Catches of CFD Trading

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Contracts for Differences - What is the Catch?

Q.: Are CFDs allowed in Sipps?

A: Changes to tax rules have made it possible to invest in CFDs and other derivatives within a self-invested personal pension (Sipp) which gives tax relief on the money you pay in. Anyone holding a self-invested personal pension (Sipp) can invest in CFDs on shares listed on a recognised stock exchange, and CFD issuers now offer dedicated CFD Sipp accounts.

Unlike ISAs, SIPPs have few restrictions. An ISA may only contain stocks listed on an official stock exchange (so no AIM stocks, as it's not an official exchange), with some additional restrictions. A SIPP is much less restrictive and can include all sorts of derivatives including contracts for difference, UK listed warrants and US traded stock options.

However, be aware that only a small number of brokers providing tax-free SIPP wrappers (Self-Invested Personal Pensions) will accept CFDs. And the ones that do have strict scrutiny and monitoring requirements before they will allow you to proceed. This is because the Self Invest Personal Pension (SIPP) provider acts as a trustee and as such should a client fall into a negative balance the broker could be held liable.

One important restriction placed on Sipps is that no instrument should have a contingent liability. This implies that you should not be able to lose more than you have invested. So only contracts for difference (CFDs), with a guaranteed stop-loss are permitted while spread betting must be conducted outside of the account. Also, should your account move into negative territory you may be forced to inject further cash into the SIPP to meet a margin call and this is subject to a 40% HM Revenue and Customs unauthorised payment charge, which will cost you even more.

Q.: What is the catch?

A: If you understand how to use CFDs properly, it is an invaluable trading instrument.

For example, I have $10,000 cash - I could...

a) Buy $10,000 of fully paid ordinary (FPO) stocks and own them outright.

or

b) Buy that same $10,000 of stocks through a CFD - but only put upfront a margin of $500 (for a 10% margin stock) and still control the same number of shares.

Why is option b) better? -:

1. Only committed $500 in capital... the remaining $9,500 (less brokerage fees) can sit happily in a high interest earning savings account.
2. Get paid FULL dividends on the ex-dividend date immediately.
3. Pay more or less the same brokerage as option a).
4. Trade through the DMA model. No MM are manipulating prices.
5. Can short the stock as easily as if you are going long.

1. Paying overnight interest on $10,000.
2. Not really having ownership of the stock

If the stock falls...yes...you will have to inject funds to cover the margin... but the maximum you could lose is no different to what you could have lost through owning the FPO.

Another way that I use CFDs is for hedging myself against falls in my core shareholdings. There are various reasons as to why I don't want to close out my FPO stocks position - (e.g. want to own the stock for the full 12 months to minimise CGT, etc)... I could use very little funds to short the stock and protect my open FPO position. For around 10% (depending on the margin required) I could open a short position of equal size to my FPO. All the while, I would be earning interest. Note that if it goes ex-dividend, I'm going to PAY dividend - but the net effect should be $0 as you'll be paid dividend on your FPO position. If you are smart, you could close off your CFD hedge before the ex-div date to avoid paying the dividend.

One of the reasons as to why people think CFDs are dangerous is that they are OVER LEVERAGED. If you have a trading portfolio of $50,000 cash... just trade to up to say 140% (or less) of your $50,000 and you'll be safe... Just because you can leverage...doesn't mean you should be using your $50K to control $500,000 of stocks.

However, if you are going to be using CFD as a leverage tool, then RISK and CAPITAL MANAGEMENT is the KEY to surviving. Sure you can try to control $500,000 of stocks,.. but just remember to have a trading plan - especially when things go bad - you'll know EXACTLY how much is at risk.

 ...Continues here - Mifid Implications