Get more for your trades

Many investors view CFDs as the preserve of stock market junkies. While that is true of some types of trade, Ceri Jones explains why they are useful for managing risk or backing a hunch

Contracts for difference (CFDs) are an easy way to trade thousands of shares globally, as well as foreign exchange, commodities and stock indices. Saxo Bank, for instance, offers 6,500 share-based CFDs from 25 exchanges and 16 index-tracking versions.
These instruments got their name because, essentially, they are a simple contract agreeing to exchange the difference in value of a particular asset or index between the time the contract is opened and the time it is closed.

Investors can take long (buy) or short (sell) positions, and trades are conducted on a leveraged basis with a margin based on a small percentage of the value of the trade, so you can open a position without having to put up its full value. But trading on margin means any losses you make will be magnified. The margin will range from 2 per cent for major currency pairs; 5 per cent for major indices, gold and silver; and 10 per cent or more for UK, US or European shares.

Banking on share price rises
At the start of the year, the majority of private investors were playing the banks and the financial sector dominated three-quarters of their trading. ‘Most clients have done well with the banks going up,’ says John Prior, director of Killik Capital. ‘Many bought Barclays at 73p and rode it all the way to £2 or £3. But a lot of them would have been burned badly on the way down trying to catch a falling knife,’ he adds, using a phrase that describes the dangerous practice of buying shares in freefall.

‘We had a client who bought 25,000 Barclays shares on a CFD at 71p on 12 March and sold them at 192.5p on 21 April,’ says Prior. ‘He made a profit of £30,375 before commission and funding costs. The margin he had to put up to fund the trade was only 15 per cent of the value of the trade or £2,662.50 [25,000 shares x 71p x 15 per cent].’

‘That particular trade is getting a bit long in the tooth,’ adds Prior. ‘For the long side, we now prefer resources shares. If the markets move up it will usually be banks or miners that drive it.’

CFDs are a convenient and cost-effective way for investors to go short to profit from a fall in the underlying asset. For example, one of Saxo Bank’s clients believed Prudential was overvalued and placed a trade to sell 100,000 shares as a CFD at 475p on 19 May. For this, he had to make an initial 10 per cent deposit of £47,500. Three days later 
his prediction proved correct and he closed out his position at 437p, making a profit of £38,000 before commission and financing charges (38p x 100,000 shares).

According to Stephen Bower, institutional sales trader at Saxo Bank, sellers have only recently returned to the market looking for a retracement after heavy short selling in cyclical stocks, such as retail and property, during the summer months of last year,.

The ability to short also opens up the opportunity for ‘pairs trading’, where an investor buys a share and, at the same time, sells exactly the same amount of another share, usually in the same sector. This will create a balanced collateral position, while maintaining market sensitivity, because shares in the same sector should be highly correlated and will generally move in roughly the same direction so their market performances should negate each other.

The profit comes in picking which stock will move the most – perhaps one has been overlooked or marked down for a particular reason, there is a reason to suspect it will bounce, or a reason for thinking the share you sold will drop like a stone. A popular pairs trade is to buy Taylor Wimpey or Barratt Developments and sell Persimmon.

Pairs trading can cut risk
Pairs trading does not have to be within one sector, however. ‘In this market, traders could go long on a resources share and short a bank,’ suggests Prior. ‘This would take a good deal of the market risk out of the trade.’

Trading CFDs can be cheaper than spreadbetting, as CFDs trade at almost exactly the same price as the underlying market. In spreadbetting, the price you trade at is not the price you see on the screen, so CFDs are easier to keep track of and their costs are more transparent.

‘Spreadbetting compared unfavourably because of wider spreads, but spreadbetting firms have now come more into line,’ says Navaz Sachedina, senior vice president at GDI Markets.

Nevertheless, CFDs are often a Direct Market Access product. This means when an investor places a CFD order, the trading platform automatically generates an identical hedging trade into the relevant stock exchange that can be seen on the exchange’s order book via the Level 2 screen. Frequent traders learn to play within the spread, by buying at a certain limit order a few pence lower than the price and moving in and out when the price moves by one or two pence.

Another difference is that CFDs will be priced in the currency of the issuing country, whereas a spreadbet will be priced in sterling, which makes the CFD of a foreign share or asset more attractive when sterling depreciates.

However, the big attraction of CFDs over spreadbetting is that losses can be used to offset your liability to capital gains tax (CGT). ‘You can hedge your portfolio when you go on holiday or in the closed period around a company’s announcements, to ensure your profit and loss will be zero,’ says Joshua Raymond, market strategist at City Index. ‘Whichever side makes a loss you can use it to offset your CGT bill.’

This facility to offset CGT liability can also be used more generally. James Daly, investor centre representative at TD Waterhouse, points out that any CFD losses can also be offset against the sale of other assets such as a second home.

The cost of financing CFDs is linked to Libor (the London inter-bank offered rate) and as Libor has been slowly falling in line with the Bank of England rate, the cost of holding CFDs has fallen. Consequently, CFD traders now tend to hold their positions longer than spreadbetting clients who risk larger amounts and often get in and out within the day.

‘Investors are now prepared to take on more risk and clearly think there is a real opportunity,’ says Asghar Hussain, head of derivative products at Interactive Investor. ‘They are starting to trade in much larger sizes. Trade sizes are up three or four-fold.’

He’s seen a big increase in equity trading in the last three months, as confidence has returned to the market – trading had been split 20 per cent in equities and 80 per cent in favour of indices, commodities and foreign exchange. But in the last three months the equity portion has risen to 40 per cent.