Financial markets are constantly changing. A significant breakthrough in trading on stock exchanges occurred in the 1980s, when futures markets developed in the United States. They started trading futures for currency pairs, stock indices and financial instruments based on interest rates. However, futures markets are intended for large players with larger capital. It was not until the 1990s that the financial markets for a retail investor were opened. It was not until the 90’s that financial markets opened for the retail investor. It has led to the development of CFDs offered on over-the-counter markets. CFDs are very similar in its construction to futures contracts, so let’s follow the development of both.
The first trade in futures contracts dates back to the 16th and 17th centuries. The first commodity exchanges were located in Belgium, in the city of Antwerp and in the capital of the Netherlands Amsterdam. The first famous speculative bubble appeared on the Amsterdam commodity exchange, and it concerned the price of tulip bulbs. Prices reached such levels that for the equivalent of several bulbs you could buy a house in Amsterdam. Of course, at some point the bubble burst, the prices of bulbs dropped sharply, and many people lost their fortunes, just like any bubble that continues to this day. The first tulip bulb price bubble described dates back to 1636.
The oldest futures exchanges
The oldest futures exchanges that operate to this day were created in the United States in the nineteenth century. A significant part of them is located in Chicago. The Chicago Board of Trade (CBOT) established in 1848 and is the oldest commodity exchange on which futures and options contracts are traded today. At the end of the nineteenth century, in 1898 another Chicago stock exchange was established, namely the Chicago Mercantile Exchange (CME). In 2007, the commodity exchanges merged and is now managed by the CME Group.
Let’s now discuss about the futures contracts. A futures contract is simply an agreement between two parties, the buyer of the contract (long position) and the seller of the contract (short position) for the purchase and sale of a specific instrument in the future. Futures contracts are traded only on futures exchanges, which precisely define the parameters of each contract, as well as the settlement of resulting receivables and liabilities.
Currently, futures contracts refer to a very large number of various instruments, including:
- stock indices,
- currency pairs,
- weather phenomena etc.
As I have already mentioned, futures contracts have parameters strictly defined by the exchange, which means that they are standardized. The commodity exchange determines the following parameters of each contract:
- the underlying instrument (e.g. crude oil WTI),
- the size of contracts (e.g. 1000 barrels),
- duration of the contract (e.g. the contract expires in a month and the next series enters),
- the smallest possible price change (so-called tick, for example 0.01 USD per barrel, which means that having one contract of 1000 barrels, a change in price by one tick means a change in the account balance by 10 USD plus or minus).
- delivery conditions (in the case of contracts for commodities, oil, gold, wheat, etc.),
- and many other parameters.
Of course, we do not have to hold the contract until it expires. We can sell it if there is sufficient liquidity (that is, there will simply be a willing person who will buy this contract from us). if we bought a contract and want to close the position, then we have to sell it, and a new buyer must be found on the market, which will take our place in the contract. Exactly the opposite happens when we sold the contract, so we took a short position. To close the contract, we must buy it back, that is, find an investor who will take our place in the contract again. Therefore, Open Interest may not change even when we close the position.
Here are all possible variants of change of Open Interest:
- a new trader buys a new contract (a new long position), a new trader sells a new contract (a new short position) – Open Interest increases,
- a new trader buys the contract (a new long position), an old trader sells the contract (closes the long position) – Open Interest unchanged,
- an old trader repurchases the contract (closes the short position), a new player sells the contract ( a new short position) – Open Interest unchanged,
- an old player sells the contract (closes the long position), an old player repurchases the contract (closes the short position) – Open Interest decreases.
In a situation where the price movement is accompanied by an increase in the Volume and an increase in the number of Open Interest, the trend should be continued. In the case when the volume and the number of Open Interest are reduced, the probability of changing the current trend increases.
Settlement of futures contracts
Settlement of receivables and liabilities of the parties to the futures contract takes place in the marking to market process. Each party, the buyer and the seller, must pay initial margin, which is a percentage of the entire contract. Every day the account of both parties is corrected in plus or in minus, depending on price movements of the underlying instrument. In addition, a maintenance margin is set, which is usually slightly lower than the initial margin. When the amount on the account falls below the level of the maintenance margin, the investor is requested to top it up (margin call) and must pay a so-called variation margin.
Theoretical price of futures contracts
- F – futures price
- S – the price of the underlying instrument
- S x r x n/360 – cost of carry
The CFD’s market is an over-the-counter market (OTC), which unlike the stock market, does not have one headquarter. The over-the-counter market is created by banks, investment funds, hedge funds, brokers, etc. The OTC market can operate 24 hours a day (currency market, better known as Forex), and even on weekends, as in the case of cryptocurrencies (bitcoin, ethereum etc.).
The OTC market often gives the opportunity to negotiate the terms of the contract, especially how we conclude it with the bank in order to hedge against the risk, for example a forward contract or a currency option. As it has already been mentioned on the stock exchange, there is no such possibility. All parameters are predetermined.
The OTC market allows to protect against various types of risks (currency, interest rate, credit), which are mainly served by forward contracts, options, swap contracts, credit derivatives. The OTC market also allows speculation with financial instruments. CFD contracts are mainly used for speculation, to a lesser extent they are used to protect against these risks.
CFD Contract, Contract for Differences – means an electronic transaction based on fluctuations in the prices of underlying assets, such as:
- currency pairs,
- stock indices,
- cryptocurrencies etc.
When we buy a CFD contract, we will earn a price increase, and the selling party will lose and vice versa. We do not physically buy a given asset, we speculate about the price change in the future and we earn on it.
The first CFDs were traded in London in the 1990s. They were invented to avoid taxes on share trading on the London Stock Exchange. However, it was not until the 21st century that CFD contracts became much more popular. CFD contracts have made the markets that have not been available to a retail investor, such as forex, to be available to practically anyone. CFDs are only available on the OTC market. Trading them takes place thanks to CFD brokers.
Advantages of CFD contracts
- CFDs provide the possibility of unlimited trading on the bear market, i.e. the so-called short sale. In the stock market trading on the bear markets is not always possible. The stock market must admit the equity to trade on the dips.
- The market for CFDs based on currency pairs is available 24 hours a day for 5 days a week, and in the case of CFD contracts based on cryptocurrencies, we can trade even on weekends.
- Hundreds of markets in one place – thanks to CFD contracts, it is possible to trade practically on all instruments that are traded on major stock exchanges and over-the-counter markets in the world. You can speculate on the currency market, stock market, bond market and commodity market, and recently also on the cryptocurrency market.
- High leverage – leverage is a tool that allows you to open more transactions than your account. Suppose your capital is 1000 USD, and the broker’s leverage is 1: 100. We can therefore open a position with a value of up to USD 100,000. Thanks to the leverage, you do not have to have the entire amount to invest in a given instrument. Unfortunately, the leverage works in two directions. If you make too much leverage, your losses may even exceed your account equity.
CFDs have opened many markets for retail investors. Additionally, thanks to leverage, we can start trading with really small capital. It is very important to speculate that CFDs are the choice of a broker who will act as an intermediary in CFD transactions. There are two types of brokers, Market Maker and STP/ECN. The first one is always the other party to the transaction, and the other one should theoretically transfer the transactions to liquidity providers, but it is different. Therefore, a very important element is a stable trading partner, in this case a broker.