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Contracts for difference: Value for investors

Started by Admin, May 03, 2024, 11:12 AM

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Topic keywords [SEO] TRADINGCFD


CFDs changed the market and revolutionized trading by offering traders the ability to speculate on the rise or fall of a stock with leverage, using a computer and an Internet connection. CFDs had few competitors in the financial services sector and were quickly adopted by investors seeking financial independence.

A CFD is a financial product created from an underlying instrument. There is no receipt or delivery of the underlying instrument, and the result of the exchange (the monetary difference between the buy and sell price) is settled in cash. CFDs are available on a wide range of underlying assets, from individual stocks to stock indices, currencies and commodities.

British market

The UK CFD market has been around since the 1980s and has become very dynamic since the mid 90s with the advent of the internet. The UK CFD market exploded when the bear market of 2000-2002 hit and investors demanded more leverage and more efficient ways to short stocks. Since then, CFDs have become a mainstream form of trading in the UK for both professional and private investors.

The volume of equity CFD trading has grown significantly in recent years. Excluding trades between professional firms such as investment banks and brokers, equity CFDs account for around 30% of all transactions in the UK stock market.

Demand in Europe

Demand has also grown in continental Europe, with institutions using CFDs for hedging purposes and retail traders turning to CFDs to replace more traditional investment products such as warrants and certificates. Four important developments have collectively accelerated the process of disintermediation, the elimination of the intermediary and the significant transfer of financial power from investment banks and financial institutions to individuals. In some order, these are the introduction of SETs in October 1997, the emergence of new financial instruments and derivatives, the full visibility of the market through Level II, and the impact of the Internet as a resource and means of execution.

CFDs entered the retail market in 1998, almost a decade after they had established themselves as a legitimate alternative to traditional equity trading in the institutional arena. The driving force behind their emergence was a combination of the prohibitive stamp duty regime in the UK and the difficulty of creating and maintaining short positions in individual stocks. CFDs are ideal for short-term trading. They are neither a substitute nor an alternative to long-term investing.

A more accessible market

As mentioned above, four fairly significant events have converged to make the UK stock market more accessible, visible, profitable and user-friendly.

In October 1997, the London Stock Exchange (LSE) introduced SET, a computerized order management system that replaced the traditional market-making system for the top 200 stocks. Although initially viewed with skepticism, SET is now firmly established as a major source of price discovery and liquidity. According to the latest LSE data, more than 60% of trades are executed on SET. SET is also used to determine official closing prices and pre-, intra- and post-market auctions, which provide CFD traders with many trading opportunities. The ability to become a price maker, not a price taker, and to submit limit orders within the market spread is a key feature of today's market.

CFDs are not the only financial instruments experiencing explosive growth. The popularity of spreadbetting, the introduction of universal stock futures by LIFFE and the growing use of the options market are all indicators of investor appetite.

See market depth

The ability to see market depth has now become essential. A number of brokers offer this service, and the ability to see all buy and sell orders submitted in the market provides an effective insight into the balance of power between buyers and sellers. However, this information should also be treated with caution, as market makers and other participants may intentionally "load" their books with multiple orders to give the false impression that support is well maintained, and these orders usually magically disappear as soon as they are close to execution. Market depth puts one on equal footing with large organizations, but it should not be viewed as an aid to trading or the only source of information.

The fourth major event

The fourth important development is the growth and proliferation of the Internet, both as a resource and as a means of execution. The fact that online spreadbetting has enjoyed such strong growth cannot be entirely independent of the fact that it is anonymous and can be performed with minimal human contact. The internet has been instrumental in bringing markets closer together, increasing their visibility, reducing brokerage commissions and enabling almost direct processing of trade orders. In the UK, unlike in the US, price-sensitive news is often published during the trading day, which has traditionally given an advantage to investment banks and market makers who can adjust their prices accordingly. Now, thanks to the order book and direct access, individuals can also act quickly to take advantage of imprecise prices.

What types of CFDs are available

As you probably know, you can buy contracts for difference on many underlying financial instruments such as stocks, indices, currencies and so on. The CFD format is flexible; all that is needed is a sufficiently liquid market with a large number of trades for a broker to create a CFD.

The broker can operate in two ways, and the third is currently only available in the Australian market. The first is the market maker (MM) model. The MM CFD broker sets buy and sell prices based on the underlying market for their clients. While this ultimately boils down to complete control by the broker, and therefore some people feel they can be manipulated, it is a viable system that is used by exchanges around the world. Competition from the large number of CFD brokers offering similar services keeps prices generally fair, even if some complaints are sometimes valid.

Second system

The second system used by CFD brokers is the direct market access (DMA) model. This brokerage system gives the trader direct access to the underlying instrument, allowing them to trust it to accurately reflect market prices. Whereas with a market maker system, traders often complain about re-quotes when an order is rejected. In a DMA system, orders are always executed when there is sufficient liquidity because orders are placed directly on the underlying security, but they can sometimes suffer from slippage (the difference between the requested and received price) if there is insufficient liquidity for the requested price.

Third system

The third system is called "exchange traded CFDs." These CFDs are traded directly on a centralized exchange. Introduced on the Australian Securities Exchange (ASX) in 2007, this system is controlled by the Australian government, making it as robust as traditional equities. It eliminates counterparty risk, or the risk of broker default, as these CFDs are guaranteed by the ASX. There are some disadvantages: the number of CFDs available is limited and the cost tends to be higher as you have to cover exchange fees as well as brokerage commissions.