taken out.
So returning to the example above, but this time applied to a ‘short’ CFD, you agree a CFD to
sell 1,000 units in the future. Assuming that the current price of that asset is £10, and you are required to deposit 10 per
cent of the asset's initial value, you deposit £1,000. But with this type of CFD, you are committed to paying the price of
the asset at the time the contract ends, minus the price at the outset.
Assuming the asset's value falls to £8, you pay £8 minus £10 x 1,000 units, you owe your broker -£2,000 (ie
a negative amount), so you have effectively made a £2,000 profit, less dealing charges. So your broker has to pay you back
£3,000 (£2,000 profit plus the £1,000 upfront margin payment).
But, as in the example earlier relating to a long CFD, if you get is wrong, and the asset rises in price,
you could make an equally substantial loss.
Interesting Features
One of the attractions of CFDs is that, unlike share dealing, they don’t incur stamp duty. Hedge fund
managers, in particular, like this feature, which is part of the reason why they are a popular instrument with these funds.
If you take a long position, then if the company whose shares you have contracted to buy, pays out dividends,
then you get paid the dividends, just as if you had bought the shares.
However, CFDs, unlike spread betting, are eligible for capital gains tax. But the capital gains tax cloud
has a silver lining - of sorts. If you make a loss, you can use this as an offset against other gains.
So in a way, you can use the fact these instruments are liable to capital gains tax as a way to hedge against
your investment. Making a loss is disappointing, but at least you can use this loss to reduce capital gains you have made
elsewhere.
For heavyweight investors, like hedge funds, CFDs bring another benefit. They are anonymous instruments, so
you can go long, or short on a company without anyone knowing who you are.
Indeces, Commondities, Treasuries (ICTs)
INDEX CFDS
An Index CFD allows a trader to speculate on the movement of an index taking either a long or short position.
West Capital Markets quote all major global indeces.
COMMODITY CFDS
WESTCAP's commodity CFD services offer popular instruments to trade including but not limited to Oil, Cocoa,
Gold and Silver through to Pork Bellies.
TREASURY CFDS
At WESTCAP, we currently quote a number of Treasury products including the T-Note, Gilt, T-Bond and Eurobond
issued by both domestic and foreign governments.
Futures, Options and Forex
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FUTURES AND OPTIONS
An option is a contract giving the investor the right to buy or sell an underlying
security at a specific price on or before a specified date. The investor enjoys the right to exercise the option contract
to obtain or liquidate the underlying asset but is not obligated to do so. As a matter of fact, most options are not exercised,
but instead do expire worthless. The option is a binding contract with strictly predetermined terms of agreement and properties.
Options are also known as derivatives, which means an option derives its value from something else. As an example, if you
buy 1 contract of an IBM July 100 call, the value of the contract is partly based on its derived value from the underlying
stock (i.e. in this case, it is IBM)
Options are very versatile securities that can be used in a number of different
ways. Options can be used by traders as a speculative vehicle in betting on the direction of a stock, or traders can use options
to hedge against loss of a stock price. In terms of speculation, the trader either buys or sells options depending on his/her
believe of whether a stock will go up or down, respectively. So speculation is nothing more than betting on the direction
of a stock. Using options as speculative vehicle is the reason why options have the reputation of being risky. This is because
when an option is bought, the trader has already bet that the price of the stock is either going to go up ( in terms of buying
a call option ), or the price will move lower ( in terms of buying a put option ). Also, the magnitude and the timing of the
stock's price movement are also critical components of options trading. To succeed, the option trader must correctly predict
whether a stock will move higher or lower and the trader must also be correct in terms of how much the price will change,
as well as the time frame it will take for all of this to occur.
Options can also be used as a hedge to protect the investor from losing all
of the value in the underlying stock. Hedging can be interpreted as an insurance policy against catastrophic events.
There are two main types of options: the American options and the European
options. The American options can be exercised at any time between the date of purchase and the expiration date. Most exchange
traded options belong to this type. The European version of options only allows the trader to exercise the options on the
date of expiration. Options can also be characterized as short-term options or long term options. The long term options are
also called LEAPS, which stands for "Long-Term Equity Anticipation Securities". While short-term options have expiration within
one to 9-months, LEAPS are defined as those options that have hold dates for as long as one year to several years. Whether
a trader participates in trading LEAPS or short-term options, or makes transactions using the American or European versions
of options, the basic building blocks of options are the call and the put options. A call option allows the holder of the
call to buy the underlying security at the predefined price within a specific period of time. For instance, an IBM July 100
call indicates that the holder can buy the IBM shares at $100 per share on or before the July expiration date ( which is typically,
the third Friday in the specified month ). A put option allows the holder to sell the underlying security at the predetermined
price within a specific period of time.
FOREX
The Foreign exchange market is a nonstop cash market where currencies of nations
are traded. Foreign currencies are constantly and simultaneously bought and sold across local and global markets and traders'
investments increase or decrease in value based upon currency movements. Foreign exchange market conditions can change at
any time in response to real-time events.
The participants in the currency exchange markets have traditionally been the
central and commercial banks, corporations, institutional investors, and hedge funds managers. In 2002, Bank of America
alone made a $530 Million profit in Forex trading as stated on their annual statement under "Global Investment Income". In
1986, Caterpillar made a 100 Million profit in Forex trading and would have actually had an operating loss for the year on
their normal business if it were not for that profit from Forex. In 2003, half of Daimler Chryslers 2Q operating
profit was from currency trades, making more money on foreign exchange than by selling cars.
Due to its popularity and the potential for very lucrative returns on investment,
many private investors have also migrated into this fast growing arena. Some of the major reasons why private investors are
attracted to currency exchange market and short-term Forex trading are:
* The Forex market is open for business around the clock. Nonstop 24
hours a-day 7 days a-week access to global Forex dealers are at the disposal of the trader.
* The Forex market is the biggest market in the world. It is an enormous
liquid market, with a daily turnover of more than 2.5 trillion dollars, making it easy to trade most currencies around the
clock.
* The Forex markets can be very volatile due to the interdependencies of the
world economy on current events. As such, the Forex market offers opportunities for huge profit potentials that are
derived from volatilities of world currency prices.
* The Forex Market contains inherent standard instruments for controlling risk
exposure.
* An investor has the ability to profit in both a rising or falling market.
* The investor can maintain leveraged trading with relatively low margin requirements.
* The Forex trader has many options for zero commission trading.
Just like in any other market, the goal of the investor in Forex trading is
to make profits from price movements. In Forex trading, an investor makes money by trading foreign currencies and the
trading is always done in currency pairs. For example, the exchange rate of EUR/USD on Jan 15th, 2004 was 1.0757. This number
is also referred to as a "Forex rate" or just "rate" for short. If the investor had bought 1000 euros on that date, he would
have paid 1075.70 U.S. dollars. One year later, the Forex rate was 1.2083, which means that the value of the euro (the numerator
of the EUR/USD ratio) increased in relation to the U.S. dollar. The investor could now sell the 1000 euros in order to receive
1208.30 dollars. Therefore, the investor would have USD 122.90 more than what he had started one year earlier. However, to
know if the investor made a good investment, one needs to compare this investment option to alternative investments. At the
very minimum, the return on investment (ROI) should be compared to the return on a "risk-free" investment. One example of
a risk- free investment is long-term U.S. government bonds since there is practically no chance for a default, i.e. the U.S.
government going bankrupt or being unable or unwilling to pay its debt obligation.
The whole premise behind trading currencies is that, the investor trades only
when he expects the currency that he is buying to increase in value relative to the currency he is selling. If the currency
he is buying does increase in value, he must sell back the other currency in order to lock in a profit. An open position
is a trade in which a trader has bought or sold a particular currency pair and has not yet sold or bought back the equivalent
amount to close the position. However, it is estimated that anywhere from 70%-90% of the FX market is speculative. In
other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency
in the end; rather, they were solely speculating on the movement of that particular currency. Most of the remaining
percentage of the forex market belongs to hedging (managing business exposures to various currencies ) and other activities.
Forex trades (trading onboard internet platforms) are non-delivery trades, i.e., currencies are not physically traded, but
rather there are currency contracts which are agreed upon and performed. Both parties to such contracts ( the trader
and the trading platform ) undertake to fulfill their obligations: one side undertakes to sell the amount specified, and the
other undertakes to buy it. As mentioned, over 70% of the market activity is for speculative purposes, so there is no
intention on either side to actually perform the contract (i.e., the physical delivery of the currencies). Thus, the
contract ends by offsetting it against an opposite position, resulting in the profit and loss of the parties involved.
Spreads are the difference between Buy and Sell ( or BID and ASK). In other
words, this is the difference between the market maker's selling price (to its clients) and the price the market maker buys
it from its clients. If an investor buys a currency and immediately sells it ( and thus there is no change in the rate of
exchange), the investor will lose money. The reason for this is the spread. At any given moment, the amount that will be received
in the counter currency when selling a unit of base currency will be lower than the amount of counter currency which is required
to purchase a unit of base currency. for example, the EUR/USD bid/ask currency rates at your bank may be 1.2015/1.3015, representing
a spread of 1000 pips (percentage in points; one pip=.0001). such a rate is much higher that the bid/ask currency rates that
online Forex investors commonly encounter, such as 1.2015/1.2020, with a spread of 5 pips. In General, smaller spreads are
better for Forex investors since they require a smaller movement in exchange rates in order to profit from a trade.
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Price, Quotes and Indications
The price of a currency (in terms of the counter currency), is called "Quote".
There are two kinds of quotes in the Forex market:
The Direct Quote: the price for 1 US dollar in terms of the other currency,
e.g. - Japanese Yen, Canadian dollar, etc.
The Indirect Quote: the price of 1 unit of a currency in terms of US dollars,
e.g. - British pound, euro.
The market maker provides the investor with a quote. The quote is the price
the market maker will honor when the deal is executed. This is unlike an "indication" by the market maker, which informs the
trader about the market price level, but is not the final rate for a deal.
Cross rates - any quote which is not against the US dollar is called "cross".
For instance, GBP/JPY is a cross rate, since it is calculated via the US dollar. Here is how the GBP/JPY rate is calculated:
GBP/USD = 1.7464
USD/JPY = 112.29
Therefore: GBP/JPY = 112.29 X 1.7464 = 196.10
Because currencies are traded in pairs and exchanged one against the other
when traded, the rate at which they are exchanged is called the exchange rate. The majority of the currencies are traded against
the US dollar (USD). The four next-most traded currencies are the euro (EUR), the Japanese yen (JPY), the British pound sterling
(GBP) and the Swiss franc (CHF). These five currencies make up the majority of the market and are called the major currencies
or "the Majors". Some sources also include the Australian dollar (AUD) within the group of major currencies.
The first currency in the exchange pair is referred to as the base currency
and the second currency as the counter or quote currency. The counter or quote currency is thus the numerator in the ratio,
and the base currency is the denominator. The value of the base currency (denominator) is always 1. Therefore, the exchange
rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange
rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency.
For example, an exchange rate for EUR/USD of 1.2083 specifies to the buyer of euros that 1.2083 USD must be paid to obtain
1 euro.
At any given point, time and place, if an investor buys any currency and immediately
sells it - and no change in the exchange rate has occurred - the investor will lose money. The reason for this is that the
bid price, which represents how much will be received in the counter or quote currency when selling one unit of the base currency,
is always lower than the ask price, which represents how much must be paid in the counter or quote currency when buying one
unit of the base currency. For instance, the EUR/USD bid/ask currency rates at your bank may be 1.2015/1.3015, representing
a spread of 1000 pips (also called points, one pip = 0.0001), which is very high in comparison to the bid/ask currency rates
that online Forex investors commonly encounter, such as 1.2015/1.2020, with a spread of 5 pips. In general, smaller spreads
are better for Forex investors since even they require a smaller movement in exchange rates in order to profit from a trade.
Banks and/or online trading providers need collateral to ensure that the investor
can pay in case of a loss. The collateral is called the margin and is also known as minimum security in Forex markets. In
practice, it is a deposit to the trader's account that is intended to cover any currency trading losses in the future. Margin
enables private investors to trade in markets that have high minimum units of trading by allowing traders to hold a much larger
position than their account value. Margin trading also enhances the rate of profit, but has the tendency to inflate rates
of loss, on top of systemic risk.
The ratio of investment to actual value is called "leverage". Leveraged
financing, i.e., the use of credit, such as a trade purchased on a margin, is very common in Forex. Using a $1000 to
buy a Forex contract with a $100,000 value is "leveraging" at a 1:100 ratio. The invested amount of $1000 is all that
is under risk in order to achieve the gain of $100,000. The loan/leveraged in the margined account is collateralized by an
investor's initial deposit. As a result, this may result in being able to control $100,000 for as little as $1,000.
Five ways private investors can trade in Forex directly or indirectly:
* The spot market
* Forwards and futures
* Options
* Contracts for difference
* Spread betting
A spot transaction is a direct exchange of one currency for another. The spot
rate is the current market price, otherwise known as the benchmark price. Spot transactions do not require immediate settlement,
or on-the-spot payment. The settlement date, or "value date," is the second business day after the "deal date" (or "trade
date") on which the transaction is agreed to by the two traders. The two-day period provides time to confirm the agreement
and arrange the clearing and necessary debiting and crediting of bank accounts in various international locations.
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