Advantages and Popularity of Contracts for Differences


Q.: Do investors tend to trade in CFDs as an addition to their investment arsenal as opposed to buying more shares?

A: I think that trading shares on margin and trading them via CFDs go hand-in-hand. Only it is apparent that the majority (estimate 80%) of 'retail active traders' are not comfortable being short. However, in our current environment of becalmed ranges in one day followed by sporadic volatility the next, it is highly improbable that being a long-only trader will win the day. There is only one answer: become comfortable with shorting the market, consider shorting as frequently as buying and use it in your armoury of frequent trading strategies, irrespective of market conditions.

Some basic statistics based from my own experience: markets really only trend 10% of the time; these trends can be down as well as up; markets fall three times faster than they rally. The reason why shorting has been regarded as belonging to the realm of more experienced investors is that, in theory, you have unlimited downside. While it is true that losses could be significant, the 'unlimited' moniker is ludicrous. If losses are unlimited in shorting, then that means the share price can also rise to infinity. That is clearly nonsense. You can assess the upside potential in most companies, and there is always a ceiling that can be assessed. No share price will ever rise to infinity, so there is no such thing as 'unlimited' losses.

Remember also that the City analysts will almost never tell people to sell individual stocks, so even if a company's outlook is atrocious, City firms don't want to step out front and say: 'Sell this share.' Because if they do, that's one company that definitely won't use their investment banking services. And who needs the advice and services of an investment bank more than a struggling, downtrodden company?

 

Lastly, in some situations a shareholder would often want to hold on to more stock if a dividend payment is due or would like to use CFDs a hedge against a short-term drop in his share portfolio. What investors often do is only partly hedge their positions, because they don't want to take the risk that the market doesn't fall, and if it goes back up again they end up making no money. So they may often just partially set out CFDs against their underlying positions.

Q.: What are the main advantages of CFDs from an investor perspective?

A: To start with contracts for difference are very easy to understand and to trade - in fact CFD trading has often been described as share trading with bells and whistles. This is because everything you know about share trading can be applied to CFD trading and CFD prices move in tandem to the actual share price movements.

CFDs also allow you to benefit from any market conditions providing you deal the right way. Not only can you profit from a rising share price by 'going long' you can also benefit from a falling share price by 'going short' (i.e. sell a CFD on a share you do not own). In these volatile markets going short can enable you to make profits where trading ordinary shares may not. Also, unlike other derivatives that have expiry dates and end up becoming worthless upon expiry, CFDs don't have an expiry date. This means you can hold CFDs for as long or as short a period as you like.

Two of the other more attractive elements of CFDs are cheap commissions and low margins. In fact one of the main benefits of trading CFDs is that you get the opportunity to take a larger position than you normally would if trading ordinary shares for the same outlay. When trading shares your broker will usually ask you to pay for the full amount of the transaction. With a CFD deal your broker will just ask you to make a deposit on the deal, which initially is often as low as 10% of the transaction value. The advantages of being able to trade on margin, or gear your investments, is that you can either trade the same size positions as you would do with your broker but free up your cash to use elsewhere. Or you can use the facility to increase your average deal size in the hunt for higher returns on smaller price movements. The latter, naturally, is a higher-risk option...

In a nutshell -:

1. Use of leverage to enhance returns and levels of market exposure: Leveraging an investment up to 20 times is by definitition not suitable for all investors. But for aggressive, risk willing investors this feature is probably the most important advantage of the CFD. Since you trade on margin you do not need to deposit the full amount of the exposure taken in the CFD trading account. Say, your trading capital amounts to 50K. You may only need to deposit 5k in order to trade the size of a 50K account.

2. Convenience. A single trading account can be used to acesss stocks, commodities and indexes.

3. Selling the market short is very easy by using CFDs. No worries about borrowing stock or paying financing cost for selling, makes it simple to short the market - simply hit the sell button and buy back the CFD at any time in the future.

4. No fixed contract size - trade the number of shares you choose. Instantly tradable prices, for anything but the largest deals, is another attractive feature. You can hit the price immediately when you see the price you want and in most cases, you will receive back confirmation of your trade at that level, unless the market has moved rapidly for or against you.

5. Low transaction costs. For instance in Australia to trade via a traditional stock broker the minimum commission usually starts at $20 dollars while with a CFD you can pay as low as $7 per trade. The commissions vary from country to country but CFDs usually allow for cheaper access

6. Trade any time frame - no fixed expiry date.

7. Hedging an existing portfolio is a popular use of CFDs. If you do not wish to liquidate your physical stock portfolio for some reason, you can quickly an efficiently secure it by selling the appropriate CFDs for a short or long period, until you feel more confident about the market again.

8. No Stamp Duty (in the UK) - which removes one of the greatest costs when trading shares, although you still need to pay taxes on gains.

9. Less complex than options and warrants.

10. Receive dividends when long (but no franking credits).

11. Participate in rights issues, share splits and other company activities.

12. Stop loss and contingent orders easily placed.

13. Online account reporting and daily statements. CFD platforms are really good and quick.

Q.: Why is it so popular among investors?

A: Well, aside from being widely available and free of many of the usual restrictions associated with most financial products, CFDs also have a variety of benefits that appeal to traders the most notable of which are leverage, ability to profit in up or down markets, wide range of markets available and immediate execution.

Margin trading is possibly the biggest reason that investors move into CFDs. Again, hindsight teaches us important lessons about using margins, particularly because many investors who trade on margin overstretch themselves and end up with a huge portfolio that they are unable to cover should the market turn against them. The lesson from those who have suffered such a loss is to keep some cash in an emergency reserve fund.

Also, undoubtedly shorting shares carries more risks than simply buying a share because you think it can go up. There are more dangers and pitfalls - but it can also be a highly lucrative activity for brave short investors. With the current equity markets volatility hitting all-time highs and concerns about the economy going forward, it is no wonder that contracts for difference are exploding in popularity!

Q.: How do CFD providers quote their cash index prices?


Is it based on fair value of the index future prices?

A: Quite simply all Index and FX CFDs are linked Tick for Tick to the corresponding Futures market not to the Index, not ever!! So index CFD prices are taken from the futures markets although the providers will add a little extra onto the bid-offer spread. Note also that the charts should replicate the futures charts when over-layed.


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