Contracts for difference have hugely increased freedom, flexibility and opportunity for the individual trader. But many more could benefit from the advantages that CFDs offer. Shares' David Jones and a panel of experts who work in the field discuss the exciting possibilities now open to you
David Jones, Shares: Contracts for difference have really exploded over the past four or five years. But for the benefit of some of our readers who may not be too sure what a CFD is, can you define it?
Nick Sparkes, GNI touch: I think the term CFD was invented by a politician just to confuse people. If we could wind back the clock, I would call them something like 'synthetic stock contracts', because that's effectively what CFDs are.
If a client wants to buy say, Vodafone CFDs, we go to the real market and buy the stock on behalf of that client. The stock is then held in a GNI holding account. Clients avoid paying stamp duty, because they do not hold the physical stock, and as CFDs have become so popular the commission levels have reduced dramatically.
Effectively there is very little difference between a CFD and the stock itself, apart from the fact that the voting rights are held by the company that holds the contract. Any movement in the underlying stock, up or down, will affect the client in exactly the same way as it would if he or she held the underlying stock. The ability to short the stock is an added bonus of CFDs.
Zak Mir: I think Nick's right when he suggests the name 'synthetic stock contracts' - we really believe CFDs will make further inroads into the traditional stockbroking business. If you can deal in CFDs with the right costs, the right firm and in the right direction a decent percentage of the time, it is the best tool to trade with by some way.
Tom Hougaard, City Index: We explain it as an agreement between two parties to exchange the difference between the opening price and the closing price in the contract traded. One party is City Index, the other party the client. The traded price is the current market price, with the actual market spread at the current time of the trade. In other words the client simply makes or loses the difference between the opening price and the closing price.
Jones: So as far as we are concerned as end users, it does exactly the same job as a share price with some added benefits.
Jones: There is still a reluctance among a lot of people to get involved with CFDs because they perceive them as risky, as being for gamblers. Why would I, as a private investor who has bought and sold shares over the years, start looking at CFDs, either side by side with my traditional share dealing or instead in certain cases?
Geoff Langham, CMC: There are some immediate benefits. It's just as easy to go short as to go long - there are no concerns about borrowing stock and the costs associated with that. With us there is no commission to pay, which I think is an extremely powerful argument and one that's not possible if you're dealing on the exchange.
Along with that I think some firms have excelled by offering free charting and free news - terrific software that offers thousands of products, not just in the UK but all the major equities, futures, foreign exchange and commodities markets in the world.
Some firms have excelled by offering free charting and free news - terrific software that offers thousands of products, not just in the UK but all the major equities, futures, foreign exchange and commodities markets in the world
Tom Hougaard, City Index: Many people prefer CFDs over traditional share trading: they realise that they gain the same kind of exposure in the market at a much smaller cost. This is much like buying a house where you only put down a marginal amount to control a much largern stake. That is a huge advantage to the active trader and investor who may be trading in and out of shares 50 to 60 times a year.
Jones: People don't have to go mad with leverage, they can use it in their favour - they can still have the same-size positions and put the rest of the money somewhere else.
Jones: How does shorting work? We know it's a way of profiting from a falling share price but how hard is it to do with CFDs?
Nick Sparkes, GNI touch: A lot of people misunderstand shorting. They think it's something strange. The way I explain it is this: say you wanted to buy a second-hand BMW and I said: 'Give me £20,000 and I'll sell you one'. I don't have the BMW but I might think 'I can buy one of those for £18,000 round the corner because I think I spotted one like that'. So I've shorted you a BMW.
Effectively shorting stock is the same thing. You want to make money out of the stock moving down, so you short it first. At some point in the not too distant future you're likely to buy that back.
One of the misunderstandings that a lot of clients have when they start trading CFDs is that there is a limited period of time you can stay short. That is not the case. There is a very remote possibility that the short stock that has been borrowed is recalled but in the five years I've been in this business I have never had to make a single phone call to a client to say, 'Your short position has been called in and we've got to close it out.'
Jones: We're all used to buying at £1 and selling at £1.50 - it's just buying and selling in reverse.
One of the misunderstandings that a lot of clients have when they start trading CFDs is that there is a limited period of time you can stay short. That is not the case.
Jones: There's been a discussion in Shares over the past few months in which some people think derivative products like CFDs, are damaging the stock market and harming the private investor. In my opinion that's a misguided view but do you think there's any merit in it?
Zak Mir: Say you've bought Sainsbury at £2.50 and every hedge fund in town starts buying CFDs. The shares then go up to £2.90 whereas maybe 10 years ago, when things weren't so geared up, there would only have been a small advantage. You'd be quite happy about the effect of derivatives on the market.
These days markets move much more than they used to. They are more difficult but if you get it right you have greater rewards. If you get it wrong, hopefully you have a stop loss in and won't be hurt too much.
Tom Hougaard, City Index: Some people like to blame CFDs for increasing volatility in the market. While it may be true in cases where hedge funds have shown a particular interest in one select stock, it is generally not the case. More shares have become available because big pension funds managers are making their stock positions available to the market in what we call 'stock lending'. If someone is going short a stock, say AstraZeneca, in reality they are borrowing that stock from somewhere and selling it to the real market. They are selling something physical - they just promise to buy it back at some point when the fund manager wants the stock back. The more shares available on the market, the more it will tend to create a much more prompt equilibrium between buyers and sellers.
Nick Sparkes, GNI touch: You get a lot of spikes in certain stocks but with the introduction of CFDs over the past three to five years, the bigger price moves are not there any longer.
When I started, little stocks would blip up and down - they'd miss out pennies and they'd miss out 3p or 5p. Now they don't miss out anything because there are so many other people looking at them, so may private CFD traders.
Tom Hougaard, City Index: Because a CFD is a derivative, people associate it with S&P 500 futures or pork belly futures where you can increase the amount of open interest in the market. But we can't do that with a CFD because it will always be bound against the physical holding. The only thing we're doing is attracting back into the market stocks that would otherwise have been tied up in pension funds and institutional funds.
Jones: There is a lot of rubbish talked about shorting. Some people think it helped the bear market on its way down - and maybe it did but it wasn't responsible for the market sliding. We did have a bubble in stock markets that popped in early 2000.
Tom Hougaard, City Index: I should point out that even in countries where shorting is illegal it did not prevent the market from collapsing. The Hong Kong market is a classical example of that.
Jones: So is shorting a good thing for the man in the street to have at his disposal?
Geoff Langham, CMC: Absolutely. I think it's a good thing for all to have at their disposal - to be able to make up their own minds whether a stock should go up or to go down, and to be able to act on that belief, either long or short, with equal efficiency. There's no reason why stocks have to go up. If a company is underperforming, its share price should not go up nor stay the same, it should go down. Twenty years ago, it was very difficult to act on the idea of a stock going down. Nowadays with a CFD it's simple.
Jones: Let's talk about margin - another reason why people think CFDs are dangerous is a lack of knowledge. What does margin mean and how does it apply to CFDs?
Zak Mir: When you are trading on margin, you are essentially borrowing money equivalent to the consideration you're trading in. A few weeks ago, my father was trading in Amec. The shares went up 10p and he made £100, because he was just buying the physical shares. Even though he'd got it right he wasn't able to make a decent amount of money but if he'd bought a CFD he could have made five or 10 times that amount.
Tom Hougaard, City Index: A good example is if you buy £15,000 worth of physical stock. It goes up to £20,000 worth and you've made 33.3%. But if you are trading through a CFD you are trading with 10% margin so the £15,000 that you just bought will only cost you £1,500, which is frozen in collateral. It goes up to £20,000 and you've made £5,000 profit against an initial outlay of £1,500. So in reality you've returned 333% on your initial capital.
Nick Sparkes, GNI touch: 10-times gearing is the standard but there are people out there offering 20 times. To be honest, 10 times is about where you want to be.
We used to only allow our clients to use half their margin on any one stock, for the obvious reason that there is then less risk of being wiped out. Let's say you've got someone with £100,000 who buys £1 million worth of one stock which just happens to have a profit warning. The guy will have a serious loss on his hands.
Jones: But as a rule of thumb, margin used sensibly is a good thing?
Geoff Langham, CMC: I agree with that and you have to let the clients set their own risk parameters. With CMC you have 20 times leverage available, although clearly you can set your own level, be it 10 or five times. The generous margin facility is there should you choose to use it. We have many tools to help people do that, such as guaranteed stops or limits or normal stops, plus being able to access their accounts 24 hours a day, either on the system or over the telephone.
Zak Mir: We allow clients to choose whether they require 10 or 20 times leverage. 10 times is sufficient for most traders.
Jones: We've talked about shares mainly so far. What else can I trade CFDs on?
Zak Mir: Almost everything - commodities, indices, sectors. it's a very wide range.
Jones: A lot of people think, 'If I'm going to trade CFDs I need to be in front of my screen 10 hours a day, jumping in and out of Vodafone 150 times a day.' I'm sure there are people who trade that way, but how do you see your clients trading CFDs?
Geoff Langham, CMC: There is a wide variety of clients, not just from the UK but from all over the world. Our clients are diversified, representing a broad spectrum of experience and countries. Quite a number trade frequently and with the commission free it makes it very affordable to trade often. We also have a number who trade more on a weekly or monthly term or longer.
It also depends on what instrument you're trading in. Some are more applicable to shortterm trading while other instruments are more applicable to longer-term position-taking.
Zak Mir: We specialise in the advisory area - I advise on a technical basis normally on an hourly or daily charge. Most of the trades are what people know as 'swing trades' - the sort where you're in there for a couple of days, buying or selling ahead of results, with a 2% or 3% stop loss and hopefully 5%-plus profits. Most people prefer that approach, especially those who have a day job, rather than sitting at a screen watching the share price.Our clients are diversified, representing a broad spectrum of experience and countries. Quite a number trade frequently and with the commission free it makes it very affordable to trade often
Nick Sparkes, GNI touch: We have a really broad spectrum. A lot of our income does come from people who are doing it professionally. You call these people day traders but actually there's more to it than that. Day trading gives the impression of some young person who's just jumping in and out of stocks hell for leather throughout the day. These people are experienced, know what they're doing, know the risk, and know the fundamentals behind the stocks. They know how to research and about technical analysis and they do it for a living.
This type of client has been around for the past four or five years. But we have 10 times as many clients who have full-time jobs and are doing this as a sideline.
Four years ago most CFD clients we had were on the long side. It's only in the last two or three years that clients have decided there's no greater risk from the short side.
Jones: If I'm trading CFDs, I am not actually owning the shares, I'm basically trading with my CFD broker. So if I go long, say, 1,000 CFDs in Vodafone, is it in your interest for me to lose money?
Tom Hougaard, City Index: No. When you're trading CFDs you will pay a commission. Whenever you execute a CFD we will hedge it in the open market. We do look after our clients as much as we can by providing them with economic data, news flow and Level 2 data. We have absolutely no interest in our clients losing money - we want them to win, the more the merrier.
Nick Sparkes, GNI touch: These trades are done straight away in the market. We have no other counter parties, we never take the other side of those deals and in fact the top 20 or 30 clients we have at GNI in terms of commission payers are the same ones as two or three years ago. They are profitable to both themselves and GNI.
Jones: And the same at CMC - I guess they want happy, profitable clients too?
Geoff Langham, CMC: Absolutely. We rely on trading flows from thousands of clients. A profitable client is a long-lasting client.
Zak Mir: They take it very seriously which is why I am responsible for all our advisory trades and am available to speak to all our clients personally.