The Dangers of CFD Trading

When one of our readers lost 96 per cent of his portfolio in a month after following the advice of a contract for difference broker, Mr Oakey tried to find out what went wrong, and who was to blame.

So Dave decided to open a contract for difference (CFD) account to hedge the risk in his portfolio. He considered several possible CFD brokers, including Blue Index.

Mike Estrey, Blue Index's head of research, had written to Dave to answer his questions about the returns he could expect. While stressing that past performance in no way reflects what might happen in the future, Mr Estrey outlined the "pleasing" returns from following Blue Index's UK trading recommendations during July. "As at yesterday, we had increased our total profit to 30.1 per cent in the first 11 sessions of the month," wrote Mr Estrey, "which would equate to an approximate return of around 20 per cent, after all costs, in just over two weeks."

After speaking to the people at Blue Index, Dave decided to invest £10,000. He says that the firm emphasised its use of stop-losses to protect capital. And, by pulling out early of trades that went wrong, Dave would control his risk. Even if he lost half the time, he would still win since his winnings would be bigger than his carefully curtailed losses.

Due to his lack of experience in short-term trading - he usually buys over several weeks or months - Dave decided to sign up with Blue Index on an advisory basis. "They traded for me on their recommendations alone, and I always went with their suggestions," he says. Each trade would cost £30, which he knew was double what a CFD broker such as Barclays would offer. But, as he was new to derivatives, he thought it safer to seek advice.

On Monday 31 July, he began to receive ideas from one of Blue Index's senior traders, Greg White. Two days later, he had lost 34 per cent of his £10,000 portfolio. Blue Index's traders had advised him to make 59 trades in those two days, costing Dave £1,770 in commission alone. Excluding dealing costs, the trades had lost him 16.5 per cent.

"They had explained previously that I could well experience significant swings in the account due to the nature of CFD trading and unexpected events," recalls Dave. "A swing of perhaps 12,000 to 8,000 would be perfectly normal, but, overall, they had considerable success for their clients."

Come the Thursday, he was down to 56 per cent of the £10,000, having lost a further 17 per cent to the market and 27 per cent in trading commissions. The next day, Blue Index suggested Dave close 12 positions. Six of them made money (before commissions) and six of them lost it. Unfortunately, the 50:50 win rate translated not into an overall profit, but a trading loss of £1,023, before costs of £422.

The following Monday was even worse. Dave paid £667 in commission to follow trading ideas that cost him £1,355. By Tuesday, his account was down to £1,868 - just seven days after starting to trade.

Alarmed at the speed of his losses, Dave called Blue Index. "Don't panic," he was told...

Alarmed at the speed of his losses, Dave called Blue Index. "Don't panic," he was told. This sort of thing happened all the time, and there was still time to turn it around. Dave rejected the idea of topping up his account with more money, but accepted the suggestion to switch trader and cut dealing fees from £30 to £20 per trade.

It made no difference, though. The trading dragged on, occasionally recording a big profit, but mostly continuing on its downward path. On 8 September, Dave finally closed the account with £397 left. He had paid £5,150 in dealing fees.

We contacted Blue Index for its reaction. We wanted to know where it thought Dave had gone wrong. After all, he was only following its advice. "In fairness, it does happen all the time," says James Sanders, managing director of Blue Index. "If you took 100 of our accounts after a week, half of them would be doing great and half would be doing terribly. We actually say to people over the phone, 'look, you've got to be prepared if you're going to trade with us for your account to double and half'. Every one of our clients knows the risks, because we won't accept them otherwise."

Clearly, then, cases like Dave's are not unheard of, but they need to be put in the context of other clients who win. So we spoke to James Hunt, one of Blue Index's highly successful customers. In the past three years, he has built up a good working relationship with Blue Index traders, who know the kind of stocks he likes.

Mr Hunt has had fat years and lean years, like everyone in the market, and 2005 was a good one. On an account of around £12,500, he made £35,000 profit. He considers Blue Index's trading ideas on their merits, and decides which ones to follow up. But even Mr Hunt was surprised at the number of trades Dave did in the first two days. Mr Hunt's maximum is three or four round-trip trades on a busy day, but his average is around seven trades a fortnight.

On that basis, Dave traded as many times in two days as Mr Hunt usually does in two months.

So, who is more representative of the typical CFD client - Dave or Mr Hunt? According to Mr Sanders, the "industry rumour" is that the vast majority of spread-betting clients lose money. "But the industry does not want to promote the fact. How often has a spread-better admitted to you that 95 per cent of its clients are losing? You'll never hear it," says Mr Sanders. So, given the fundamental similarities between CFDs and spread-bets, there is no reason to think that the proportion of winning clients is wildly different. CFDs are "damned dangerous products, but with danger comes risk, and with risk comes possible reward"

What might explain Dave's experience was that the summer months were terrible for most people in the market: "I don't know many spread-betting or CFD people who made a lot of money in July and August". So market conditions may certainly have played a role. Although August was not a dramatic month - volatility was relatively low - it was the kind of directionless market that trips up traders.

Dave knew there would be risks, too. But he thought paying extra for advice would reduce them. Unfortunately, Blue Index's traders called the market wrong too many times. Mr Sanders was unapologetic because he knows how markets work. "You know what the derivatives business is like," he says. "We often get 20 trades in a row wrong. We do. And, like anyone in the stock market, we have times when everything we touch we just can't get right."

So was Dave simply unlucky, or was there something he could have done differently? Surely the 59 trading suggestions given to Dave in those first two days - all of which he acted on - suggests a mistake?

Not so, says Mr Sanders. Dave did not have to act on any of them. With an advisory service, the final decision always rests with the client. Blue Index has views on every FTSE 100 stock, and about 30 of those will be strong views. Dave had told his trader, "Let's do them all," according to Mr Sanders.

At this point, Dave's version of events differs from Blue Index's. Both sides acknowledge that the company typically publishes five trading ideas each day on its website to stimulate clients' thinking. But, far from instigating the hypertrading of the account's early days, Dave insists he was only reacting to suggestions from his Blue Index trader. "They said 'we need to get into x, y, z...' and I said 'yes, OK'. I considered myself unqualified to challenge them and took the view that they were experts."

It is also worth remembering that, in order to trade CFDs, you have to demonstrate to the broker that you are an 'intermediate' client. Among other things, this means you must prove your investing experience and that you understand the greater risks involved. However, one poorly-recognised consequence of signing up as an intermediate customer is that you cannot take individual complaints to the Financial Services Authority (FSA). In contrast, many spread-betting account holders are classified as novice investors, which means that they can ask the FSA to look at specific grievances (or threaten to do so).

Ultimately, it seems that Dave and Blue Index failed to understand each other. Dave wanted an expert hand in helping to protect the rest of his portfolio from downside risk. Blue Index seemed set on helping him to up the risk ante. 'We're not in the investment business, we're in the speculation business,' says Mr Sanders. That said, he is still sorry for Dave's bad experience. "We're not rubbing our hands together when someone loses £10,000 because it's a customer that isn't going to recommend us," he explains. "But it does happen, and it has happened with far bigger money than £10,000."

As for the £5,150 commission, Mr Sanders points out that it paid for exposure to the upside to trading £500,000-worth of shares. On that basis, a £10,000 loss is just 2 per cent and, had the markets moved in his favour, Dave could have made a substantial profit.

 ...Continues here - Lack of Transparency

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