A SIMPLE GUIDE TO CFDS (Contracts For Differences)

A SIMPLE GUIDE TO CFDS

(Contracts For Differences)

CONTENTS

Contract for Differences (CFDs) were originally designed by a company

called Smith New Court in the 1990’s for its hedge fund clients who

wanted to short sell the market without having to borrow the stock.

Since then demand for CFDs has grown dramatically and now

reportedly represents over a third of the LSE’s total daily volume. This

guide will attempt to explain the key concepts and features of CFDs,

the advantages and risks in trading them, the key terminologies and

the ways that CFDs can benefit you and your client’s portfolios.

INTRODUCTION

17. STRATEGIES 18. SUITABILITY 19. CFDs IN SIPPs

A CFD is simply a contractual agreement between two parties to exchange the difference between the opening and closing price of a financial instrument such as a share. Neither of the parties owns the financial instrument only the contract. Essentially a CFD behaves exactly the like the underlying financial instrument but allows the trader to both go long and short with ease, while the CFD can also amplify returns by using leverage.

WHAT IS A CFD?

Margin

A CFD is traded on margin, this means that you do not have to pay the full value of your position you only have to pay a deposit (called margin). This enables the trader to utilize their investable wealth far more efficiently than they would by investing in a pure shares deal.

Long and Short

Long and Short is simply market terminology for buying and selling the market. When a client is long they have bought at one price in order to profit from selling at a higher one. Conversely, when a client is short they have sold at one price in order to profit by buying back at a lower price. In other words, buy low sell high and sell high buy low.

Leverage

Leverage is the term used to describe gaining exposure through the use of borrowings. Clients lever up their equity investment and so control a larger amount of stock. In other words for a small deposit you can borrow the amount you would otherwise have bought.

The ability to easily go both long and short

CFDs have the flexibility to go both long and short. Using regular shares going short is a difficult process and is the domain of sophisticated and professional investors. However, with CFDs traders can go long and short with equal ease. No stamp duty (0.5%)

Fidelity’s star fund manager Anthony Bolton believes hedge funds have a performance advantage over mutual funds, investment trusts and pension funds. In Bolton’s opinion this advantage is the use of CFDs and other equity derivatives which bypass stamp duty. He sees this 0.5% as an impairment to the performance of institutional investors. Clients who invest using CFDs thus have an intrinsic performance advantage over mutual funds and investment trusts.

Lower dealing costs

Commission on CFDs is much lower than on traditional share dealing, often by up to 70%.

ADVANTAGES

Leverage amplifies returns and risk

Leverage magnifies the returns an investor makes, consequently the returns on initial investment can be much higher than if they had invested in the underlying shares.

The combination of leverage and lower all round dealing costs enable investors to take a more nimble, active approach to their portfolio. This, along with the ability to go short with ease, means that CFDs are especially useful in volatile and sideways trending markets.

Overleaf are two examples of CFD trades, their rationale, their returns and the comparable returns for share trades of the same notional value.

A trader has been watching the market and its constituents fall from relative highs at 5600 and on February 10th he checks his indicators and notices that volatility is beginning to decline, which the trader views as a bullish signal, while global macroeconomic fears are also starting to decrease. The trader believes the market will now resume its uptrend following the correction. On a stock specific basis, the trader likes the look of mining giant Xstrata whose share price has fallen, peak-to-trough from 1302p to 985p, fundamentally the trader views the stock as one which will see additional benefits from strong Chinese growth and global metal demand while Xstrata’s high beta nature fits perfectly as he believes the trend is now up. The trader selects an entry point at 1000p and a price target of 1100p.

XSTRATA LONG

On 3rd_{March Xstrata trades at 1120p and the trader decides to take the}

profits offered by the market after exceeding his price target. The table overleaf demonstrates the return on investment offered by traditional shares and by CFDs, whilst the table below that illustrates the comparable costs of taking and holding such a position.

XSTRATA TRADE TABLE 9TH FEBRUARY 2010

Cost comparison - Share trade Vs Cost comparison - CFD trade

Cost to buy 5000 Xstrata shares @1000p £50,000 Open a CFD for 5000 Xstrata shares @1000p£5,000

Stamp Duty (0.5%) £250 Stamp Duty (0.5%) £0

Commission @1% £500 Commission @0.30% £150

Sell 5000 Xstrata shares @1120 £55,600 Close CFD for 5000 Xstrata shares @1120 £55,600

Commission @1% £556 Commission @0.30% £167

Financing costs(2.66% x 22 days x 55,600)/360 £90.50

Total costs £1,306 Total costs £407.30

Capital commitment £50,000 Capital commitment £5,000.00

SHARE TRADE

CFD TRADE

On 9th February Xstrata trades 1000p On 9th February Xstrata trades 1000p

Account value £50,000 Account value/Margin available £5,000

Buy 5000 shares @1000p Buy 5000 shares (using 10x leverage) @1000p

Transaction value £50,000 Notional transaction value £50,000

Commission @ 1% £500 Commission @ 0.30% £150.00

Stamp duty (0.5%) £0 Stamp duty £0

On 3rd of March 2010 Xstrata price is 1120p On 3rd of March 2010 Xstrata price is 1120p

Sell 500 shares @1120p Sell 5000 shares @1120p

Final transaction value £55,600 Notional transaction value £55,600

Gross profit £5,600 Gross transaction profit £5,600

Commission @ 1% £556 Commission @ 0.30% £167

Financing costs

(2.66% x 22 days x 55,600)/360 £90.50

Profit - costs £4,544 Profits - costs £5,192.50

Account value £54,544 Account value £10,192.50

% Return 9.09% % Return 103.85%

On March 15th the trader believes that the market has had a strong run from its February lows, and is due for a correction. Given this the trader wishes to short sell either the market or a stock that he feels may have a relatively negative short term outlook. The trader is reluctant to short the most volatile stocks such as the miners as he is betting against the trend and consequently may get stopped out. He feels that mobile network operator Vodafone is poised for a short term pull back. The trader is sure that the market is overvaluing the likelihood of Vodafone’s 45% stake in Verizon Wireless producing a dividend, while he also perceives there to be negative newsflow for Vodafone in the future.

VODAFONE SHORT

Combining this with the trader’s wider market view he decides to short Vodafone at 152p, with a stop-loss at 156p which would represent a new high for this trend and imply the market has pushed on further.

On March 18th Vodafone trades at 147p, representing a strong short term profit for the trade, which the trader takes.

The above trade demonstrates two of the benefits a CFD can provide. The trader, on viewing Vodafone as being short term overvalued, was able to short sell Vodafone and also aims for a much lower price target due to leverage and lower dealing costs.

The table overleaf shows the short sale of Vodafone along with a breakdown of the profits and costs.

VODAFONE SHORT SALE

SHORT CFD TRADE

SHORT SHARES TRADE

On 15th March 2010 the Vodafone price is 152p Not possible Account value/Margin available £10,192.50

Sell 65,000 shares (using 10x leverage) @152p

Notional transaction value £98,800

Commission @ 0.30% £296.40

On 18th of March Vodafone is trading @147p

Buy 65,000 shares @147p

Notional transaction value £95,550

Gross transaction profit £3,250

Commission @ 0.30% £286.65

Financing received

(2.66% x 3 days x 55,600)/360 £21.90 Profits + financing received - costs £2,688.85

Account value £12,881.35

The use of leverage amplifies loses as well as gains. Investors can lose more than their initial deposit. An investor’s account may approach a point where their losses begin to outweigh the margin on account and they may be required to add additional funds in order to continue trading and fund this paper loss. If the client does not wish to fund the account the position will be sold by the clearing broker at a real loss to the client.

RISKS

Directional trading – Typical CFD investors attempt to time the market and often use numerous indicators to call continuations, changes or divergences from trends. These could range from attempting to call or time market tops or bottoms, or a continued strengthening in a given sector or stock. Pairs trading – investors may wish to trade in securities that have, historically, behaved in a similar way. These may be two stocks in the same sector whose share prices have diverged, the investor believes that the relationship will revert to its historical mean, so the investor shorts one stock whilst going long the other.

Market momentum – an investor may perceive a stock to have broken through an established trend line and believe it will now push on to new highs. The investor goes long the CFD and captures further market rises. Scalping – The trader attempts to make the spread between the buyers and sellers in the market for a particular stock, a strategy that is very difficult to employ without the added assistance leverage offers with CFDs.

Although a more efficient product to trade the markets, CFDs are relatively inefficient when investors desire income from their portfolio. This is because the holder of the CFD receives only 90% of the dividend paid by the underlying share. This reduction in dividend received means that investors aiming for an income based portfolio will receive less income from the CFD than they would traditional shares, additionally CFDs are also a relatively short term product so it is unlikely that traders will be in their positions long enough to receive the full dividends. Consequently CFDs are not suitable for investors desiring a high level of income from their portfolio.

Importantly the use of leverage amplifies losses as well as gains; consequently the product is not suitable for clients who do not have a high tolerance for risk. Due to this high level of risk CFDs are only suitable for clients with strong financial market knowledge and equity investment experience.

SUITABILITY

CFDs can be used effectively in Self Invested Personal Pension Plans. While all the benefits of CFDs still apply, there is also the added benefit of Capital Gains Tax relief when investing within a SIPP. A CFD account can also be used as an effective hedge against current equity investments.