# Understanding CFD's



## Duke of Marmalade (6 Feb 2014)

Bronte said:


> So I've a question on something I read. Those wonderful CFD (contracts for difference - for those not acquainted with the shorthand -but you will be soon enough ) Are they an investment vehicle or are they pure gambling? What's the difference etc I await the 'investing in shares' experts on AAM to guide me on this part of the opening day.


Now don't get me wrong I am not at all posing as an expert but I think I understand this one. RTE described it as betting with the bookie on what the difference will be between today's price and the price at some date in the future. So you might bet on the upside in Anglo's price of €10 today in three month's time. If price goes to €12 you "win" the €2 difference and vice versa if the price falls to €8. On the face of it you are gambling €10 as that is what you could lose but typically you will only be asked to post a "margin" of say 10% i.e. €1. So you see a very highly leveraged exposure to the share. To buy the share outright would cost €10 but for €1 you get the same exposure. Also you don't have to disclose your bet whilst a direct holding would be disclosed if big enough.

That is in fact an overly simplification. There is huge betting on horse racing and the football and, except for the odd fraud, the betting has no impact whatsoever on the actual outcome. Sean Quinn could bet €2bn on Man City winning the premiership and it would have no effect on the outcome even if it were found he couldn't pay up.

The difference is that with contracts for differences the "bookies" (investment houses) do not actually bet. What they do is actually buy the Anglo shares to cover their "bets", they take no risks (they thought) and simply charge the punter a relatively small fee. If word got out that Sean Quinn might not be able to honour his bets there would be a serious panic by the bookies as they dump the shares that they had bought to hedge the bets. That is why Anglo were so concerned about Quinn betting on their shares in a way that Man City couldn't give a damn who is betting and how much on them.


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## Bronte (7 Feb 2014)

Thanks Duke for getting back on this, I'm sorry but I still don't understand it. I know that I have a blind spot in this area so please bear with me. 

I understand what a straight bet on a horse is, and the odds. And that bookies lay off if they think too much has been bet. 

I also understand that you can bet a horse will win or lose. 

*Buying shares for cash*

So for shares, you can buy shares outright at 10€ each. If they go up to €12 Euro, you have now gained €2 - if you sell. If they drop to €8 Euro you have lost €2 per share - if you sell. 

If you have to sell or the shares never recover, (recent case with BofI and AIB bluechip shareholders), you may wipe out all your 'investment'

*Borrowing to buy shares*

You borrow the money somehow to buy. You now have the added cost of interest. All fine if the shares rise, you can sell and cover the cost of borrowing. But if it's a problem if you are forced to sell when the shares have tanked. In this case you've lost not only the difference between the purchase and selling price, but you still owe the original price plus interest. 

(Actually I did this once, with my one and only purchase of shares - Eircom. I knew the risk, and took the gamble, a calculated gamble I thought at the time and it paid off but risky all the same. Plus it was so easy to borrow as well)

*Contracts for Difference / CFD's*

This is what I called a product. It's a relatively recent invention to gamble on buying shares. Do you consider it gambling, what about the other two options above?

Here you do not buy shares, and you do not borrow to buy shares. You bet on share prices rising or falling. So if your bet is on a rise, and they go up to €12 you 'win' €2 and if you bet they go down to €8, you also win €2. 

Can you bet on both at the same time or does one generally bet on either one?

To do this bet you don't actually put down any of your own money. Now this is the bit I get a bit lost on. If you bet they will go up to €12 but instead they by down to €8, you lose the original share price of €10. And you have to now pay this €10

What do you mean by 'post' a margin of 10%? You are asked to pay something down, 10% of the share price of €10 I guess. So that's where you came up with the €1. Can it really be true that an 'investment house' will take only €1 when you could be on hock for €10. This I guess only can be done with the Sean Quinns of this world. What would he have had to do. And where would he get the 10% margin from. He didn't use savings.

Why is it a good think that using a CFD means you don't have to disclose your bet.

As for the rest of your post about the hedging of the bets, my poor brain is muddled enough with the above to be sorted first.


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## Duke of Marmalade (7 Feb 2014)

_Bronte_ maybe if I can explain "margin" the penny (€2bn) will drop. CoDs, Financial Spread Betting, Forwards, Futures are all economically identical albeit different in legal form. They are similar economically to borrow to invest but there is a difference. If you borrow €10 to buy shares the lending will be a separate legal arrangement and subject to normal credit criteria. The bank probably doesn't care that you are borrowing to buy shares. In that way you can maybe borrow 100% of the share purchase to give 100% gearing.

Lets take FSB. Here you notionally buy the shares off the FSB firm on say a 3 month contract. In 3 months you are required to notionally sell them back at the then price. This is identical to borrow to invest economically but structurally this is a *notional* borrow to invest. Now the FSB firm is not in the business of lending against credit risk so it will require an amount to be deposited with it which would cover any likely losses that might be incurred. This is the margin. Its size depends on the type of underlying investment/bet. For currencies the margin will be small. For individual stocks much higher. Another key thing to note is that each day the arrangement is "marked to market". That means the margin is topped up (or drawn down) if the share prices moves against (for) the punter. In that way the FSB firm can decide its margin policy on a very short term horizon. So 10% for Anglo might have been about right.

All the other instruments I mentioned above operate in a similar fashion. *This is not a bet that the price will move to 12. It is a notional purchase of the stock at 10.* Whatever the *difference* between the final settled price and the notional initial price will be the win/loss.

Is it gambling? Well, that depends on motivation and indeed on name calling. FSB firms are desperate to call their contracts "bets". That's because bets are free from CGT. Exchanges are desperate to call their futures contracts "investments" as the likes of life companies are not permitted to "bet". The regulations determine whether a life company is betting dependent on its motivation. If the "bet" is a mere speculation then that is gambling and is disallowed. If it is to hedge other exposures then that is risk management and is allowed. Similarly if it is an efficient way of replicating direct investment then that too is allowed.

Was Sean Quinn gambling? He claims that he didn't think so, he thought this was a good "investment".


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## Bronte (7 Feb 2014)

*Understanding CFD's - no discussion of the current court case*

I have to understand this or I'll never be able to keep up with the trial. 

Notional = meaning you and everybody else pretend you're buying at a future price that you think the shares will be at. To Bronte this is a bet. To Duke and everybody else in this business it 'depends'. 

Margin = as you're not putting down the share price, you must put down an amount to cover if you lose, but it may not cover the full losses. And this is also called a deposit. And it's also because the people you're doing the bet with are not going to loan you the money to place the bet.

Questions: 

1. Where did Quinn get the margin from, was it cash he used, was it borrowing on his Quinn empire, was it using Quinn shares

2. I understand his bet lost, and now he had to pay up, he had already paid the margin/deposit, but it wasn't enough, where was the extra money coming from.

3. If before the 3 month deadline is up the investment company FSD will look every day at the share price and if it's going bad for Quinns bet, then he will be asked to put down more margin/deposit, is that correct?

4. There is an added risk to all of this, not just that the share price doesn't go the way you want. Other people can bet against you, how does that come into the Quinn story.

5. Did this added risk happen in the Quinn story. Or did the shares tank for another reason. 

6. deleted 

7. Quinn had built up a stake of 28%, this I don't understand as I thought he hadn't actualy purchased any shares, only notional future prices. 

8. I totally do not get why some of these transactions, depending on what type of company it is, that it's a bet for one and an investment for another?  How can the motivation define the legal definition for tax purposes.  

(Didn't we have a guy on AAM in the last 6 months who was gambling/investing, and constantly winning and we had a debate about whether he was gambling or trading or investing. I think Jim in Switzerland was involved in that one)


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## Duke of Marmalade (7 Feb 2014)

_Reference to jury deleted _




Bronte said:


> Notional = meaning you and everybody else pretend you're buying at a future price that you think the shares will be at. To Bronte this is a bet. To Duke and everybody else in this business it 'depends'.


Kinda. Actually it can be shown mathematically that the correct "notional" price is in fact very close to the current price rather than the expected future price, but let's not go there. I'll admit that it walks and quacks like a bet but then again so does every transaction in the multi trillion derivatives market. Some argue that direct investment is also gambling.





Bronte said:


> Margin = as you're not putting down the share price, you must put down an amount to cover if you lose, but it may not cover the full losses. And this is also called a deposit. And it's also because the people you're doing the bet with are not going to loan you the money to place the bet.


8 out of 10





Bronte said:


> Questions:
> 
> _reference to matters at trial deleted _
> 
> 2. I understand his bet lost, and now he had to pay up, he had already paid the margin/deposit, but it wasn't enough, where was the extra money coming from.


I am not sure about this but I think Anglo bankrolled him to the bitter end and that there were no losers on the other side of the CFDs.





Bronte said:


> 3. If before the 3 month deadline is up the investment company FSB will look every day at the share price and if it's going bad for Quinns bet, then he will be asked to put down more margin/deposit, is that correct?


Correct but it looks every day at the market not just coming near the end. It always tries to keep enough margin to allow it survive a "worst possible" day in the market.





Bronte said:


> 4. There is an added risk to all of this, not just that the share price doesn't go the way you want. Other people can bet against you, how does that come into the Quinn story.


Yes indeed and at these huge levels secrecy is paramount because otherwise you become a sitting duck for the shorties.





Bronte said:


> 5. Did this added risk happen in the Quinn story. Or did the shares tank for another reason.


I am not sure but we now know that fundamentally the shares were worthless so my presumption is that normal market forces were at play rather than a conspiracy. 





Bronte said:


> 6. deleted
> 
> 7. Quinn had built up a stake of 28%, this I don't understand as I thought he hadn't actualy purchased any shares, only notional future prices.


You are technically correct here and I think this is carelessly reported. He had no stake in the bank but an exposure similar to a 28% stake. This bit I find hard to understand. Did he intend at some stage to actually buy the shares? I presume so.





Bronte said:


> 8. I totally do not get why some of these transactions, depending on what type of company it is, that it's a bet for one and an investment for another? How can the motivation define the legal definition for tax purposes.


The motivation does not usually impact on tax assessments but the legal form can, though in recent times the taxman has been moving towards looking at substance rather than form. The FSB companies go to great lengths to stress that you are "betting" but the Revenue could at any time overturn this if they saw it as a CGT avoidance mechanism. Indeed they did see CFDs as a stamp duty avoidance scheme and went after them to howls from the great and the good. I was unsure whether your "gambling" motif had a moral dimension to it in which case motivation is a relevant factor


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## Bronte (10 Feb 2014)

*Understanding CFD's - no discussion of the current court case*

I guess Duke/other experts can answer my questions on CFD's, of which I have many, but I was getting to slowly understand them. So I've opened a new thread.  Also assuming we can discuss how Sean Quinn purchased the CFD's which is central to understanding them, without in any way discussing an actual court case.


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## Brendan Burgess (10 Feb 2014)

Hi Bronte

There is no problem in discussing how CFDs work, so I have restored your thread.

I have deleted many references to issues at trial.   This actually takes a fair bit of reading and judgment on my part. If it becomes too much work, I will just close the thread again.

It's probably simpler to have a discussion of CFDs without referring at all the current trial. You should be able to apply the principles to any case.

Brendan


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## Bronte (10 Feb 2014)

Thanks BB. 

Investing/gambling on CFD's at a very high level has to be done in secrecy as someone else might undermine your 'bet' by betting against you, in this case by causing the share price to crash. In Anglo's case this was not the reason, but how can anyone be totally sue of secrecy. The people working in investment house FSB knew, they could have told someone. Don't all the traders have TV screens and monitors and can see what is going on.

People who invest in CFD's, what type of people are these. The likes of George Sores etc? It seems such a high risk way of making money. 

Is there a way to minimise the risk, by laying off, how would that work with a CFD. You would bet that the share price would go down, that way you're hedging your bet I guess. 

Is it normal to borrow to 'purchase' CFD's. Doesn't that make it doubly risky. 

I explained this to my OH, the nearest thing he came up with is that it's Poker. He gambles occasionally on horses and cards. Years ago he was told by the real gamblers not to play Poker with them.  It's a high stakes game for which you need nerves of steel.  Does CFD's bear any resemblance to Poker, in it's thrill and risk.


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## Duke of Marmalade (10 Feb 2014)

Bronte This is a typically excellent explanation from _Wiki_. It makes many of the points that I have already made. One feature I was unaware of, and which may be relevant to the current situation, is that CFDs are open ended. That is they do not expire in 3 months time or at any other fixed date, they simply roll over indefinitely until you "close" them out.

You seem to understand the economics but I feel you are overplaying certain aspects. Generally, secrecy is not really that important. At the enormous levels in this case obviously it was very important.

It is not at all like poker, other than involving taking risks. Poker is very much _ad hominem._ It involves bluff and it involves judging how the other players will react to your bets and you in turn making judgements about their bets, it has surprisingly little to do with being able to judge the quality of your hands, most people are capable of that. Secrecy is of course essential. You couldn't win at poker by putting all your cards on the table 

But you could win on CFDs even if you published your position in the National Press, unless the position is so outrageous that you would be vulnerable to "ganging up" against you.


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## Bronte (13 Feb 2014)

Duke of Marmalade said:


> Bronte This is a typically excellent explanation from _Wiki_. It makes many of the points that I have already made.
> 
> .


 
_CFDs are traded between individual traders and CFD providers. There are no standard contract terms for CFDs, and each CFD provider can specify their own, but they tend to have a number of things in common._
_The CFD is started by making an opening trade on a particular instrument with the CFD provider. This creates a ‘position’ in that instrument. There is no expiry date. Once the position is closed, the difference between the opening trade and the closing trade is paid as profit or loss. The CFD provider may make a number of charges as part of the trading or the open position. These may include, __bid-offer spread__, __commission__, overnight financing and account management fees._
_Even though the CFD does not expire, any positions that are left open overnight will be ‘__rolled over__’. This typically means that any profit and loss is realised and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. The industry norm is that this process is done at 10pm UK time._
_CFDs are traded on __margin__, and the trader must maintain the minimum margin level at all times. A typical feature of CFD trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on screen. If the amount of money deposited with CFD broker drops below minimum margin level, margin calls can be made. Traders may need to cover these margins quickly otherwise the CFD provider may liquidate their positions._
_To see how CFDs work in practice see the examples of typical CFD trades. The ‘margin percentage’, and ‘charges’ shown may vary from provider to provider, but are typical of CFD providers._

From that link the above is a good explaination.  Duke do you consider CFD's to be pure gambling or investing?  To me the description is like spread betting.  And the margin calls are crazy, you have your bet, but to keep that bet going you have to up the stakes, is that not Poker?  And if you don't pay the margin then you lose your full bet, which presumably means not just the margin, but more because you didn't put down the full bet.  You described that earlier as the full share price of 10 Euro.  

Surely to borrow to pay margin is the most crazy prospect ever to win.  And then to chase your losses, again and again.  

I still totally do not get one thing, how does this CFD affect the share price.  Because it's nothing to do with it.  

Why would a bank loan on a margin call, on CFD's, would they not have asked what was the money for.  Which CFD etc.


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## bazermc (13 Feb 2014)

Is it contracts for difference*s* or contracts for difference?

The RTE reporter (Orla whats her face) reporting on the case seems to interchange them
i.e. last night she said Quinn had CFD, while the previous night it was CFD's


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## Duke of Marmalade (13 Feb 2014)

Bronte said:


> From that link the above is a good explaination. Duke do you consider CFD's to be pure gambling or investing? To me the description is like spread betting. And the margin calls are crazy, you have your bet, but to keep that bet going you have to up the stakes, is that not Poker? And if you don't pay the margin then you lose your full bet, which presumably means not just the margin, but more because you didn't put down the full bet. You described that earlier as the full share price of 10 Euro.
> 
> Surely to borrow to pay margin is the most crazy prospect ever to win. And then to chase your losses, again and again.
> 
> ...


Okay,we're getting there. Forget poker, totally different game. CFDs are promoted as a facility for "day trading". Day trading IMHO is gambling no matter what the vehicle. But CFDs bring other advantages such as escaping stamp duty and in this particuar case maintaining secrecy. It seems to me that this particular case is more strategic than gambling. The distinction between gambling, speculation, investing, strategic stake building is all very blurred and one woman's gamble (I understand you may may be of the opp gender, I have no problem with that, some of my best friends are of the opp g) is another's strategic investment.

The share price is affected because at these enormous levels if the punter can't honour his bets the bookies are forced to dump the shares which they have been holding as a hedge against the bets.


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## demoivre (17 Feb 2014)

It surprises me that some commentators, who should know better, compare trading CFDs to betting on horses. There is a crucial difference in that a CFD position can be closed out at any time after it is opened, with minimum losses if the trader so chooses. You do not have to fund the margin calls if the trade is moving in the wrong direction - you can simply close out the trade and take the hit of the loss. If you bet on a horse you can't get most of your stake back after two furlongs if you reckon that your chosen horse looks exhausted and isn't going to win ! This is a critical difference and is precisely why astute traders can make money from trading financial markets whether it be through CFDs, futures, options or whatever - cutting your losses short and running your profits is the key to making money. You can't do this with horse races.


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## Brendan Burgess (20 Feb 2014)

An interesting bit I learned from attending the trial yesterday and listening to the evidence of Matt Moran, Anglo's Chief Financial Officer. 

Seán Quinn had CFDs with 6 different suppliers. 

The terms and conditions would be different on all contracts as there is no standard contract. 

One contract could oblige the CFD provider to deliver the actual shares within 3 days.
Another could oblige them to deliver the shares but give them,say two weeks, to do so.
Another might not have any obligation to deliver the shares. They would just have to pay the profit on the CFD to Quinn. 

Matt Moran said that Morgan Stanley were very concerned that a liquidation of the CFDs could cause a price squeeze _upwards_. If the CFD provdiders did not hold the underlying shares they would have to buy them in the market. This would cause the price to spike upwards "artificially". (There was then a dicsussion as to whether this was artificial or not). 

They prepared a standby scheme whereby the shares would not actually be traded but which would be lent to the brokers.  I didn't follow it, and the judge asked quite a few questions about it as well.  It doesn't seem to be reported in today's papers, so I suspect that the journalists didn't follow it either. In the end, Morgan Stanley confirmed with the CFD providers that they could all deliver the actual shares and the standby scheme was not needed. 

But it's interesting that there was a concern that the Anglo share price might spike upwards.


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## Bronte (20 Feb 2014)

demoivre said:


> It surprises me that some commentators, who should know better, compare trading CFDs to betting on horses.
> 
> you can simply close out the trade and take the hit of the loss.
> This is a critical difference and is precisely why astute traders can make money  cutting your losses short and running your profits is the key to making money. You can't do this with horse races.


 
But if you bet on a horse, you can lay it off, bookies do it all the time.  When too many people have bet on one horse the lay it off.  Is that different to what you are saying?  

If making money on CFDs is so easy why did Quinn lose?


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## Bronte (20 Feb 2014)

Brendan Burgess said:


> One contract could oblige the CFD provider to deliver the actual shares within 3 days.
> Another could oblige them to deliver the shares but give them,say two weeks, to do so.
> Another might not have any obligation to deliver the shares. They would just have to pay the profit on the CFD to Quinn.
> 
> ...


 
I find this bit interesting to and it's maddening it's not reported on. Duke and I discussed it as I couldn't understand if he was gambling on CFD's why it's constantly mentioned Quinn had a shareholding.  Maybe Duke could oblige again and explain the Morgan Stanley concern.  

 What is a liquidation of the CFD's, why and what would squeeze upwards?

It appears the CFD providers sometimes did not hold the shares, but then they might be forced to buy them, why?

It is quite amazing to me that in such a high profile case, one we've been waiting for that no Irish media has deemed it fit to hire a CFD expert.


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## Brendan Burgess (20 Feb 2014)

Hi Bronte

I used the word "liquidation" a  bit loosely. I meant the closing of the position. 

If the CFD contract obliges the provider to deliver the shares, and they don't actually own them, then they would have to go into the market and buy them. If there was an attempt to buy 25% of the company over a period of a few days, then the share price would rocket. 

Some CFD providers don't buy the underlying shares because they would have both sellers and buyers of CFDs on their books. For example, if you buy 10,000 Ryanair CFDs and I sell 10,000 Ryanair CFDs, the provider is taking no risk. Your gain is my loss. 

I presume that the CFD providers manage their risk carefully. If someone has a huge CFD position which could require the CFD provider to buy shares to close out the position, they then buy the shares and hold them. If the buyer of the CFDs closes out their position, then the CFD provider would sell the underlying shares.


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## Bronte (20 Feb 2014)

Brendan Burgess said:


> I presume that the CFD providers manage their risk carefully. If someone has a huge CFD position which could require the CFD provider to buy shares to close out the position, they then buy the shares and hold them. If the buyer of the CFDs closes out their position, then the CFD provider would sell the underlying shares.


 
Ok let's take that bit, is that what happened with Quinn.  He's bet was losing, the provider could see this, and got him to pay up on the margin, but meanwhile as it was such a large amount the provider, bought the actual shares and held onto them and then what?  How did this help?


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## elcato (20 Feb 2014)

> Ok let's take that bit, is that what happened with Quinn.  He's bet was  losing, the provider could see this, and got him to pay up on the  margin, but meanwhile as it was such a large amount the provider, bought  the actual shares


They didn't actually buy the shares as that would have made the share price go sky high. This in turn would mean that other people (using their services) could win and close out their position with MS, thus they would lose a lot on that bet and would not be guaranteed that Quinn would stump up his share.


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## Brendan Burgess (20 Feb 2014)

Hi elcato

I understand that in most CFD cases, the provider does actually buy the underlying share.  They might not do it if I buy a CFD for 1,000 Ryanair shares. But if someone buys the equivalent of 3% of a company, they would definitely buy the shares.

Brendan


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## Sunny (20 Feb 2014)

Its very rare that you will have physical settlement in CFD's. Most times there is simply a cash settlement as investors tend not to want to own the shares. They simply want to trade the share price. This was different as they wanted to convert the CFD position into a physical position. I would imagine that Morgan Stanley were worried about the price rising due to a potential squeeze because of the risks that it could be considered share price manipulation. That's just a guess though.


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