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Getting to grips with CFDs

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Contracts for difference can enable investors to leverage portfolio returns, profit from market volatility and hedge against losses. However, as Cherry Raynard reports, they come with a health warning.The volatility of the past three years has accelerated the use of derivative instruments as investors have sought to profit from market volatility or hedge their portfolios against losses. Since the contract for difference (CFD) first became available to private investors in the late 1990s, it has become an increasingly popular alternative to spreadbetting.

As with spreadbetting, CFDs can be highly profitable or uniquely toxic, depending on how they are used. A CFD creates, as its name suggests, a contract between two parties betting on the movement of an asset price. That asset might be a share, a currency or an index. The ultimate payout will be the difference in the price of the asset between the time the contract is opened and the time it is closed.

If the asset rises in price, the buyer receives cash from the seller, and vice versa. In many ways, CFDs look and feel like normal equities and the price of a CFD will simply mirror the underlying market. The attraction for investors is that they do not have to actually own the shares, so they can speculate on price movements without shelling out a lot of cash. Also CFDs do not attract stamp duty. Different brokers will demand different levels of deposit, but it is usually around 10% of the value of the underlying shares.

Investors can also use a CFD to go short on an asset and potentially profit from falling prices. Brokers hedge their risk by demanding 'margin' or interim payments, while the contract is open to reflect changes in the price of the asset.

David Jones, chief market strategist at IG Index, says CFDs have undergone a significant surge in popularity in recent years: "People are becoming more aware of the gyrations in financial markets. They want to take charge of this volatility and are increasingly allocating a portion of their portfolios to more speculative trading. It helps that over the past five to 10 years, these products have been made very accessible. Private investors also have access to real-time data and news, the same information as market professionals."

What's on offer

CFDs are available on a huge range of different assets, including global indices, stocks, sectors, currencies and commodities. The types of CFDs that can be traded will vary from broker to broker. IG Index, for example, has CFDs on shares with as small a market capitalisation as £10 million. Investors can trade CFDs on most major currencies, indices such as the Euro Stoxx or Nikkei, and most commodities.

Jones says: "Whether a CFD can be created will largely be a function of liquidity, so CFDs are available on pretty much any financial market you can think of."

James Daley, investor centre representative at TD Waterhouse, says most investors tend to use CFDs for long positions to gear up their positive returns on different asset classes. He adds: "People are generally optimistic. CFDs mean they can gain greater leverage to the market. If you deposit 7.5% on the CFD you want to buy and the share price goes up 2.5% or so, you will make more than 30% on the CFD."

Jones agrees that most people still use CFDs for directional trading and like the fact that their initial outlay is so small. He says: "If Tesco (TSCO) is 380p to buy and you purchase through the normal market, you would need £3,800 to buy 1,000 shares. With a CFD, because of the margin required, you might only need to put up 5%, so you would only tie up £190."

Hedging tool

CFDs also have a clear role as a hedging tool to help investors profit from a falling market. Private investors may foresee a period of prolonged volatility in equity markets but not want to sell out of their portfolios for tax reasons or because unwinding a significant equity portfolio involves expense and hassle.

In such a scenario, an investor may go short on one of the major equity indices, such as the FTSE All-Share, so that they will make a profit on the CFD if the market falls to compensate for any losses on their underlying equity portfolio.

However, despite their utility, there are significant risks attached to CFDs. There is a smaller amount of money controlling a larger exposure. As Stephen Walsh, product manager at Selftrade, points out: "This means that losses, as well as profits, can be magnified. When opening a trade, you are required to make an initial deposit to cover the required margin. However, if your position goes the wrong way, you may be required to make additional payments."

If the FTSE All-Share rises, for example, the losses on the short CFD position are, in theory, unlimited. This is fine if the value of the underlying portfolio rises in line with the losses, but if it is full of actively managed funds that do not keep pace with the market, this will create problems.

In addition, investors will lose at least part of the benefit of a rising market. They will also have to keep making margin payments, despite having not realised any cash from their standard portfolio or the CFD. For these reasons, many professional investors will only use these techniques at crisis points.

Daley says many investors will use stop-loss techniques to put a cap on the absolute risk. Using this technique, investors can specify the level of loss at which the contract is automatically closed. Although this can be painful at the time, it helps overcome the natural tendency of investors to stick with their losses in the hope of a turnaround.

Spreadbetting is the major alternative for investors looking to employ this type of trading technique in their portfolios. CFDs have some similarities with spreadbetting. Both products allow the investor to go short. Also because the investor only has to pay a fraction of the full cost of ownership, they can generate a geared return. Their capital at risk is a multiple of their upfront capital. Neither product attracts stamp duty.

But CFDs differ from spreadbetting in a number of ways. CFDs attract capital gains tax, whereas spreadbetting, because it is seen as gambling, does not. While this initially looks like a disadvantage of using a CFD, it means CFD capital losses can be set against gains elsewhere. Spreadbetting losses cannot.

Investors may also take a currency risk with CFDs in a way that they don't with spreadbets. CFDs are usually quoted in the domestic currency of the market being traded - the Euro Stoxx in euros and the Nikkei in yen, for example. Even commodity prices may be set in alternative currencies - gold is denominated in dollars.

This may or may not prove profitable. In practice, however, most CFD trades take relatively short-term positions of two to three days and, as a result, are unlikely to see significant currency swings, although there is a risk of this. Spreadbets, in contrast, are quoted in sterling.

CFDs do not have an expiry date and a daily funding charge applies until they are sold. This will increase or decrease depending on how the CFD is performing. In contrast, spreadbets have a premium already built into the price. This means they will usually trade above the share price of the underlying asset.

Personal preference

Daley says that, ultimately, choosing between a CFD and a spreadbet tends to come down to personal preference: "People tend to go for one or the other. If they like CFDs, they don't like spreadbetting, and vice versa. Overall, CFDs tend to be used for slightly shorter intra-day trading or for perhaps two to three days."

Used with skill, CFDs can enable investors to leverage portfolio returns, profit from market volatility and hedge a portfolio against losses. However, they can also be an extremely quick and effective way of losing a lot of money. Risk management techniques such as stop-losses can ensure that the 5% or so of your portfolio set aside for speculative trading does not cause the rest to disappear in a puff of smoke.