Contracts for Difference - CFDs

All the supposed benefits without ownership. A value investing minefield!

Contracts for difference (CFDs) are offered on a wide range of securities, although most traders stick to stocks.

CFDs are a leveraged bet on the movement of the underlying security. In this discussion, I refer to stocks as the security.

The emphasis here is on the movement in price of the stock rather than the 'value' characteristics of the company. Hence I don't view CFDs as a value investing opportunity.


CFD Characteristics

The exchanges that take place in a CFD deal are cash payments. There is no exchange of actual shares.

So the CFD is a pure play on the price of the underlying security. You are buying a 'contract', not a share.

Contracts for difference provide investors with all the benefits and risks of owning a share without actually owning it. Makes sense?

The extra cash to gain the leverage is provided by the CFD provider who charges interest on the loan amount. If prices do not move in your favor, you could be up for much more than the principal on the loan.

The contract does not entitle you to actual ownership of the stock and you are not entitled to vote at the AGM.


Short or Long a CFD

Contracts for difference allow you to bet on the price of the share going down, that is going 'short', as well as taking a 'long' position by betting on the price going up.

It costs the same in commission to short a CFD as it does to go long.

When you 'long' a CFD, the interest charged will be the official cash rate plus 2-3 per cent.

When you short a CFD, interest costs over the holding period are credited to your account since effectively, you are the seller.

Commission can vary from CFD broker to broker. The fact that some brokers offer advice can account for extra costs. Also, some brokers execute the trade through an exchange and others don't.

More exchanges around the world are starting to offer CFD trading. Trading through an exchange offers transparency and you receive market prices.


Buying and Selling CFDs

Most contracts for difference can be bought on a five per cent or 10 per cent margin. You multiply the margin by the amount of exposure you want and that is your down payment to get started.

If the position you have taken is losing money, and you have breached your margin, the contracts for difference provider will require you to either pay up to keep the trade going, or to close the trade.

If you do nothing, they will close it for you. Isn't that nice?


Potential Losses

Big losses can occur if the share price drops suddenly and the market 'gaps'. That is, the price moves from a higher price to a lower price without trading at prices in between.

In these circumstances having a stop-loss in place, that is, paying for the broker to automatically close the trade at a particular price below what you entered at, won't work.

The free fall causes the price to zoom past your stop-loss price without any trades taking place at that price.

It is possible to pay for a more expensive guaranteed stop-loss. This of course eats into any overall profits. It also raises the question "If you can't stand the heat ... what are you doing in CFDs?"


Hedging Advantages of CFDs

Contracts for difference are seen by some as a good hedging instrument because of their simplicity and flexibility.

To explain, supposing you had 3,000 shares in the mining company BHP Billiton that you bought for $35 each with a total outlay of $105,000.

If you were worried that the price of copper was likely to drop, you could hedge your bets by deciding to short 3,000 BHP share CFDs at $35 on a 10% margin for a total outlay of $10,500. That is ... 3000 X $35 X 10/100 = $10,500

If the shares dropped over the course of the following week to $32, you could sell your CFDs for a $9,000 gross profit, (3000 x the $3 difference in the share price) before interest and brokerage costs.

While your shares lost $9,000 over the course of the week, you made up for the loss by being 100% hedged through your CFDs.

However, if the BHP share rose by $3 over the course of the week, the hedging strategy would lose you $9,000 excluding interest and brokerage. However, your share portfolio would be up $9,000. You pay for protection by losing the profit in the gain in share price.


To Conclude ...

The simplicity and flexibility of CFDs can be a two-edged sword for the unwary, as any leveraged investment in the stock market magnifies risk.

From a value investing standpoint, I don't use CFDs as I don't speculate on share-price variation. I consider that my buying strategy and selling strategy provides me with sufficient protection from share price movements without the need to hedge as in the example above.

When stock exchanges allow CFD trading (not all do), they are effectively encouraging gambling, and are partly turning themselves into gambling casinos.

The related articles below examine the importance of my non-CFD strategies in more detail.

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Related Articles

My buying strategy - is designed to include a margin of safety into buying decisions by minimizing risks and so cushion against any large falls in the market.

My selling strategy - includes a staggered selling of overvalued stocks during periods of stock market gains.

A stop loss - is designed to limit an investor's loss on a trade. Worth considering if dabbling with CFDs!.

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