CFDs: Swings and roundabouts, and a wild ride

Smart Investor magazine, November 2008

 Contracts for difference can magnify your gains many times if you’re right about a stock, but the opposite applies too – any losses will multiply. That means this ride’s not for everybody, Chris Wright reports.

 Contracts for difference, or CFDs, are among the fastest-growing financial products in the world. They account for 30 to 40 per cent of all transactions on the London Stock Exchange, and, while they’re still fairly new to Australia, they’re on the rise here as well. Traders estimate they already represent 10 to 15 per cent of Australian Securities Exchange volume, just a few years after being launched here.

According to Mark Johnston, principal at researcher Investment Trends, there were already 26,000 active traders in CFDs in Australia by August – although reflecting market volatility, that represented a drop of 5,000 from the previous April – while a further 33,000 are expected to begin trading within a year, Johnston’s survey shows. One CFD provider, CMC Markets, handled 1.1 million trades in September alone – almost as many as CommSec, the leading broker for mainstream shares.

 So what are CFDs and should we all get in on the act?

Picture a share trade. You buy at a certain price. After a while, you sell. Your profit, or your loss, is determined by the difference between those two prices.

With a CFD, it’s the same except for two key differences: you don’t actually own the shares (in other words, CFDs are derivatives of those shares), and you can be very heavily leveraged. Leverage is when you need only commit a relatively small amount of capital up front to secure a much greater amount of exposure, which means you can magnify your gains – or losses.

CFDs are also an easy way to take a short position on a stock, which means positioning yourself to benefit if that stock falls in value rather than climbs.

Let’s take an example. Let’s say BHP is trading at $30 and being quoted in the market at a bid/offer of $29.99/$30.00. You think it’s going to go up. You could buy the shares, or you could buy a share CFD. Typically, CFD providers require you to make only a 5 per cent outlay (although this varies, typically between a 3 and 10 per cent minimum), so in this case if you wanted to buy 1000 BHP shares as a CFD, your initial outlay would be 5 per cent times 1000 shares at $30, or $1500. Buying that many shares outright would cost you $30,000; or, to look at it another way, that $1500 would have bought you just 50 shares purchased directly.

A month later BHP is trading at $35/$35.01. You decide to sell. Your gross profit (ignoring commission and interest for a moment, which we’ll come back to) is $35 – $30 x 1000, or $5000. Fantastic! That’s more than three times what you put up in the first place.

That’s the happy story. But what if BHP fell to $25? That way, you’d be down $5000 instead – so as well as losing all your money, you’d have to put in much more just to exit the position.

This is the first lesson of CFD trading: like all leveraged trading, it can be very good or very bad – and you can lose more than you put up in the first place.

“The inherent thing people need to be aware of is the higher level of volatility they’re going to be exposed to when they add leverage to a trading portfolio,” says David Land, chief market analyst at CMC Markets. “The smaller your position size, the lower your risk is going to be. Good awareness of risk management is the paramount aspect of dealing with CFDs.” All the big providers offer demonstrations or seminars, often online, to get up to speed with these issues.

The safeguards

It’s increasingly common, though, to mitigate potential losses in CFD trading using products such as stop-losses (some players call them conditional trading). In this case, you can set up a facility that automatically closes out your position if you reach a certain level of losses – or, indeed, a certain level of gains you want to lock in. David Trew, the managing director at CMC, says the majority of clients use these stop-losses.

There’s an important distinction to understand here, though. You’ll hear of stop-losses and guaranteed losses. In essence, a stop-loss order means the provider will do its best to close out at a certain price, but in certain circumstances that might not happen – a stock’s value might jump straight over the stop-loss level because of a profit warning, for example, or because of unpopular takeover bid. A guaranteed stop-loss, by contrast, will close out the position at that level no matter what happens.

Different providers have different models for these structures; in some cases stop-losses are free, but in all cases a guaranteed stop-loss costs more, as a trade-off for the improved peace of mind.

Cost, though, is generally one of the appeals of these products. To take IG Markets as an example, Australian shares require just 0.1 per cent commission; it’s the same at CMC Markets. That’s much cheaper than brokerage.

There is, though, a rate of interest charged on your position for the length of time that you hold it. According to InfoChoice, examples include 6.25 per cent at First Prudential Markets and MF Global, and 7.25 per cent at Macquarie Bank.

If you’d made the BHP trade above through Macquarie, therefore, assuming you’d held it for a month, you’d probably have an interest adjustment of about $300 to pay. (The corollary of this is that if you take a short CFD position, you earn interest instead.)

CFDs seem a lot like options at first glance, but there’s an important difference: options have a time limit, CFDs don’t. They don’t have to come in a fixed parcel size and they don’t have a set strike price. In that respect, they’re more flexible.

For you?

CFDs aren’t for amateurs. “The person needs to have a solid understanding of the underlying market they’re dealing with, which for most people is the sharemarket,” says Land at CMC Markets.

“Generally I’d suggest people look at a minimum of $5000 to trade with. That way you can take on a position size where you’re risking only a small percentage of your overall capital, but you’re in a position where things like commission and so forth aren’t starting to eat into your overall profitability.”

And leverage? “We always suggest people look to keep overall leverage levels quite conservative.” Even if (as with CMC) you can put down a margin of only 10 per cent, meaning 10 times leverage, “a leverage level of no more than three times your available trading capital is generally considered relatively conservative,” he says.

Land says that one advantage of leverage is that, since the initial outlays are lower, you can build a more diversified portfolio than you might otherwise have been able to afford.

Johnston says that most people say they get into CFDs for two reasons: leverage and short selling. In theory, this is a perfect environment in which to be able to short – if you’re good at predicting when it’s going to happen. It’s certainly good to be able to benefit from movements in share prices no matter which way they’re heading.

But one problem with shorting is that your potential losses are unlimited – there’s only so far a share price can fall, which limits your losses, but there’s no ceiling to how high they can go.

 Other uses

Although we’ve focused on share CFDs so far, many providers offer them over a range of other things – such as international shares, indices, commodities and foreign exchange.

In forex, in particular, the degree of leverage can be even higher and there’s generally no commission, with the profit instead being made in the difference between the buy/sell prices.

Investment Trends’ research shows us, though, that the vast majority of turnover in CFDs has to do with local shares. In Johnston’s previous report for 2007, 40 per cent of turnover was in the top 50 Australian blue-chip stocks. A further 37 per cent was over other Australian shares, then another 12 per cent over indices, chiefly domestic. Areas such as forex, overseas shares and commodities accounted for less than 5 per cent apiece. Trew, though, reports a clear trend towards these types of securities in recent months.

CFDs can also be used as a hedging tool – providing protection to a portfolio against a big shift. If you have many investments in overseas stocks you can protect yourself against big movements in the currency by using a CFD, for example. However, it appears few do so at this stage; 17 per cent of respondents to Investment Trends’ 1997 surveys said they used CFDs to hedge direct shares, and almost nobody to hedge currency risk.

Some feel, though, that this should be the main reason anyone uses a CFD. “The best strategy for using them is to hedge your existing shareholdings in the market,” Macquarie’s Daniel Semmler says. “As far as using CFDs for directional trading, we find in Australia that cash or share trading is a lot more effective because of the way the tax system is constructed.”

He argues that you can generally get just the same level of gearing into a share trade as you can in a CFD (at Macquarie, anyway) and that “if you can do it via a share trade it’s a much more efficient outcome for an end client”.

Specifically, on a CFD trade, you don’t get access to the franking credits on any dividends, which for some people is a very important distinction. Also, with CFDs you pay interest on the face value of the trade; with a geared share position, you pay interest on the amount of money you borrow.

“The best way to explain this is to think about how a mortgage works,” Semmler says. “If you bought a $100,000 property, with $20,000 collateral, you’d pay interest on $80,000. If the value of the property went up to $150,000, you’d still pay interest on the $80,000 loan. If you did a CFD over the same property, even though you put down $20,000 you’d pay interest on $100,000 – the full face value; and as it increased to $150,000, you’d be paying interest on $150,000.” Also, in geared share trades the interest can usually be prepaid and is tax-deductible.

It might sound odd to hear this from Macquarie, itself a provider of CFDs, but it offers them in combination with a range of other products through its Prime platform. Other groups that combine CFDs with other offers such as straightforward share trading or margin lending include CommSec and E*Trade.

CFDs are clearly here to stay, and they clearly have merit for the informed trader with a keen awareness of their own risk tolerance. But they offer some of the highest levels of gearing any ordinary investor can reach without having to prove their sophistication or knowledge, and that opportunity comes with great risks too. Buyer beware.

 BOX: The ASIC ban and CFDs

 On September 19, the Australian Securities Exchange announced a ban on naked short selling, effective from September 22. Covered short selling – where you have a binding agreement with someone to lend you the stock you’re shorting – is still permitted, but under stricter regulation.

 With CFDs marketed in part on their ability to allow shorting, where does that leave them? Strangely, opinion is strongly divided, even within the industry. “Different CFD providers have chosen to interpret the ASIC restrictions differently,” says Gavin White at provider City Index. “Some locally are allowing clients to establish short positions in equity CFDs on the basis that the provider will not hedge this into the market… City Index however has taken the view that we will abide by the spirit of ASIC’s restrictions and we are not allowing clients to undertake shorting trades in equity CFDs until further announcements from ASIC.”

 Trew at CMC disagrees. “The short sell ban is just on securities, not on derivatives,” he says. “Some CFD providers have misunderstood that. If ASIC wanted to ban short selling on derivatives they would have done it.”

In any event, says Trew, “clients don’t really go short a hell of a lot anyway. The basic human condition is to buy things and to hope they go up; if things aren’t going up, you sit on the sidelines and wait until you think they’re cheap enough to buy them.” He says clients use shorting to hedge positions, protecting themselves against falls in equities that they own. For White’s part, he says the impact of his approach has meant a decrease in trading activity, but since clients can still short indices – which are easily accessed through CFDs – business has actually increased.

NEED TO KNOW

• CFDs give you exposure to shares without owning them. They’re derivatives.
• They can use a lot of leverage. That’s great if you get things right, bad if you get them wrong.
• Most smart traders use stop-loss orders to limit how much they can lose on a trade.
• You can short sell stocks using CFDs – that is, benefit from the falling – although providers differ on whether that is currently permitted.
• Shorting can also be used to hedge a position, by protecting you against a fall in something else you own.
• CFDs are becoming very popular: turnover may hit $600 billion this year and many providers report 50% growth over last year.