Questions about the 'behind the scenes' of CFDs

[telstrareg]

I’ve read up a fair bit on the subject, but one thing doesn’t seem to be explained anywhere I've looked. CFD is a contract for difference between buy and sell price between 2 parties. Obviously I am one of the parties and can only assume that the service provider and its underwriter are the other party. So my questions (assuming a DMA market) are:

a) If I’m holding a long position in ABC, then is the provider holding an offsetting short position in ABC in the underlying equity?

b) if a) is true then when is the short position executed? The instant the trade is made, at market, or are the offsetting positions simply balanced gradually throughout the day (obviously there will be some clients long and some short on ABC so they cancel each other and don’t need to be balanced continuously).

Assuming I’m on the right track here, if I go long on a ABC CFDs, the provider goes short on the underlying. Depending on the volume, this short puts downward pressure on ABC. The consequence is that unlike buying the equity where buying exerts upward pressure (which is what you want), buying CFDs would actually exert downward pressure (what you don’t want) on the market. This ‘pressure reversal’ is also leveraged against my position.

 

[smoothsatin]

I’ve read up a fair bit on the subject, but one thing doesn’t seem to be explained anywhere I've looked. CFD is a contract for difference between buy and sell price between 2 parties. Obviously I am one of the parties and can only assume that the service provider and its underwriter are the other party. So my questions (assuming a DMA market) are:

a) If I’m holding a long position in ABC, then is the provider holding an offsetting short position in ABC in the underlying equity?

b) if a) is true then when is the short position executed? The instant the trade is made, at market, or are the offsetting positions simply balanced gradually throughout the day (obviously there will be some clients long and some short on ABC so they cancel each other and don’t need to be balanced continuously).

Assuming I’m on the right track here, if I go long on a ABC CFDs, the provider goes short on the underlying. Depending on the volume, this short puts downward pressure on ABC. The consequence is that unlike buying the equity where buying exerts upward pressure (which is what you want), buying CFDs would actually exert downward pressure (what you don’t want) on the market. This ‘pressure reversal’ is also leveraged against my position.

When you go long, your CFD provider does the same, for example when you buy 10,000 ABS at 7.43, you cfd provider buys the actual underlying stock, i.e holds 10,000 purchased at 7.43. CFD providers are essentially finance companies.

 

[telstrareg]

Thanks SS. Obviously I had it all wrong and the market forces are working in my favour. For the system to work then, the average of all trades from the client base would have to at least break even, since the commission is usually 10 basis points as with normal share trading where the broker does not wear any risk.

 

[>Apocalypto<]

When you go long, your CFD provider does the same, for example when you buy 10,000 ABS at 7.43, you cfd provider buys the actual underlying stock, i.e holds 10,000 purchased at 7.43. CFD providers are essentially finance companies.

what if it goes against you dont they hedge it as well?

 

[smoothsatin]

what if it goes against you dont they hedge it as well?

The CFD providers hedge is buying the shares. To follow on from the example if they buy 10,000 shares at $7.43 in response to your CFD order and the shares go to say 8.00 and you sell your CFD and the CFD provider sells the underlying shares....the CFD provider makes $5,700 (10,000 * (8.0-7.43)) on the trade of the share, loses $5,700 to you for the CFD...net poisition = even.... but makes commissions on the buy and sell orders you execute with them and the ineterst on the entire position. Same if it goes down, they lose on the common stock but gain from your CFD.

Hope this is clear

 

[telstrareg]

The CFD providers hedge is buying the shares. To follow on from the example if they buy 10,000 shares at $7.43 in response to your CFD order and the shares go to say 8.00 and you sell your CFD and the CFD provider sells the underlying shares....the CFD provider makes $5,700 (10,000 * (8.0-7.43)) on the trade of the share, loses $5,700 to you for the CFD...net poisition = even.... but makes commissions on the buy and sell orders you execute with them and the ineterst on the entire position. Same if it goes down, they lose on the common stock but gain from your CFD.

Hope this is clear

When you put it that way, it's bloody obvious. I don't know why I tried to make it so complicated (embarrassed). Thanks again!

 

[doctorj]

I'm not sure that smoothsatin is correct all the time. Remember that a cfd provider will have many clients, simultaneously long and short the same instrument. So, at any given time they may not be perfectly hedged, instead waiting for another customer to take the opposition position.

Being perfectly hedged all the time costs a CFD provider. In addition to the brokerage they pay on the trade and the lost interest income (from having your money in the bank, rather than in stock) they give up the opportunity to make money if you lose out. Given that cliché that 90% of traders go bust, I refuse to believe CFD providers are not led into the temptation of higher profits in exchange for retaining higher risk.

And this isn't unheard of either - insurers live on risk retention. Take your insurance policy for example. They charge you a premium based on the risk they will have to make a payment on the policy. They have the option of reinsuring 100% of the risk (ie. so someone like Munich Re pays them if you make a claim and in exchange they pay Munich Re a premium) and just profiting from the lower premiums they're likely to get as a bulk customer. Alternatively, they can reinsure a percentage of the risk (ie. retain some of the risk themselves) and keep the extra premium themselves in the hope they don't have to pay.

So while all CFD providers may not do this and I'd bet risk retention is more common in the MM CFD providers, be aware that there's a good chance they profit when you lose more than when you win.

 

[telstrareg]

I'm not sure that smoothsatin is correct all the time. Remember that a cfd provider will have many clients, simultaneously long and short the same instrument. So, at any given time they may not be perfectly hedged, instead waiting for another customer to take the opposition position.

Being perfectly hedged all the time costs a CFD provider. In addition to the brokerage they pay on the trade and the lost interest income (from having your money in the bank, rather than in stock) they give up the opportunity to make money if you lose out. Given that cliché that 90% of traders go bust, I refuse to believe CFD providers are not led into the temptation of higher profits in exchange for retaining higher risk.

And this isn't unheard of either - insurers live on risk retention. Take your insurance policy for example. They charge you a premium based on the risk they will have to make a payment on the policy. They have the option of reinsuring 100% of the risk (ie. so someone like Munich Re pays them if you make a claim and in exchange they pay Munich Re a premium) and just profiting from the lower premiums they're likely to get as a bulk customer. Alternatively, they can reinsure a percentage of the risk (ie. retain some of the risk themselves) and keep the extra premium themselves in the hope they don't have to pay.

So while all CFD providers may not do this and I'd bet risk retention is more common in the MM CFD providers, be aware that there's a good chance they profit when you lose more than when you win.

MM and DMA are two entirely different propositions. It makes perfect sense for DMA providers to do what SS described. MM does have the luxury of keeping it's options open, but the DMA model seems pretty foolproof. They pay lower transaction costs than their customers and pocket the difference plus any interest.

 

[yonnie]

hi all,

cfd providers are really making their profits on the interest they charge.

If you buy a CFD on a 50% margin share, you still have to pay interest on 100% of the position, so 2x the interest you should pay.
If your investment doubles in value, you pay interest on the full value of your CFD and now you pay 4x the interest you should be paying.

Greedy?

 

[>Apocalypto<]

hi all,

cfd providers are really making their profits on the interest they charge.

If you buy a CFD on a 50% margin share, you still have to pay interest on 100% of the position, so 2x the interest you should pay.
If your investment doubles in value, you pay interest on the full value of your CFD and now you pay 4x the interest you should be paying.

Greedy?

when u work it out the interest is really such a small amount, unless you have 1 000 000$$ parcel sizes then it would add up but if you can afford to make trades that size what the hell is a couple hundred bucks per day?

 

[Broadside]

When you put it that way, it's bloody obvious. I don't know why I tried to make it so complicated (embarrassed). Thanks again!

I don't know that the CFD always trades the underlying asset in order to hedge themselves, in fact I can see massive risks for CFDs or their customers in times of extreme volatility. They are a relatively new product so it may be trial by error if and when something happens, I hope their risk management is good. I trade CMC sometimes...I don't see market depth change when I trade, but I am not trading large amounts this way.