Trading CFDs on Margin Versus Borrowing to Buy Shares

Q:What is the difference between trading CFDs on margin and traditional margin trading?

A: Usually you need to have 100% of the cash available to buy a share. In some cases you can take out a margin loan and borrow to invest but you will still be required to have about 40% of the investment in cash. Also, with CFDs the amount of initial margin required may be 5% or less. This means that potential profits (and losses) with CFDs are much larger due to the gearing employed which can be more than 10 times that available when trading stocks. However, it is important to note that leverage magnifies both gains and losses. The most you stand to lose when buying shares is equivalent to 100% of your capital, assuming you have not borrowed any money to invest. This is not so with CFDs where losses can exceed 100% of your initial investment, if you do not effectively manage your risk

What are the differences between trading CFDs and stock market margin trading?

With traditional margin trading you still own the underlying stock (with all the admin and paperwork that this entails) but with CFDs you don’t actually own the underlying stock – you are simply entering into a contract with your broker to exchange the difference between the opening value and the closing value of a share, although the resultant stock exposure is hedged out by the CFD broker using equity swaps. It is worth noting that with shares bought on margin, your broker will hold a portion of the securities (say 40%) as collateral that can be liquidated if necessary. However, with a contracts for difference, there is no ownership of the underlying asset, and therefore no collateral (the CFD provider simply hedges any excess risk by offsetting exposure in the relevant exchange).

The effect of this is that shares bought under a margin lending agreement will provide you access to beneficial rights such as voting rights, corporate actions, tax benefits and tax credits as well as economic rights in the form of dividends and investment returns. Contracts for difference are structured under a contract similar to the ISDA (International Swaps and Derivatives Agreements) master swap agreements and only give economic rights over the asset: an economic return only. Thus, with CFDs you still stand to receive a portion of dividends, but not franking credits. If you go short on a stock and hold it overnight through the ex-dividend date you will also have to pay the dividend out of your trading account. CFDs also have lower brokerage fees and it is generally easier to short-sell an instrument using CFDs than through margin lending.

Another point worth mentioning is that CFDs are primarily OTC (over-the-counter) agreements (exceptions being the ASX CFDs in Australia that are exchange traded/priced), meaning that they are an agreement between you and the provider and may not necessarily track the underlying asset’s price movements on an exact basis (as opposed to a margin lending agreement where you are still in effect buying the asset on the open market at the prevailing price). Adaptations of this include market maker CFDs that are quote driven (you request a quote and the broker returns a price) and DMA CFDs that are priced either on a one-to-one basis to the market price or at a set distance thereof.

CFDs being an over-the-counter agreements may give rise to a number of extra contract-specific agreement terms especially when they are based on more exotic assets. These terms may refer to distinct ownership duties or contract expiry terms (futures/bonds/asset backed shares/options/aircraft leases/private equity…etc). Additionally, CFDs being at their core a synthetic instrument (although not always synthetically priced) could mean that CFDs may offer a connection not limited by market metrics; for instance a contracts for difference may provide exposure of 150% of a company’s market valuation.

A margin loan is like a line of credit loan. Margin lending is better for those who look at a longer term approach and comes with franking credits. Perhaps an advantage of taking a margin loan to trade stocks (as opposed to a CFD) is that with a margin loan you will only pay interest for the amount and time you use the loan for. On the other hand with CFDs (depending on the OTC provider’s terms), the interest is not based on the amount of funds that you actually borrow to make up the full value but on the full face value of your open positions based on the closing price. This means that even if you have sufficient funds (cash) in your CFD brokerage account to cover any open positions (i.e. you aren’t leveraged), you will still be charged interest on your open CFD positions. Having said that, again depending on the provider’s terms the extra cash balance might accrue interest at its own inverse rate to the rate applied to the resultant exposure.

Moreover, it is important to note that the valuation of a margin lending contract is regarded as separate to the actual Profit or Loss obtained or lost on the asset and thus may involve a separate gain/liability from a tax-reporting perspective. On the other hand on a contract for difference the ‘lending agreement’ of the swap part should be priced into the asset such as the dirty value which would include financing fees (i.e. interest) or credits under the agreement and these values can thus be included in any tax reports.

The general rules for funding arrangements (margin lending) compared to swaps (such as a contracts for difference):

-> funding is separate to the investment and comes with financial risk, counterparty risk, credit risk.
-> swap agreements ‘are’ the investments and come with financial risk, credit risk, counterparty risk and liquidity risk.

Note that margin lending is not available for anything except company shares and managed funds although some brokers also allow you to do covered call options and most will allow you to do warrant products.

Q:I’m thinking of applying for a margin loan. Is it correct that interest is only charged from the time the loan is used to buy the shares until the time the shares are sold?

A: Yes, you only pay interest for the amount and time you use the loan for. So if you take out a $16,000 margin loan at 10% per annum interest and you hold the shares for 20 days the interest would amount to -:

0.1 x 16,000 divided by 365 x 20 = $87.67.

Some lenders may require you to take a margin loan at a minimum of $20k but you still only pay interest on the amount you use regardless of the rest sitting in your account.

Q:What are contracts by installments?

A: These are considered less risky derivatives and are mostly relevant to Australians. Installments are a type of gearing product where you buy half of the shares now and pay the balance at a later future date. They are offered by the ASX (Australian Stock Exchange) or listed companies. The difference between the two is that the ASX installments have an optional second payment. It means if the stock you purchased falls to zero or below 50 per cent of its value, you can walk away and not pay the second installment. However, with installments issued by listed companies, if the value of the shares falls to zero, you still owe the company the second installment. The main benefit of installments is you receive an income stream through dividends and franking credits.