CFD Trading - Leverage and Trading Strategies

Magnus Grimond explains a pair of investment strategies that can reap huge profits - or losses.

They account for as much as 40 per cent of the daily turnover of the London Stock Exchange. Tens of thousands of people use them regularly and their number is growing at more than 20 per cent a year. But they are not shares as we know them.

The effects of leverage

Contracts for difference (CFDs) and spread-bets have become increasingly popular since the market turned in the spring of 2003. Both allow the buyer to go long on a share, index or currency, thus benefiting from its subsequent rise in price; or to go short and cash in if the price falls.

This is a double-edged sword, however. If the bet goes the wrong way, the losses, theoretically, can be limitless. Because only a fraction of the cost of the underlying investment is paid for when the bet is placed - it is bought on margin - the effect of movements in the underlying price are magnified. Profits or losses can snowball. The more mainstream private client stockbrokers still regard them a little sniffily, possibly with good reason. Anecdotal evidence suggests that most spread-betters lose money.

Angus McCrone, a director of Twowaytrade.com, a CFD broker, says that this is certainly not a market for the uninitiated. "People think it's easy to make money, but actually it's very difficult," he says.

Clive Cooke, chief executive of City Index, one of the bigger brokers in the market, says that a typical private client holds a position for only about three to four weeks. "Generally speaking, it's for people who would like to benefit from a short-term movement in, say, a share price or an index."

CFD holders ultimately pay the difference between the buying and selling prices. This is deemed to involve an element of borrowing. Ramy Soliman of IG Index, the biggest broker in the market, explains: "Every day you hold a long position, you have to pay a financing charge, because you are effectively borrowing money to hold the position.

"Our rate is 2.5 per cent above base rate, which is 7.25 per cent at the moment. So on a notional £10,000 contract, you would pay £725 interest a year, or a daily interest charge of £1.98.

"That's if you are long. But if, say, you thought that the stock was going down and you shorted the stock, your account would be credited with interest at 2.5 per cent below base rate, or 2.25 per cent currently."

More important is tax. While there is no stamp duty on spread-bets or CFD purchases, any gains made on the latter do attract capital gains tax (CGT) at up to 40 per cent. This makes spread-bets, which are free of CGT, the weapon of choice for most punters.

As well as the tax advantages, spread-bets are simpler in many ways. Commission, financing and the effect of dividends are rolled up in the "spread", the difference between the buy and sell prices quoted by the broker at any particular moment.

You decide what you want to bet - let's say £10 for every penny rise (called a point) in a share. If the price rises, your gain is the difference between the two prices, multiplied by £10. If you believe that the price will fall, you do the same thing in reverse by "selling" the shares.

Mr McCrone says that a spread-bet or CFD could help to provide insurance for someone who wanted to protect holdings from a fall in the market without selling the share.

But Mr Cooke gives warning that "people should have in their mind set amounts that they are prepared to lose on spread-betting, and not use money earmarked for an Isa".

Ultimately, most people would be better off sticking with an Isa. Spread-betting and CFDs are strictly for those with the time and talent to apply to them.

CASE STUDY: Quick learner aims to stay on top of the charts

Martyn Grant, left, reckons that he has had only one down year in the five or six since he started spread-betting and trading contracts for difference.

"I lost money in my first year and learnt a good, hard lesson," says the 43-year-old property entrepreneur from Wiltshire. "I held on too long with no stop-losses.

"I didn't know what I was doing, which is true of most people - they merely scour the bulletin boards for recommendations and then buy without looking at anything else."

Bulletin boards, such as those run by ADVFN, the financial website, can be useful, but Mr Grant tends to ignore rumours and tips from other people. "I have sat in so many brokers' offices in London and have heard so many stories," he says. "As soon as they hear a story, brokers pass it on.

"Unless your dad owns the company, or you know someone who works in it, there is always someone else who knows more than you - and that shows in the charts."

Mr Grant relies on graphs of a company's share price for direction on how to bet. "The graphs pick up that there is something going on," he says. "For example, if the chart is bottoming out and there is a lot of trading volume."

He calculates that his annual profits have ranged from 30 per cent in 2000, when he went short after the technology bubble burst, to about 900 per cent last year.

"Most of my bets are long. I am still a bull," he says. "I think this is just a correction in a long bull market, but in a couple of days my view could change and I could become the biggest bear ever."

Mr Grant prefers to use smaller brokers, such as Luke Securities, for his bets. And though he believes that he could devote less time to his activities, he actually spends much of his working day looking at market screens.

As for day trading, he says: "There's no money in day trading: it's a mug's game."