Shares digital

Current volatility makes now the ideal time to overcome those nerves

by David Burrows

The benefits and flexibility of CFDs have been well documented – there is no requirement to pay stamp duty and you are investing in a share’s movements rather than buying the actual share itself so there is never the need to offload any unwanted stocks. The argument goes: ‘Why should you hold £5,000 in BP shares when for £500 you can have the same exposure via CFDs?

CFDs allow you to replicate the share price movements, without ever taking delivery of the actual shares, and thereby incurring stamp duty.

Because CFDs are margin trades, you simply pay a margin or deposit of as little as 10% of the contract value. This allows you to take a larger position than you usually could.

Having heard the case for the defence, what about the counter argument that highly geared products are not suitable in the current risk-averse climate? So you are investing in share price movements rather than the share itself and there is no stamp duty, but is this really so attractive, with share prices jumping all over the place and a market proving very difficult to call? At least when you own a share you have something tangible that may recover in time.

As highly geared products CFDs can translate into much bigger profits if you invest the right way. Of course, the flip side is you can incur equally big losses if you invest the wrong way.

Given that UK investors are generally showing increasing interest in lower-risk products (cautious managed funds or structured products) has there been a fall in the number of CFD traders, or are speculators making the most of fast-moving markets?

James Daly from the TD Waterhouse investment centre explains that trading levels in CFDs have come down markedly in the past few months as traders have preferred to keep their powder dry. ‘The level of CFD trades peaked in January but volumes for February and March are 15% below that. I think markets have moved unexpectedly and this has impacted on CFD trading. With markets not going up, there is a benefit in going short, and some traders who have guessed right have done well out of this. But it is never as smooth when a market goes down as when it goes up. Traditionally, traders go long on CFDs rather than short but I’m not sure is the case at the moment. Over the past six months there has been an increase in currency and commodities trades. We have also seen an increase in sector CFDs, they are popular as they are similar to an ETF. You don’t have to get bogged down in individual reports, you can take a more top-down analytical approach.’

CFDs are also being used tactically to make money from falling markets, says Marc O’Brien, of Barclays Stockbrokers. ‘Clearly volatile market conditions can make investors feel risk-averse on their investment strategies, but we have seen good volumes in our CFD business, with clients looking to take advantage of the market conditions. Some clients use products such as CFDs to speculate on short-term price movements, allowing them to quickly realise profitable positions if they make the right calls.’

Missing a trick

Mark Allen, stockbroker with Simple Investments, argues that CFD volumes are down but he believes traders may be missing a trick. ‘CFD trading on the FTSE in the first few days of this week was at the levels we typically see over the Christmas period. – so very low. Volumes rose when the FTSE was going up a few weeks ago, and levelled off when FTSE hit 6,000. Perhaps people are waiting to see whether we will go above 6,000. I trade CFDs myself and I have been very active. About 85% of my trades are short. There has been a lot of money to be made by going short.’

Allen believes too many CFD traders are creatures of habit and are only comfortable going long. ‘I know traders who hate to go short, they are only really used to trading in bull markets. The problem with this is that as a trader you are only ever using half the flexibility that CFDs offer. I have made a lot more money shorting in the past six months than I ever made going long. For instance I went short on DSG International. With the retail spending slowdown affecting sales of televisions and computers, there was hardly anyone in DSG’s stores. A lot of fundamentals looked cheap for traders but just because something is cheap doesn’t mean it can’t get any lower. British Airways I thought was another obvious short with a background of rising oil prices and an economic slowdown.’

Allen explains that advising clients in the current market is tough. ‘Some clients don’t see things my way. I had one client whom I advised to buy when the market went down to 5,500 but he was very reluctant; his instinct was to sell when in fact there was a short-term opportunity to make money going long.’

So where does Allen see the market going from here and how will that affect CFD trades?

‘I see us going up to 6,100 then coming off. Whether we go below the January low depends a lot on mining stocks. If they take a whack, that will affect the FTSE. Over the next three months I would look to trade short, but once the market is around 5,500 I would step back and maybe reduce short positions and start buying – probably mining stocks.’

Speculating or hedging?

So if volumes of CFD trades have fallen of late, what is driving the business there is? ‘As the credit crunch and associated volatility emerged, we saw a significant increase in speculative day traders looking to take advantage of the weaker and cheaper market conditions,’ explains O’Brien. For example, going long on a rolling bet on the FTSE index, which had previously been a couple of hundred points higher, provides a trader with an appetite to speculate that the index will rise once again in the short term – this was more prevalent for our FST traders.

‘As market conditions have evolved, and indeed remained volatile, we have seen CFDs continue in this mind set, with volumes remaining high during Q1 of 2008. This suggests that CFD traders are more sophisticated and have stronger appetites to continue trading in these conditions.’

He adds that there has been a significant increase in clients using CFDs to hedge their share portfolios. ‘Although they may have long-term outlooks on their equities and bond holdings and are willing to take short-term hits on the value of their equity portfolios, they are also using this time to capitalise on the significant opportunities that CFDs can offer in falling or indeed volatile market conditions.

‘CFD stocks and Indices are our most popular types of trades and, as you would expect clients, are often looking to take advantage of the big stories in the financial sector, which has driven volatility. This makes sense for clients who are more risk-averse in terms of their equity portfolios, where they will often have large exposure to such sectors. By trading on banking stocks, for example, with CFDs or FSTs they are able to hedge their exposure more efficiently rather than simply selling some or all of their holdings within equity portfolios.’

Allen on the other hand does not see much in the way of CFDs being used as hedging tools, nor does he advocate their use in this way. ‘I don’t think using CFDs as a hedge is that popular, and I certainly don’t encourage clients to hedge,’ he says. ‘If the market is going down and there is little to support a stock, just sell it – I mean, if BA stopped at 20% then fine, but when it is down 70%...?’

He adds: ‘I think CFDs are ideal for speculators but not for those looking to hedge portfolios. If you are talking about minimising risk, though, I would always advise traders to use stop-losses with CFDs – a 5% maximum. But, when trading on extremes in a trading range you tend not to need stop-losses that big. As advisory brokers we would also encourage clients to have 30% of CFDs in long-term trends (so for instance going short on a stock such as BA) with the other 70% for short-term trading’

O’Brien agrees that stop losses are a vital piece of defensive armoury for CFD traders. ‘We have guaranteed stop-loss functionality, which effectively allows clients to place their trades safe in the knowledge that they cannot lose more than the amount on the position. We also offer at market, and limit orders to cater for different client appetites.’

The gold rush

Not surprisingly, given the rises we have seen in base and precious metal prices, and of course oil, commodity indices have been a busy area for CFD trades. Allen believes some CFD traders have been richly rewarded, but he now warns traders to tread carefully. ‘I have been buying gold recently, the charts seem to be going up and there is the possibility of the dollar weakening again. Base metals have seen a massive run again but there is uncertainty on how far this will be affected by the economic slowdown.’

‘My advice to all CFD traders is stick to what you know – try and specialise. If you want to trade commodities, know the market you choose. I follow very closely what happens in the gold market but far less so the oil sector, where I would not trade CFDs: I don’t like the political interference on production and pricing. If you are going to trade CFDs on individual companies, specialise in a small universe of stocks. It is better to have a good understanding on 15 to 20 stocks than an average knowledge on many of them.

‘Watch out for good news on heavily shorted stocks. Positive news on a stock that is heavily shorted can cause the move to the upside to be more severe than usual due to normal buying and short closing.’