Smart Investor: Global investing through CFDs

Smart Investor, July 2011

There are many ways of getting exposure to global stocks: you can buy a mutual fund, get index exposure through an exchange-traded fund, and increasingly you can just buy the stocks yourself through an internationally-connected broker. But you could also consider doing so through a contracts for difference (CFD) platform.

Contracts for difference allow you to make heavily leveraged investments that give you exposure to a share, an index, a commodity, a currency (see forex feature) and more or less any other investment class you can think of. Because of the leverage they allow, they come with something of a reputation for risk, and are often associated with semi-professional day traders. But used carefully, they can be an effective method of getting international exposure.

Most of the bigger CFD platforms offer international shares in one form or another. For example, IG Markets covers 16 international exchange including Australia; and since one of those is Europe’s Euronext, you can really trade stocks from dozens of different countries. CMC Markets offers hundreds of stocks in the US, UK and various European and Asian exchanges; MF Global allows all FTSE companies with a market capitalisation of greater than GBP50 million, and stocks within the S&P 500, Nasdaq 100 and various other exchanges. And City Index offers access to exchanges including the London Stock Exchange, Nasdaq and the Hong Kong Stock Exchange. All of them also offer access to stock indices themselves.

SUBHEAD: A QUESTION OF LEVERAGE

CFDs offer a greater degree of leverage than is possible in any other method of share trading – far higher than margin loans, for example. But the precise amount varies. “The leverage depends on the stock,” says Chris Weston at IG Markets. “We look at the liquidity, the market cap, the volatility within the stock, and assess exactly how much margin we are going to offer.” But whereas Australian banks can trade on a margin as low as 5% – meaning 20 times leverage – it would be unusual to be granted such freedom on an international stock.

“Share CFDs can range from 5 to 50 or more per cent as a margin requirement, depending on the size and liquidity of the company,” says David Land at CMC Markets. Clearly something like GE or Pepsi-Cola is going to be closer to the 5% end, while a smaller US stock, or perhaps one listed on a less liquid market in Asia, will be closer to the 50.

Many investors through CFDs use what is known as a stop loss. That means that, if a position falls by a pre-agreed amount, the platform will exit the trade for you automatically to limit your losses. This is seen as prudent risk management, but it also has an impact on the amount of margin that people are prepared to allow. “If you were investing in a stock for which we would allow a 25% margin normally, if you then do a guaranteed stop loss, because you are taking less risk we will give you more margin”, says Weston. “We might bring it up to 15 or 10%. So by putting guaranteed stop losses on the trade you can leverage up.”

CFD providers say that going through them brings a number of advantages. “If you look at the UK and US, you can trade multiple exchanges,” says Weston. “In the UK there are four or five exchanges you can trade. Our platform will take the best bid and offer from each individual exchange and put that into one ticket.” Increasingly, stocks appear on more than one exchange too. “If you are trading you don’t care which index you are trading from. You need to know the best bid and price from any of those exchanges,” he says.

SUBHEAD: DON’T FORGET THE CURRENCY

For anybody considering buying international stocks, the performance of the currency is an issue. This is discussed in more detail in the forex section, but generally speaking if you buy a stock in the US and it goes up, that’s great, except if the Australian dollar has risen against the US dollar by even more – in which case you’ll come out losing money even after buying a winning share. “There are a number of factors to consider in investing offshore, and currency risk is one of them,” says Weston. “You need to bear in mind what’s going to happen the domestic currency. If you think the Australian dollar is going to appreciate as well, you will probably want to put some hedging policy in place.” See the forex chapter for more on how to do so.

Weston says that the most popular venues for international share investing through CFDs are the UK and US. “The reason Australian investors like the UK is that there are stocks there they have a relationship with: BHP, Rio.” The UK is arguably more time zone friendly for Australia-based investors if they want to be hands-on and active, he says; an Australian wanting to trade in New York generally has to stay up until midnight to do so. IG Markets also sees some activity in Japan and Hong Kong.

Land also mentions the US and UK, but adds: “One area we’ve done a lot of work is the Hong Kong market. It’s proven to be quite a popular area for people who focus their energies on technical set-ups.” Hong Kong appeals to technical traders because it is liquid but also in the same time zone as Australia; the same applies to a certain degree to Japan.

Another advantage CFDs offer is cost. When you buy a UK share through IG Markets, the commission is 0.1%, and in Japan, 0.2%. Going through a physical broker is far more expensive. Brokers themselves argue that the CFD investor never actually owns the share, instead just getting exposure to it, which is not the same thing. Weston agrees this is true, but says investors can trade through direct market access, meaning the trade does go through the physical market. “You don’t take ownership of the physical stock but we guarantee the trade and hedge against it.”

SUBHEAD: RIDING THE INDEX

Indices are very popular for CFD investors venturing overseas. They offer leveraged exposure to an entire market, which gives a more diversified position than leveraging into a single share. “Rather than trading a specific share through CFDs, may people like the ability to trade the index,” says Land. “That could be one of several indices available in the US, while regional markets like Hong Kong are very popular to trade, as is the UK. It allows you to take exposures on the wider market rather than the risk of specific shares.”

Weston sees the same trend for popularity. “There is huge interest in Australian clients trading the FTSE, but also the DAX (Germany), CAC (France) and the Dow Futures as well,” he says.

A twist on the index theme is the increasing prominence of exchange-traded funds on leveraged platforms. Already commonplace on margin lending menus, ETFs are increasingly appearing on CFD lists too. This can have some useful effects: iShares, for example, offer indices that may not otherwise be available on CFD platforms; and some more structured products may also be appealing. City Index, for example, offers an ETF that tracks the Chinese markets. Leveraging into an ETF is a lot like leveraging into an index: diversified exposure with one investment.

It stands to reason that investors should prefer index investments when they go global; after all, that’s also how they tend to use CFDs at home. When the research group Investment Trends released its findings on the Australian CFD market in 2010 – its 2011 release is due any day – 52% of investors said they traded CFDs over Australian indices, and 27% said their last trade was over an index. That’s a global theme too. “The trend towards indices is consistent with what we observe in our UK CFD research,” said Mark Johnston, principal of Investment Trends, when the report was released.

SUBHEAD: KEEPING RISK IN HAND

For anyone using CFDs, risk management is key. “There are two big things we look at in educating people on managing risk,” says Land. The first is using a stop loss – and using it properly. “One thing people have to be aware of is looking at their entry point, their stop loss point and their overall position size, and determining how much risk that puts them in.” Land feels that on any individual position, a person should be risking no more than 2% of their overall trading capital. “It’s not just a matter of having a stop loss. That’s very important, but it’s also about having a position size where, if you do get stopped out of a trade, it leaves you with a loss that is only a small percentage of your capital.”

The other is limiting the amount of leverage that people apply to their total capital. “This might mean that, if I had $10,000 in trading capital, I wouldn’t want to lever myself by more than three times. I wouldn’t take on any more positions once I had got to a maximum of $30,000 exposure to the markets.”

“So it’s balancing your position risk by the use of stop losses and sensible position sizes, but also covering total exposure to the market by controlling the amount of leverage you hold in total,” Land says. “Those two concepts are the real keys of managing trader risk.”

BREAKOUT

One of the distinctive features of CFDs is that they allow you to take short positions – that is, benefit from something declining as well as something increasing in value.

This can be applied to international shares and indices just like local ones, and can be an effective way of expressing a macro-economic view. If you think there is worse to come in the US economy, for example, you could go short the S&P 500. You could do the same thing on the UK’s FTSE-100, one of several European exchanges, or Japan’s Nikkei 225.

Something to remember about shorting is that it comes with risks. If you buy a stock hoping it will go up, the most you can ever lose is the money you put in. If you short a stock and it goes up instead of down, your potential losses are theoretically limitless. Consequently it’s a good idea to use stop losses just as you might with a long trade (one in which you hope the price will go up).

Shorting can also be used as a form of hedging during volatile times. If your overall view is that things are going up, but that the process of getting there will be choppy, a short position on a broader index helps to smooth out that volatility because even when things are going down, you’re at least making some money.