Who trades CFDs? - Retail Traders or Institutions?

Q.: Who trades CFDs?

A: CFDs appeal to a broad range of users for different reasons and the people trading in CFDs range from sophisticated retail traders to day traders, to mums and dads. Hedge funds, institutions and wholesale clients are also known to make use of CFD trading and the market is still growing.

Professional traders employed by investment banks or trading companies are able to utilise CFDs for speculation or hedging purposes. In this instance their ultimate goal is to gain from or hedge against the risk of, volatility of price movements in market instruments. Institutional investors like hedge funds and stock portfolio managers are also known to utilise CFDs to manage funds on behalf of investors; in this way CFDs provide them with additional flexibility to add to their existing investment options and allows them to manage the short-term risk associated with the daily movements in the value of their portfolios. CFDs in particular allow institutional fund managers access to cheap leveraged exposure on a wide range of market instruments (including instruments that may not have liquid markets of their own) with the added flexibility of being able to open short positions to benefit from market declines.

Indeed, the volatility of the last few years has accelerated the use of derivative instruments as investors have sought to profit from market volatility or hedge their portfolios against losses. Private investors today also have access to real-time data and news, the same information as market professionals and are increasingly allocating a part of their portfolios to more speculative trading products like CFDs.

In the past hedge funds were also known to build positions in companies whilst avoiding having to inform the market of their large positions thus avoiding attracting undesirable attention to their investment objectives (in some instances building stakes in companies that were involved in takeover talks) but this is something that authorities around the world have started taking steps to restrict by imposing disclosure requirement to CFD holdings.

Eva Diaz communications manager CMC Markets is quoted saying that that people in CFD trading fall into three groups:

• Lifestyle reasons. Diaz says many people trade in CFDs for lifestyle reasons. 'For example I interviewed one CFD trader who used to be a mid-wife for 26 years. She was getting tired of shift work so she said that maybe trading in CFDs was something she could do that would allow her to spend more time with her family. She spent two years educating herself in the market, attending seminars and share trading. Now she is fulltime CFD trading.'
• Main source of income. Diaz says there are some people who do CFD trading as their main source of income. 'For example one guy trades CFDs from the open of every day's trade to the close, as well as trading in some of the other markets in different time zones. He has a mini trading desk in his office with 10 monitors in front of him as he trades.'
• Business people. Diaz says, 'One or Two people that I interviewed have other businesses. They get extra income from trading. Many of them work from home and monitor the market anyway, so they decided to trade in CFDs. For example there is one man in Bathurst NSW who used to own a petrol station and the IGA (supermarket) but he was not making enough profit, so he decided to learn how trade in CFDs. These are people who want extra income.'
• Finally Diaz says traders with experience in derivatives also like CFDs. 'There are also a handful of traders who used to trade in options and warrants but now prefer CFDs. When they discover CFDs it's a breeze for them,' Diaz says.

There has been a big shift since CFDs arrived in the market. The number one shift is in the attitude to CFDs. In the early days of CFDs, the people who used them were the early adopters - advanced traders who had been in the market for a long time. It is getting more mainstream now. More people are more open to margin traded products now and contracts for difference have gone mainstream now. It also helps that over the past five to 10 years, CFDs have been made much more accessible. Most investors and traders today have a more sophisticated approach to trading through the use of these trading products and the vast array of technical and fundamental research material available to them, and now make up a large section of the global CFD marketplace.

CFDs offer flexibility, leverage and cost effectiveness to institutional, professional and non-professional traders alike. However, market experience is required to get the most out of CFDs and they are better suited to traders and experienced investors.

Q.: What makes a suitable investor?

A: Ideally you should have some experience prior to trading any leveraged instruments. Contracts for difference are also likely to appeal to more adventurous investors who are comfortable trading in and out of volatile markets.

The ability to trade CFDs has greatly improved the trading opportunities for a great many traders. CFDs are an ideal trading vehicle for traders with a relatively short-term time horizon and a desire to increase their market exposure on a given level of available capital. CFD trading may not be so suitable for traders with a longer term time horizon due to financing charges which can build up over time. Similarly, traders that are unable or unwilling to monitor their open positions and manage their trades might fi nd that CFDs are not suitable for them.

Thus, in practice, investors with prior trading experience and who are familiar with money management are more likely to choose CFDs as a speculative choice. Finally do understand that CFDs are not suitable for all investors. They are leveraged instruments and thereby riskier than ordinary shares trading and so require a greater degree of sophistication when trading. I frown when I go to trading exhibitions and find a number of CFD providers touting to absolute newbies. Sure, CFDs can be very rewarding when a trader has knowledge, skill, discipline and time on his side and when contracts for differences are used in the appropriate market. However, one needs time to train and develop discipline; CFDs will be there 6 months from now so what's the hurry?

Having said that contracts for differences are however a useful addition to any financial market since their presence enhances the range of financial products available to investors. The key, of course, as always, is education, understanding and knowing the right questions to ask.

Q.: Is it ok for a novice to invest in CFDs?

A: The simple answer is no; ideally you should have some share dealing experience. And another thing - start small to build confidence. I didn't start small to begin with because I'd already been share dealing for a while and so didn't really want to waste time with tiny trades.

CFDs are geared speculative products and difficult in a market like we experienced for instance in 2008. If you get it right sure you make a lot of money. But if you get it wrong you fall dramatically. And the problems we have experienced in the market with sub-prime and CFOs collateralized debt obligations and all the problems at Bear Stearns were all because of over-leverage. In other words people borrowing on borrowings on borrowings to take a punt.

It is interesting to note that the Australian Securities and Investments Commission believes that the complex structure of CFDs and the risks associated with them mean that they are unlikely to meet the investment needs and objectives of most retail investors. We disagree with this statement, however we also believe that CFDs should only be used by private traders that understand the mechanics of CFDs and preferably those who already have acquired some experience with shares trading.