Contracts for difference (CFDs) have revolutionised the way in which active investors run their portfolios. From slow beginnings, CFDs have become an essential investment tool, giving investors efficient and flexible trading at a significantly lower cost than traditional share dealing. Indeed, the UK’s financial regulator, the Financial Services Authority (FSA), estimates that CFD related activity accounts for over 30 per cent of daily equity trading flow on the London Stock Exchange.

Appreciating the difference
As the name suggests, the CFD process involves trading the difference in the price of an asset at two different points, rather than physically holding the asset itself. A CFD is essentially an agreement between an investor and a provider to exchange the difference between the nominal value of the opening and the closing trades.

Therefore, a CFD is a derivative product, like an option or a futures contract, which allows the holder to have an interest in the price movement of an asset, without having to actually buy it. There are, however, some key differences.

Charles-Henri Sabet, Saxo Bank global head of trading, explains, ‘CFDs are a leveraged instrument, so clients get greater exposure by having to contribute only a small percentage of the overall cost. In addition, a CFD provider such as Saxo Bank will allow clients to use their share holdings as collateral for margin trading.’

CFDs must be traded through a stockbroker. In fact, the broker is acting as the counterparty to the trade, constructing a CFD through direct exposure to the underlying investment and settling the difference with the investor.

Free from stamp duty
Another attraction of CFDs, particularly for very active investors, is that they do not attract stamp duty, which gives investors seeking exposure to UK shares an immediate 0.5 per cent saving each time they invest. Given that commission rates for CFD trading are also very low – typically in the range of 0.1 to 0.25 per cent, with the more liquid stocks at the lower end of that range – it is easy to see why CFDs are becoming so popular.

It is also important to realise that CFDs are not restricted to individual shares. Increasingly they are being linked to a wide range of financial assets, including commodities, currencies and other market indices. Many stockbrokers are now offering CFDs to their private, as well as their institutional, clients.

At the margins
CFDs are a margined product, so you are getting exposure to a large number
of shares for a comparatively small outlay. The exact amount will vary depending
on the liquidity of the underlying asset, but for some of the larger, more liquid stocks, it can be as little as five to ten per cent of the total exposure.

There may be other costs involved, for example there is typically a financing charge if you keep a CFD position open overnight (around two to 2.5 per cent over LIBOR). It is also important to remember that, if the price moves against you, your broker will require a margin call to keep the position option, which will require putting up more cash.

Do remember that CFDs are not a one-way bet. They are simply a leveraged
way of getting exposure to an underlying asset and, if the price of that asset moves against you, your losses will be magnified by the leverage in the same way that any profits are multiplied if the price goes up. For this reason, CFD investors are usually advised to have a stop-loss in place, in case things do go wrong.

However, it is also possible to use CFDs to ‘go short’ – effectively selling shares you do not own in order to profit from falling prices. Unsurprisingly, due to the leveraged nature of CFD trading, brokers usually require investors to have some experience of conventional share trading before they dabble in CFDs.

The mechanics of CFDs
So this is how it works. If you wish to buy shares that currently stand at £2.00, you could buy 20,000 shares for £40,000 (plus commissions) or you could buy a CFD. If we assume that it is a highly liquid stock and your broker is prepared to offer you a CFD at ten per cent margin, then you could get exposure to the same 20,000 shares for a margin outlay of only £4,000. If they then rise in price by 5p, you could close out your CFD position for a profit of around £1,000 (5p x 20,000), minus commissions or other associated costs.

CFDs are ideally suited to investment strategies that seek to take advantage of short-term fluctuations in the price of a particular share or index. Because of the extra overnight financing costs, a typical CFD would be opened and closed within a single trading day. Indeed, the most active investors will complete many CFD transactions within the course of a day, since the flexibility of the CFD mechanism, and the absence of stamp duty, makes ‘day-trading’ a realistic possibility.

The growth in available CFDs, particularly those linked to market indices, has significantly increased opportunities for investors to hedge their investment risks, not least because they require much smaller amounts of capital than, for example, futures contracts.

Coping with volatility
The lesson regarding the use of CFDs for risk management seems to have been taken to heart by UK investors. In January, Saxo Bank saw trading volumes on CFDs rise by 292 per cent.

Saxo Bank’s Charles-Henri Sabet explained that ‘The surge was driven
by retail investors looking for shelter in a year that has been marked by sharp volatility and sliding equity markets. Faced with the prospect of selling from portfolios built up in the good times, retail investors are increasingly turning to CFDs to hedge against falling prices and to profit from market turbulence.’

He points out, ‘CFDs allow investors to take advantage of today’s market volatility and go long or short at any time. The product allows you a great deal of flexibility in either a bear or bull market, without the burden of borrowing shares. Furthermore, CFDs allow you to leverage a successful trade. Using existing portfolios as collateral means investors can hedge using a CFD against a downturn without having to shore up huge amounts of capital.’

What was particularly significant about Saxo Bank’s figures was the indication that around 40 per cent of CFD volume was traded on its share index tracking products, suggesting that individual investors were using these investments to hedge their market risk.

Sabet comments that ‘CFDs can empower individuals to preserve the long-term gains of their portfolios by leveraging them to protect against downturns in the market.’
He adds, ‘To hedge a share position, you would simply sell an equivalent amount of CFDs to the shares that you own. The outcome is that, while your share position is losing money in a falling market, your CFD can make money, and provide you with capital protection with the right risk management tools in place.’

Hiding in the shadows
However, not everyone sees CFDs as a universal blessing. A key concern centres on the way in which institutional investors use CFDs to build up a significant interest in a company without other shareholders being aware of the fact.

The Association of Investment Companies (AIC) is currently urging the FSA to introduce a general disclosure regime for CFDs that will tackle this problem, which is of particular concern to investment companies worried about the activities of arbitrageurs.

The AIC’s director general, Daniel Godfrey, points out, ‘Investors are already required to tell the market when they own a significant amount of shares or have an option to buy them. This allows the market to understand the level of demand for that stock, gain a good understanding of how much the shares are worth and establish whether
a third party is building a stake, perhaps as a prelude to a takeover.’

‘As the market for CFDs has grown, so the potential for abuse has increased. CFDs can currently be used to support stake-building without informing any shareholders or the wider market. This creates problems for investors, depriving them of information they need to make an effective assessment of the ‘right’ price at which to buy or sell.’

Greater transparency
The FSA has already put some options forward, including the disclosure of all CFD holdings over a certain threshold or the creation of a ‘safe harbour’ where disclosure will not be required if the CFD meets their conditions.

However Daniel Godfrey opines that ‘Partial disclosure will not work. It will create too many loopholes, which will allow abuses to persist. It is also inherently complicated and will prove to be very costly.’

He believes that, instead, ‘The best option would be to require all CFDs to be disclosed as soon as they represent a significant proportion of a company’s issued shares. They should be counted alongside shares and options so the market knows the extent of an investor’s interests.’

The very fact that such a debate is being conducted at all is a sign of how many institutional investors and fund managers are now using CFDs to manage their market exposure and investment risk. And if professionals have realised that CFDs represent a means of managing their portfolios more efficiently, then private investors too can benefit from this thoroughly modern way of gaining exposure to
the stock market.