Contracts for Differences – What is the Catch?

Q:What is the catch?

So far I have found it very easy to predict the direction of stocks. This may be because the market is very one directional of late. So the question I ask is what the catch is. I understand the potential risk is high for CFDs and this is why the potential for profit is so high but what I don’t understand is where all the profits are coming from.

A: If you understand how to use CFDs properly, it is an invaluable trading instrument.

For example, I have $10,000 cash – I could…

a) Buy $10,000 of fully paid ordinary (FPO) stocks and own them outright.

or

b) Buy that same $10,000 of stocks through a CFD – but only put upfront a margin of $500 (for a 10% margin stock) and still control the same number of shares.

Why is option b) better? -:

1. Only committed $500 in capital… the remaining $9,500 (less brokerage fees) can sit happily in a high interest earning savings account.
2. Get paid FULL dividends on the ex-dividend date immediately.
3. Pay more or less the same brokerage as option a).
4. Trade through the DMA model. No MM are manipulating prices.
5. Can short the stock as easily as if you are going long.

The only disadvantage I see is:

1. Paying overnight interest on $10,000.*
2. Not really having ownership of the stock

* In the example given a $10,000 trade worth of stocks can be financed with “only” $500 but you are still charged interest on the $10,000 that you have effectively borrowed. That charge is usually applied whether you have surplus funds in your account or not. So, not as cheap as it seems.

If the stock falls…yes…you will have to inject funds to cover the margin… but the maximum you could lose is no different to what you could have lost through owning the FPO.

Another way that I use CFDs is for hedging myself against falls in my core shareholdings. There are various reasons as to why I don’t want to close out my FPO stocks position – (e.g. want to own the stock for the full 12 months to minimise CGT, etc)… I could use very little funds to short the stock and protect my open FPO position. For around 10% (depending on the margin required) I could open a short position of equal size to my FPO. All the while, I would be earning interest. Note that if it goes ex-dividend, I’m going to PAY dividend – but the net effect should be $0 as you’ll be paid dividend on your FPO position. If you are smart, you could close off your CFD hedge before the ex-div date to avoid paying the dividend.

One of the reasons as to why people think CFDs are dangerous is that they are OVER LEVERAGED. If you have a trading portfolio of $50,000 cash… just trade to up to say 140% (or less) of your $50,000 and you’ll be safe… Just because you can leverage…doesn’t mean you should be using your $50K to control $500,000 of stocks.

However, if you are going to be using CFD as a leverage tool, then RISK and CAPITAL MANAGEMENT is the KEY to surviving. Sure you can try to control $500,000 of stocks,.. but just remember to have a trading plan – especially when things go bad – you’ll know EXACTLY how much is at risk.