For investors looking for a cheap and efficient way to manage their market exposure quickly, CFDs can be invaluable. This type of product enables you to draw up a contract with a provider to exchange the difference between the opening and closing price of a share, commodity, currency or index. In this way, you are taking a punt on the direction of the particular market in which you are investing.

The major benefit of CFDs is the exposure you gain, without actually buying any shares. It is possible to invest long or short of the market, allowing the potential to make a return from falling as well as rising markets, depending on the contract you have in place. You can also trade on margin, meaning that you only need to put down a percentage deposit (typically ten per cent) of the overall exposure you require.

Booming business

‘Trading in CFDs has boomed in recent years as retail investors increasingly recognise their benefits,’ says Alison Cashmore, spokesperson for CFD provider City Index. ‘CFDs offer a cost-effective way to gain exposure to movements in a wide range of underlying financial instruments, many of which would not otherwise be available to retail investors.’

In addition, for those trading in shares, CFDs have the added benefit of providing a stamp duty-free trade, saving investors 0.5 per cent of the trade price. On the other hand, unlike spread bets, CFDs are subject to capital gains tax (CGT).

Cashmore continues, ‘The popularity of CFDs has been helped by increasingly retail-friendly services with transparent pricing, easy access and a range of tools to manage risk.’

Other online execution-only brokers, such as E*Trade and TD Waterhouse offer trading demonstrations, market data and charts, as well as information about the pros and cons of CFD trading.

Complicated products

However, retail investors need to be aware of the complexity of such products, according to Gavin Oldham of The Share Centre. ‘Too many investment firms have felt they have no other choice than to offer CFDs, just because everyone else has,’ he says. ‘We feel this is wrong as they are very complicated products and you have to know what you’re doing. If you do, fine, but if not you could loose a lot of money – a lot of people do.’

The Financial Services Authority (FSA) has developed an ‘appropriateness test’ to protect ill-informed and inexperienced consumers (see ‘Appropriate behaviour?’, for more information).

But why do some providers, and even the industry regulator, feel that an element of caution is needed when dealing with this type of product? CFDs give investors access to some quite complicated strategies and concepts. First of all, they allow investors to go long or short of a particular market. Richard Hunter, head of equities at brokerage Hargreaves Lansdown, describes one CFD strategy that makes use of long and short techniques. ‘The 90/10 strategy is the most basic. For example, if you have £100,000, you go long by investing £90,000 in FTSE 100 company shares, for example, and then short the same index £10,000. Therefore, if the market falls, you still win.’

You win in Hunter’s example because your £10,000 is a ten per cent deposit and, therefore, actually gives you a £100,000 exposure to the market – more than equal to the long exposure that will be lost if the market falls.

Magnified profits... and losses
And this leads us to possibly the biggest danger involved in CFD trading – ‘leverage’, or ‘gearing’. Cashmore explains, ‘The geared nature of CFDs offers the opportunity to take out a much larger position than would be possible with the same initial investment in a traditional trade. While an investor buying a share would need to pay 100 per cent of the value of the transaction, buying a CFD on the same share would require funding of a fraction of the total value – usually around ten per cent. This means that, for the same initial investment, it is possible to take out a much larger position, and, therefore, magnify potential profits or losses.’

There are, however, measures you can take to limit such losses, as Angus Rigby, CEO of TD Waterhouse, explains, ‘A stop-loss allows the investor to set a price that triggers a sell or buy. A guaranteed stop-loss guarantees to place an order at the price the investor specifies, even if the price suddenly changes and never actually trades at the specified price.’

Rigby also points out that guarantees are not available on all stocks, and stresses the importance of ensuring you have enough money in your account to cover any losses, especially if you don’t have some kind of stop-loss in place.

He explains, ‘As CFDs can remain open for as long as the investor wishes, there must always be sufficient collateral to cover potential losses. If a CFD moves into a loss-making position, the broker can make a ‘margin call’, where the investor is asked to deposit additional funds to ensure their account remains in the black and is not closed by the broker.’

The complex nature of CFDs requires a practised hand to ensure trading success. But for those with the knowledge, skills and experience, the rewards could well be high.

CFDs at work
Richard Hunter, head of equities at brokerage Hargreaves Lansdown, gives some examples of how CFDs work.

Example 1: On the up Niall is bullish on British Airways (BA)

and thinks the share price will rise. He decides to take out a CFD to buy 3,000 BA shares at 600p. The total contract value is £18,000, but only an initial ten per cent deposit (margin) payment totalling £1,800 is required.

Two weeks later, BA shares have risen to 630p and Jeremy decides to close the contract. He will now get the £1,800 deposit back plus a gross profit of £900 (30p x 3,000 shares), or 50 per cent.

Had he used the £1,800 to buy BA ordinary shares instead, the profit would have been £90 (30p x 300 shares), or just five per cent.

Example 2: Falling down

Rachael is bearish on Vodafone and believes the share price will fall. She decides to take out a CFD to sell 15,000 Vodafone shares at 100p. The total contract value would be £15,000 but, again, the initial ten per cent deposit (margin) totals just £1,500.

Two weeks later, Vodafone shares have dropped to 95p and Rachael decides to close the contract. She will get the £1,500 deposit back plus a gross profit of £750 (5p x 15,000 shares). A five per cent fall in the share price has therefore been translated into a 50 per cent profit.

Warning: Gearing means that similar losses will arise if the price moves against the investor.

Source: Hargreaves Lansdown

Appropriate behaviour?

New rules introduced by the Financial Services Authority (FSA) on 1 November 2007 could have an effect on how contract for difference (CFD) services are sold to private investors, according to Ben Goh, secretary of the Compliance Register. This is a professional interest group that helps fund management firms develop and maintain good regulatory practice.

The appropriateness test will be introduced by the FSA as a result of the new EU Markets in Financial Instruments Directive (MiFID). The aim is to increase investor protection, so firms will be required to gather information from the individual client to prove that they have the knowledge and experience to understand the risks involved in certain, more complicated transactions, such as CFDs.

Goh explains, ‘CFDs are one of the complex instruments that should not be sold to inexperienced investors. Firms, and particularly salespeople, will need to be very careful when they target investors with marketing for complex instruments like CFDs.’

According to Goh, this means that a firm will need details such as clients’ risk profile and level of investment experience before attempting to sell them certain products. ‘So, if you get an approach by email or post from someone offering you a CFD and you don’t know them, you should be extra wary,’ he warns. ‘If the trader doesn't know you, they can't possibly know whether CFDs are appropriate for you. That means they are not complying with the legislation and are almost certainly dodgy!’

Victims of mis-selling may be able to seek compensation. Details of how to make a complaint can be found on the Financial Ombudsman Service website, www.financial-ombudsman.org.uk
This article is from the November 2007 issue of What Investment.