Shares digital

Contracts for difference, or CFDs as they have become known, have helped revolutionise the share trading industry. CFDs have been traded for years by large institutions but it's only more recently that the doors have been flung open to a wider market, allowing access to these geared investments for the private investor too.

Of course, as with any geared play, the risks are also higher, but there are equally huge advantages. Few other investment tools give investors such low cost exposure to underlying asset prices, a big help to a trader’s bottom line, while being stamp duty exempt means investors also avoid having to pay potentially hefty charges on their trades.

In this CFDs Supplement we give you the low down on the exciting world of CFD trading, the basics, the charges, the trading opportunities available to ordinary traders, how to keep a firm grip on the risks, plus advice and insight from some of the market's top experts. Pretty much everything you need to get started really. Don't let these dynamic derivatives pass you by, read on and put the power of CFDs in your corner.

Steven Frazer, Editor

THE BASICS

Originally developed in the institutional arena as an alternative to traditional share trading, contracts for difference first entered the UK retail market in the late 1990s. They have since become a firm favourite among active private investors, with the overall demand thought to account for around a third of the volume on the London Stock Exchange.

CFDs are particularly well suited for short-term trading, meaning positions held for anything from just a couple of minutes up to a few weeks. This is partly because the stamp duty exemption makes them extremely cost effective, although the ability to sell short is an important contributory factor. The real clincher is that as a margined product the potential returns are that much greater than trading the physical shares direct.

Definition

Equity CFDs are a simple type of derivative that offers all the benefits of trading shares without having to physically own them. In essence they are contracts that mirror the performance of the underlying security with the profit or loss calculated as the difference between the purchase price and the selling price. This same principle also applies to all of the other markets for which CFDs are now available, including indices, commodities and currencies.

Take the example of Barclays Bank shares. With the stock trading at 445p, an investor could elect to buy 3,000 CFDs at the cash market price to create an effective exposure of £13,350. This would typically only require a margin deposit of about 5% or £668. Should the shares increase later in the day to 465p, the position could be closed by selling back the contract for a profit before costs of £600. The advantage of trading on margin is that a relatively small move in the underlying has been geared into a near 100% return on the committed capital, while the only cost is the commission of £54.60 reflecting the 0.20% charge on each leg of the trade.

The advantages of trading CFDs

The key difference between buying the shares and acquiring an exposure via a CFD is that the latter is traded on margin. This means that there is no need to put up the full capital cost of the position as only a small deposit is necessary. A CFD trader is therefore able to gear up their exposure, which opens up the opportunity to make a far greater profit for the same sized move in the underlying price. By the same token it is also possible to make a much larger loss, which is why it is essential to always use appropriate risk management.

CFDs are also extremely cost effective and this has helped them to attract a growing proportion of active UK traders away from the underlying shares. In some cases the half percent saving from the stamp duty exemption will actually exceed the round trip commission on both legs of the trade.

‘The stamp duty exemption means that people can take a position without that additional cost, while the gearing allows them to take bigger exposures than would otherwise be possible,’ says Andy Raby, head of customer services at the Halifax. ‘Of course clients should always be aware of the affordability of a position if the price moves against them.’

The main limitation with trading the shares direct is that it’s normally very difficult to sell short. Shorting is the practice of selling a market in order to make money from an anticipated fall in the price. The idea may sound strange, but it is simply the reverse of buying an exposure that is expected to rise in value. With a CFD it’s possible to do both, though when shorting the hope is to sell high and then close the position at a profit by buying it back when it is cheaper.

The attraction of short selling is that it opens up the possibility of making money from falling prices. There has certainly been no shortage of recent opportunities. In the first few weeks of January for example most major stock markets fell by about 10% and more than 80 of the individual shares in the FTSE 100 lost value. By short selling the associated CFDs it would have been possible to make a substantial profit.

Most CFDs are open-ended contracts that automatically rollover from one day to the next. Where a long position is held open overnight it will incur a small interest charge to reflect the fact that the majority of the exposure is in effect being financed by funds lent by the broker. Shorts are the exact opposite and receive a small credit. What this means in practice is that long UK equity positions held open for less than a couple of months will work out cheaper via a CFD, but any longer and the interest will outweigh the stamp duty saving making the shares the better option.

A WORLD OF OPPORTUNITY

Professional CFD traders tend to look for opportunities based on the fundamentals, but will then use technical analysis to refine their entry and exit levels. Private investors are also normally able to follow a similar approach, as most providers incorporate real-time news, comprehensive research and tick by tick charting into their online platforms. The beauty of using CFDs like this is that they are cheap to trade, give access to almost every conceivable market and can turn relatively small price movements in either direction into a decent profit.

Equity CFDs

Most providers take their equity CFD prices direct from the underlying shares and simply charge commission on the transaction. This means that for investors trading in normal market size or less, the prices will match the best bid/offer available at the time. The minimum contract size can be as low as one share and the trading hours are generally the same as the underlying exchange.

There was a time when UK equity CFDs were only available in respect of the blue chips but most providers now cover the full FTSE 350 universe. Investors who may want to go beyond this will need to sign up to a service like IG Markets, which covers all the listed shares in this country with a market cap greater than £10 million.

David Jones, chief market strategist at sister company IG Index, says that smaller caps offer the chance of a much bigger short or medium term move than the blue chips. ‘The potential profit is greater as is the risk. People tend to day trade the large caps but take a much longer term focus when dealing in the small stocks.’

Larger shares are typically traded on 5% margin, which gears up the potential return on capital by up to twenty times. By contrast, the small stocks require a bigger deposit of 10% to 20% to reflect the higher risk.

The most popular overseas market for UK investors is the US, with CFD traders able to access all of the major stocks throughout the evening until the NYSE closes at 9.00pm. It is even possible to build up an internationally diversified CFD portfolio that includes exposure to European, Asian and Japanese companies.

Equity CFDs mirror the price of the underlying shares including the effect of any dividends and corporate actions, although the holders are not normally entitled to any of the associated voting rights.

As far as dividends are concerned the adjustment to the CFD takes place when the share goes ex-div. In the case of UK companies, the cash credit on a long position is equal to the amount of the net dividend, namely 90% of the gross amount. For stocks in other markets the figure varies according to the local tax arrangements. Short positions undergo the reverse adjustment, with any dividend charged to the account.

Index CFDs

Index CFDs allow traders to speculate directly on the performance of each of the major stock markets. Most providers cover all the key indices including: the FTSE 100 in the UK; the Dow, S&P 500 and NASDAQ in the US; the DAX, CAC and MIB in Europe; as well as important Asian measures such as the Nikkei 225 and the Hang Seng.

Contracts like these are designed to reflect the best estimate of the current cash price of the market. The quotes are therefore taken from the associated futures contract, albeit with a fair value adjustment. This is necessary because the financing charge for the open-ended CFD is levied separately each night, whereas the futures price reflects the remaining cost of funding to the fixed expiry date.

Index CFDs are suitable for taking a top down view of the market, with some investors basing their judgement on the economic fundamentals and others on the charts. Either way, it is important to appreciate that whenever something significant happens, like an interest rate decision, the price will respond quickly to reflect the reaction in the futures markets.

Claus Nielsen, an executive director at Saxo Bank, says that all of the major indices like the S&P 500, the DAX, NASDAQ, Nikkei and the FTSE attract a lot of trading interest, as do the major blue chip stocks. ‘We have seen a big increase in the index turnover by several hundred percent over the last year and expect this to continue.’

Normally the value per index point of one CFD is defined as one unit of the base currency, namely a pound, dollar or euro, etc. This would mean that buying two FTSE 100 CFDs is equivalent to an exposure of about £12,000, while one CFD on the Dow would be worth around $12,400. The margin to open these positions would generally be about 3% – £360 and $372 respectively – with more volatile indices like the Nikkei and the Hang Seng needing about twice this amount.

Index CFDs are generally traded commission free with the providers adding a bit extra on to the bid-offer spread. During market hours this would typically be around four points on the FTSE, six on the Dow, five on the DAX and 20 on the both the Nikkei and the Hang Seng. Long positions held open overnight would also incur a daily financing charge.

Most providers offer the additional service of quoting index CFDs when the underlying markets are actually closed, which enables investors to take a view on what they think will happen the next day. The prices at such times will reflect both the client order flow and what is going on in the exchanges that are still open.

Other markets

One of the most popular areas to trade in recent years has been the commodity markets and with a CFD account it’s possible to access a good number of these fast moving prices. The coverage varies enormously between providers, but at best will include all the main precious metals, energies, grains and softs. Almost all of these markets have been experiencing a protracted bull run, yet with a CFD it’s just as easy to go short to make money from the reversals.

‘The most popular commodity CFDs are gold and oil, and both rose strongly last year,’ says Jones. ‘Investors tend to look at a mixture of the fundamentals and the charts when considering these areas, and there is also a lot of momentum trading as they try and make money by following the trend.’

Commodity CFDs are generally priced from the associated futures contracts and will automatically close on the relevant settlement date. Because of this the daily financing charge is built into the price and although these is no commission the provider will add a little extra on to the market spread.

Another key area of interest is the global FX market. Traders love the fact the major currency pairs are highly liquid and react quickly to important economic news like interest rate decisions and inflation data. Through a CFD account it’s possible to access these markets pretty much round the clock from Monday to Friday to take advantage of any opportunities as and when they come along. The other points in favour of the currencies are that they are cheap to trade and available on low margin rates of around 2%.

Advisory Services

The majority of CFD accounts are operated on an execution-only basis with the trading decisions left entirely in the hands of the individual concerned. Investors who want specific recommendations can however sign up to an advisory service like that available from Galvan Research and Trading.

Andrew Gibson, head analyst at the firm, says that they provide specific trading recommendations and also act as a sounding board for clients who want to discuss their own ideas. ‘Our main focus is on the UK stock market and we generally use a portfolio approach as it spreads the risk.’

Galvan looks to identify trading opportunities by spotting trends in the market and then going with them. ‘Our typical holding period is a few weeks and on that sort of timescale we believe that there is a much greater likelihood that a stock will continue its trend than reverse,’ says Gibson.

There is no separate fee for this service other than the commission on each trade. At Galvan this varies from 0.20% to 0.50% depending on the funds deposited, which can be anything from a few thousand pounds up to several hundred thousand.

Direct market access

Some CFD investors prefer the simplicity of a quote-driven service, where their provider presents them with the buying and selling price at which they can trade. For those who want it there is, however, a more sophisticated option known as Direct Market Access (DMA). DMA allows investors to place their buy and sell orders on the central limit order book of the stock exchange. This enables them to trade directly with other market participants and so avoid the necessity of paying market maker spreads.

The way these types of services work is that whenever a client places an order to trade a UK equity CFD, the company will instantaneously create the equivalent position in the underlying cash market to hedge its exposure. This shadow trade exactly mirrors the client’s instruction in terms of price and volume, and appears as an individual entry on the central limit order book as seen on the Level 2 screen. The companies offering this facility include the likes of E*TRADE Securities, GNI Touch and IG Markets.

‘DMA is mainly of interest to shorter term traders,’ says Jones. ‘Its main advantage is the greater transparency, since investors can see the full order book of the stock exchange to gauge what sort of sized order they are likely to be able to fill. They can also act like a market maker and enter their own bid or offer on to the book.’ lll

RISK MANAGEMENT

Margin trading

CFDs involve considerably more risk than ordinary share dealing and because of this they will never be suitable for everyone. The main danger with these instruments stems from the fact that they are traded on margin, which has the effect of magnifying relatively small moves in the underlying. For example, a margin requirement of 10% would gear up returns by a factor of ten times so that a 5% adverse movement in the price would wipe out half the committed capital.

Each CFD is continually re-valued and any adverse price movement will therefore result in an unrealised loss, which would absorb some of the available free funds in the account. In theory an extreme event could more than wipe out all of the deposited capital so that the investor has to pay in extra cash to clear his loss. This type of contingent liability could never happen when trading the shares direct and hence the need for careful risk management.

Stop losses

The main way to avoid this type of disaster scenario is to always use a stop loss. A stop is an automatic order that can be attached to an open position so as to limit the potential loss. With a long exposure for example this would take the form of a stop loss sell set below the current price. Should the market fall and hit the stop the order would be automatically triggered and the position sold.

The difficulty with a stop loss is judging where best to put it. Clearly if it is too close to the current price then the position could be closed out prematurely by the normal market volatility, whereas if it is too wide then the loss could be too great.

‘In general, I would recommend that CFD traders approach the issue of where to set their stops from a technical analysis perspective,’ says Nielsen. ‘They should look at the chart to identify the highs and lows, the trend lines, and the support and resistance levels. The stops should then be placed just outside of the trading range.’

In practice the placement of the stop is inextricably linked to the size of the position, since the two together define the potential loss. Inexperienced traders sometimes fall into the trap of deciding their stake and then working backwards to set the stop according to how much they are prepared to risk. The problem with this is that it takes no account of the volatility and like as not will simply be stopped out.

Experienced traders approach the problem the other way round. They will identify an entry and exit point for their trade and use the stop as a safety net in case things don’t turn out as planned. The position size then follows according to how much they want to risk.

Guaranteed stops and limited risk accounts

Normal stops are free but they are not guaranteed. In a fast market where the price gaps past the stop the order to close would only take effect at the next traded level. This slippage would result in the loss being bigger than expected. The only way to guard against these extreme circumstances is to pay for the added protection of a guaranteed stop. These take effect at the exact level of the order even where the market gaps straight past it.

Certain CFD providers including the Halifax offer the option of a limited risk account, where it is only possible to open a trade if there is a guaranteed stop and enough funds in place to cover the maximum possible loss.

‘The limited risk account insures customers against the position moving too far against them,’ says Raby. ‘It’s a good way for people to take advantage of CFDs while controlling the risk.’