Investors unlock value of Gearing Up

September 18, 2004Andy No Comments »

Leveraged investing is becoming popular among small investors, writes Peter Weekes.

Once the sole domain of large institutional investors, the investment tool known as “Contracts For Difference” is winning increasing popularity among retail investors.

Day traders, in particular, have jumped into the two-year-old market with gusto as it allows them to leverage into “shares” for little upfront cost.

The country’s three main CFD providers are tight-lipped on how many investors are in the market, but CMC Group says it is signing up 400 new accounts a month.

To be sure, what started as a slow burn is picking up pace, much like the CFD market did following its debut in Britain in 1999 where it now accounts for 32 per cent of trades on the FTSE.

“It’s exactly like share trading but you need less money to do it,” says Catherine Davey, author of Contracts for Difference: Master the Trading Revolution.

The door was unintentionally unlocked to retail investors by the introduction of the Financial Services Reform Act and has already caught the attention of the corporate watchdog.

Known in the institutional market since the 1980s as equity swaps, CFDs are an agreement between the investor and the provider to settle the difference in cash between the price at which the CFD position is opened and the price it is closed. It mirrors the price in the physical stockmarket and investors can sell back to the provider at any time.

The benefit is that the upfront cost is a fraction of the price of real shares as the remainder is borrowed via the provider. For example, if an investor decides to buy 1000 Telstra shares at $5.01 each, all that is required is a 10 per cent deposit, plus commission – about half the fee needed for the physical market. This means an outlay of $511, as opposed to more than $5000 on the physical market.

You can gear yourself up with the potential to make a lot more money but you can also lose a lot more money. JAMES FOULSHAM, CMC senior dealer
But the deposit is not a down payment for the balance of the trade, but rather a margin held by the provider as protection against any possible losses. This means that an investor may receive a margin call demanding more money if the share price falls, says Davey.

“They will get a margin call if their account gets down to a certain level because you are trading on less money than the actual value you are trading,” says Davey.

The Australian Stock Exchange’s executive general manager of market services, Michael Roche, says investors should also be aware of all the costs involved.

“The costs include not only commission but also an interest rate, so they operate in much the same way as a margin loan. Some providers will also make a margin out of the spread,” he says.

“Additionally, unlike ASX-run equity and derivative markets, which use the Australian Clearing House as the central counterparty for all trades, there is no central counterparty in CFD transactions. The contract is between the end user and the CFD provider only.”

CFDs are offered over most of Australia’s top 250 companies and stockmarket indices, as well as many global shares.

Australian Securities and Investments Commission acting commissioner Malcolm Rogers told a senate estimates committee earlier this year that the watchdog was looking at whether it should monitor trading in CFDs, as it does with stock exchange-traded securities. He said the ASX and other market players had raised “some concerns” with ASIC about the relationship between CFDs and on-market trading.

“We are looking at that issue and hope to engage in dialogue with the industry and see if there is a problem,” Mr Rogers said.

Whatever the outcome, the investing maxim still applies: the higher the return, the higher the risk.

While the increased exposure to the market through gearing dramatically increases the capital gains of any increase in the share price, the same is true on the way down.

“You can gear yourself up with the potential to make a lot more money but you can also lose a lot more money – you can lose more than you invest if a share goes down,” says CMC’s senior dealer James Foulsham.

Still, he adds: “It’s a perfect short-term trading tool” for retail investors.

Whether the investor takes what is known as a long or short position determines if interest must be paid and dividends are received.

An investor who takes a long position believing the share price will rise must pay an overnight interest charge on the value of the underlying position at a rate of about 2 percentage points below the Reserve Bank’s overnight cash rate.

Long investors receive the cash equivalent of any dividends paid by the underlying stock and can participate in buybacks and stock splits, but they do not have voting rights at annual general meetings.

“CFDs are adjusted so as not to advantage or disadvantage holders,” says IG Market sales manager, David Skilton.

Investors who go short, that is take a position believing the share price will fall, are paid interest by the provider but must pay the provider the equivalent of any dividend.

Skilton says CFDs allow investors to make money out of a falling market, as well as a rising market.

For example, if an investor believes that the price of Telstra will fall under a Latham government, which is unlikely to push ahead with further privatisation, they can short a stock and pocket the difference between the purchase price pre-election and the price post-election.

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