More on CFDs Trading

Recent years have seen a product emerge that has changed the face of share trading, hedging and speculation; a product previously available to institutional investors only but to which the investing public now has access; a product that is powerful, flexible, simple in construction and still gives you the benefit of price rises and dividends for a fraction of the cost of buying the underlying security. This product is the CFD, which, like spreadbetting, allows you to invest in a share or index without ownership of that underlying security.

The CFD was constructed to allow other market participants to open short positions and to avoid paying stamp duty. At 0.5%, stamp duty had made short-term trading using normal methods almost impossible. Returns are normally measured in small percentages and by the time the government had nipped in for its share, the profits left over were too small to be considered worthwhile.

But as the stamp duty exception spread through the City, more brokerages began to provide a CFD service, with firms such as GNI and IG Index being some of the first to offer the product to the investing public.

The process involves an agreement with your CFD broker to 'buy' the security at its current price and when you come to sell it to settle the difference in pence or points multiplied by the number of contracts bought.

Individuals who wish to trade in CFDs need to be able to demonstrate to their chosen provider that they have suitable experience to do so. Investors need also to be aware that the way in which the product is structured varies from firm to firm and there is no right way or wrong way: it is therefore best if you find a company where you feel comfortable with the structure.

Unlike other equity derivatives, CFDs are transparently priced and mirror the current market prices for the underlying shares. This structure aids the trading of CFDs as your broker will hedge everything within the underlying cash market. While still technically remaining the counter-party to the client, the structure in reality is that the private client has bought straight from the institution.

This is the benefit of electronic trading, before which none of this would have been possible. CFD trading is identical to normal share trading except that when a stock is bought or sold and the hedging transaction takes place, it appears on the provider's books and not in the investor's name - hence the ability to avoid payment of stamp duty.

Some firms, as part of their structure, track prices in the underlying market and offer a 'risk price' from the information gathered. This type of offering is limited by size and does not allow buying or selling within the offer spread.

A lot of firms also choose to provide a commission-free service but this is a system that does not deal directly with the underlying market, therefore the instant-execution service that is critical to most cannot be guaranteed. When wishing to invest in CFDs, the client will deposit an amount of money known as the initial margin. This then opens the position which is calculated as a percentage of the value of the transaction.

Contracts for difference give individuals a freedom of financial action

that was previously the preserve of the big institutions

A typical percentage rate for FTSE 100 shares is 10%. A client who purchases 40,000 Royal & SunAlliance shares, say, at a price of 77p will have to deposit £3,080 into his CFD account (40,000 shares x 77p price per share x 10% initial margin rate).

There are no fixed expiry or settlement dates so the position can remain open for as long as the client wishes. Clients can go long or short of a stock depending on whether they expect it to rise or fall.

A simplified example of a long position, ignoring interest and commission can be seen below. This is based on an investor who is trading on the FTSE 100 at a level of 4001 and expects it to rise further:

CFD broker quote = 3999 - 4001
Buy to open at 4001
Client agrees to £1 per point = £1
Value of investment (£/point x index value) = £4,001
10% margin = £400.10
Six days later, the index has risen to 4050:
CFD broker quote = 4049 - 4051
Sell to close at 4051
Value of investment (£/point x index value) = £4,051
Trading profit (£4,051 - £3,999) = £52
Profit margin on initial deposit (£52/£400.10) = 13%

Different firms have different policies regarding the size of the CFD position they are prepared to enter into. If they purchase more than 3% of a company to hedge a transaction then additional disclosures have to be made. This is why some firms have a policy of not taking a holding greater than 2% while others do not mind the disclosure and take much larger stakes.

Profits can also multiply during this process but remember - so can losses. This means that if you invest £1,000 in shares and they fall 10%, then you have lost £100. However, if you use that £1,000 as a deposit to back a CFD investment of £10,000, then a 10% fall will erase your entire stake. It is therefore very important to remain completely disciplined and focused, cutting losses quickly and without remorse. The sheer volatility in these markets makes experience vital. It is also a good idea to operate a stop-loss system. This ensures that your losses are limited to a pre-determined amount, normally 10% to 20% below the price you paid. If your positions hit this level then they will close automatically.

If you do not operate a stop-loss system and your position deteriorates then one of two things can happen. You will either receive a margin call, which is normally in the guise of a phone call from your broker requesting more funds, or failing that your broker will close your position for you.

Despite the complicated nature that surrounds these useful trading tools, investors and entrepreneurs have used them on many occasions. A couple of years ago, in early 2002, Shami Ahmed, founder of the Joe Bloggs jeanswear group, used this vehicle to build up a significant stake in Moss Bros. At the time Moss Bros had lost its way, suffering from weak sales and a falling share price, which promptly fell even further when the size of Ahmed's position was realised.

The stake he had built had been accomplished with relative ease and totalled some 20% of the Moss Bros retail chain. Not only did Ahmed have a significant share stake but he had also ascertained ownership of the voting rights to the company by way of a side letter from the CFD broker.

Ahmed eventually withdrew from his bid approach but subsequently sold his CFD position and voting rights to Kevin Stanford, co-founder of the Karen Millen clothing chain. He now effectively owns some 28% of Moss Bros and has turned over a tidy sum of £3 million on his CFD stake thanks to the improvement in the company's share price.

There has been another more recent example of CFD usage during merger and acquisition activity. This occurred during the bidding war between Philip Green and M&S that took place during the summer just passed. It was estimated that up to 20% of the M&S stock was covered by CFDs, giving a much higher degree of uncertainty for both Philip Green and M&S as the level of support for the attempted takeover was much harder to ascertain.

CFDs as part of merger and acquisition activity have actually been used for some time now. Nearly 10 years ago, when Trafalgar House was bidding for Northern Electric, it took out several CFD positions in Northern's rivals. Why? It hoped that it would lead to an upward rating of the sector to take some of the pressure away from its bid costs. Successful? No, not really as all the move did was to attract attention to the fact that CFDs are a very powerful tool in anyone's armoury and as a result changes were made to the UK takeover code.

With no complicated settlement procedures, CFDs are a cost-effective product, providing ease of execution for investors and speculators alike. Can you afford not to use them?