Advantages and Disadvantages of CFDs

Any glossy brochure can tell you the benefits to using CFDs, or what brokers or CFD providers want you to think are benefits. But what about actual things – useful to the average trader or investor?

No-one likes paying needlessly more for something than they have to. There are more than ten providers of CFDs to the private investor and it can be hard making direct comparisons. The first thing a potential user of CFDs must decide is whether CFDs are an appropriate instrument for that individual. CFD trading is predominantly based around short-term trading and a comparison must be made between the savings made in not paying stamp duty with the additional financing cost of the CFD. Indeed we can quickly calculate the break-even point if we compare these two costs directly, if we set aside commission costs for one moment for simplicity’s sake.

The additional cost in running a CFD position compared with a traditional stock transaction is the funding cost associated with the CFD. The EXTRA funding cost of the CFD is the 3% on the 80% of the position that the CFD provider lends to the client. On the other hand, trading traditional stocks incurs a 0.5% stamp duty charge up front immediately. So the crossover point will be when the funding costs of the CFD overtake the saving made on stamp duty. The point at which the funding cost matches the 0.5% of the transaction value in days is (0.5/0.8) x (365/3) = 76 days i.e. about 11 weeks. In other words for trades that are less than three months it is economically more viable to trade the CFD rather than the underlying stock. Of course this is a crude measure as there are other costs involved but it is a useful comparison. For very short-term trading or even intra-day, where the financing costs would be zero, the argument is compulsive. Where the CFD also gains is when the position is traded more than originally anticipated or a target price is reached quicker than planned, as the drag on net returns incurred because of stamp duty are avoided and the financing costs are lower than originally catered for.

However this is not the only aspect as experienced investors will be aware. There are also other considerations. When placing an opening trade, whether on a stock or CFD, the investor should be aware of all costs and risks associated with that trade. Stock liquidity and bid-offer spreads are as important, if not more so, than low commissions and levels of stamp duty. One wouldn’t buy foreign currency simply because it was commission free; the two-way exchange rate is just as important and is a good reflection of how competitive the provider is.

CFD providers are divided into two main types. Those that provide an ‘agency’ service, i.e. they hedge all underlying CFD orders in the underlying cash market and charge a commission, and those that ‘make markets’ in CFDs around the underlying cash market, charge no commission, but add on an additional spread with reference to the price of the underlying stock. All CFD providers make a proportion of their income on the financing of their clients positions.

It is up to the individual to make up his mind what relationship he is most comfortable with. The relationship is intrinsically different, although technically, as CFDs are over the counter derivative instruments, the CFD provider is counter party to the client in both cases. However, in the first example, where the provider hedges everything in the underlying market, the provider is in effect acting as agent on behalf of his client, probably via his regular account handler with whom he will have built a relationship. There is every incentive to get the best possible price for the client by dealing inside the spread. The client should also consider what else he gets; whether the company provides a good quality research product, with trading ideas, strategies, technical analysis and research on current take-over situations and forthcoming IPOs. Also the nature of the trading platform is important, whether he has access to Level 2 prices (full market depth), can participate in pre-market, intra-day and post-market auctions in the underlying stock and whether phone broking is also supported. CFD prices are based on the underlying stock and a reflection of underlying liquidity, and the individual must ask himself whether he wants access to the best local liquidity. The credit rating of the provider should also be given due consideration.

Advocates of the commission-free structure claim that trading costs are lower as spreads are no wider than the UK Sets system. This argument is somewhat flawed as spreads early and late in the day are always wider on Sets than during the more liquid mid-day period, making for an unreliable comparison. True, these commission-free prices can be competitive in the very liquid stocks such as Vodafone or British Telecom, which is fine if this is all you trade but if you want to trade a less liquid stock, surely you want direct access to the local liquidity rather than a variable two-way price made around the underlying. Trading and paying commission gives a fixed cost of entry, whereas trading commission-free with a variable spread around the underlying adds some uncertainty to this calculation. The ability to trade within the spread and place orders within the spread is as important, and good execution can easily offset the commission costs.

I also saw a recent claim that transactions through the London Sets system are only around 20% of the total Stock Exchange business. I decided to do a little investigation of my own and I took a visit to the London Stock Exchange website, taking the month of October 2000 as reference, the most recent month on which statistics were available at the time I visited.

Of the 2,283,101 bargains transacted on the LSE, 811,384 were conducted over Sets, giving a raw figure of 35.5%. However this is not the full story as the Exchange explained to me, non-Sets trades are double counted due to the reporting procedure so adjusting the figures gives a staggering 52%. Doing the same calculation for value transacted in £m gives a raw figure of 33%, adjusted to 49.7%. I took a look at October 1999 to see if I could judge if this figure was more or less static and discovered that twelve months previous, the relevant figures were 28.9% raw and 45% adjusted and 26.6% raw, 42% adjusted, by consideration. I anticipate the trend will continue, particularly in light of the recently introduced Central counter party system.

In summary then, the active trader will give due consideration to all these aspects and should be able to form his own opinion as to whether a CFD account is appropriate to his style of trading and investing. I personally believe that they are an invaluable tool, but should complement not replace more tradition normal stock trading accounts, ISA accounts and spread betting.

Despite all the negative noise, borrowing to invest is one of the most popular growth strategies for both businesses and serious investors. Most wealthy people build their wealth to some extent assisted by other people’s money. But you have to be careful with the timing and affordability from a cash-flow point of view and, of course, the quality of the investment that you are going to put your money into.

Gearing suits a more aggressive investor who is prepared to take a greater degree of risk and accept greater volatility. Gearing will magnify the possible gains, as well as the losses – as many will have seen in the past 12 months.The biggest trap is overcommitting. Borrowing too much, being too aggressive and then not being able to fund or finance the debt.

The Advantages of CFDs include:

• Liquidity – CFD prices mirror directly what is happening in the underlying market. This means that CFDs provide you access to the liquidity in the underlying market, in addition to the liquidity offered by the CFD provider.
• Tradeable on Margin – CFDs are a leveraged product, so you only need to deposit a percentage (typically from 5-10% to for shares and 1% for indices) of the total value of the trade. This allows you to enhance returns and levels of market exposure. For a similar and usually smaller cost per trade you can gain 10 times the results (if not more) from a trade due to the inherent leverage. This means a more efficient use of your capital as that there is no need to invest in the full value of the shares.
• Tax efficient trading – Gearing can also provide tax benefits as the costs of investing – such as interest repayments are generally deductable. And not only that; instead of crystallising a potentially taxable capital gain in a share position, an investor can sell a CFD and thus control how to realise the capital gain.
• Low transaction costs – brokerage using CFDs is usually MUCH cheaper than buying shares through a full service broker. Also, the additional cost of holding a long CFD position over a traditional purchase is only the interest cost while a traditional share purchase incurs stamp duty at 0.5% (in the UK). In the case of CFDs there no stamp duty on CFDs since the stock is not actually being purchased. Some CFD providers charge as low as £10 for trades of up to £5,000. Any trade more than £5,000 may be charged 0.01% of the total trade amount.
• Transparency and ease of execution – trading or investing with CFDs is almost exactly the same as trading with shares. One share usually = one CFD, so they are not confusing to use.
• Trade long or short with equal ease – this empoweres traders to profit from a falling market by taking advantage of share price declines. Because the CFD trade is on the price movement of a financial asset – and does not require its ownership – selling is as easy as buying, and the mechanics are identical. Before the advent of CFDs, going short a share could only be done using a traditional stockbroker that would usually charge additional fees on top of the normal brokerage. In contrast, your CFD provider will typically pay you interest on short CFD positions.
• Ability to trade international markets from one account – many CFD providers offer CFDs on international shares as well as things you normally aren’t able to trade like Gold, Silver, Oil, Indices, Sectors, Commodities, Treasuries…etc This gives traders the ability to be more diversified in the investments across their portfolio.
• Ability to trade out-of-hours – many providers offer extended hours meaning that you can trade some markets (like the FTSE or Dow) even after the underlying exchange has closed for the day.
• Trade any time frame – no fixed expiry date.
• Receive interest on short positions.
• No fixed contract size – trade the number of shares you choose; it doesn’t matter if you trade small or large volumes.
• Much less complex than options and warrants. Unlike options or warrants the CFD price directly mirrors the price and liquidity of the underlying market.
• Receive dividends when long or bonus issues (but no franking credits) – and with CFDs you get the dividend as soon as the share goes ex-dividend as opposed to having to wait for the share dividend payment date (sometimes up to a month later…) If holding CFD positions over the long run this helps with financing charges.
• Participate in rights issues, share splits and other company activities. Since contracts for differences mirror the price and movement of the underlying physical stock, they also mirror any corporate actions that take place in the underlying stock.
• Stop loss and contingent orders easily placed – this means that you can place sophisticated orders like ‘if the market hits this price, then buy this many, but only after 2pm’
• Many CFD Providers offer ‘Guaranteed Stop Loss’ orders, meaning that if the stock price gaps through your stop loss, you are guaranteed to get your stop loss price.
• CFDs allow you to hedge an existing shares portfolio by selling short individual shares or leading indices and sector indices but not selling your shares. For instance, investors can make use of a CFD to hedge an existing long physical position in a share by taking advantage of any short term price declines while protecting the portfolio from short-term price drops.
• Online account reporting and daily statements.

The Disadvantages of CFDs include:

• Price re-quotes and crossing the price spread with Market Makers CFD providers.
• Leverage can be a double-edged sword. i.e. margin trading means your potential profits are magnified, but it is important to remember that losses are also magnified so it is essential to apply appropriate money-management techniques.
• Trading CFDs is higher risk than trading shares. Even though you don’t need to deposit the whole value you still could lose your initial margin plus if the market moves against you, you may also need to meet a margin call where you either contribute more cash or be forced to sell down assets. For a short position investors are exposed to potentially unlimited loss.
• Beware of what exactly you are trading. For instance, whilst the ASX200 index (XJO) is referenced as the benchmark index for Australian stocks yet there is no CFD broker that offers the XJO index. This also carries over to futures – the Sydney Futures Exchange (SFE) charges too much money for quoting the SPI200, therefore most CFD providers cut costs by providing a product that ‘mirrors’ the SPI200.
• Easy of access and low capital requirements can lead to over-trading.
• Positions that are held overnight are subject to overnight financing (this consists of a daily charge based on the size of the contract and is linked to Libor). Long trades held for extended lengths of time attract ever-increasing interest payments. The interest charged for long positions held over large timeframes (6 months +) can reduce significantly the effectiveness of returns in many cases rendering the leverage obtained as comparable to buying a contract or share completely in the market.
• Interest payable on the whole transaction: As opposed to margin lending (or any shares gearing) the contracts for difference trader has to pay interest on the total transaction market exposure, irrespective of the margin that they have contributed.
• Contracts for difference have a collateral requirement which means that open positions are ‘marked to market’, and should the position move against you this will reduce your cash balance. If there is insufficient collateral on account to support the open position losses, the trader will be subject to a ‘margin call’ which means that you will have to deposit additional funds into the account (or close the position).
• Inflexible leverage levels: The CFD provider sets the margin level applicable to each market. The trader has to accept this leverage level and try and come up with risk management strategies around the level. This leverage level can be changed as the CFD provider sees necessary, therefore if the CFD broker increases the margin required mid-trade the trader may have to contribute more margin monies to avoid being closed out.
• A CFD investor has no rights as a shareholder since there is no physical ownership of the underlying asset (which implies no voting rights or say in the company).
• As CFDs are an over-the-counter derivative product it’s important to note that you don’t own the underlying share or instrument over which the CFD is quoted, this also means that you cannot transfer your position to a different CFD provider or stock broker, you can only deal with the CFD broker that you opened the position with.
• For an investor who opens a short CFD position, he is liable to pay out the full dividend value if he holds his short position over the record date.

So to conclude, CFDs have been instrumental in bringing generous levels of gearing to the retail trader market and introduced the retail trader to Forex and Index trading like never seen before. However, as described above there are some disadvantages.

It is for shorter term trading and longer term hedging that CFDs and spreadbets have a clear edge when compared to traditional share dealing, and they are both beneficial for those who wish to ‘go it alone’ as far as trading costs are concerned. This benefit can be quantified in terms of the length of time each trade is open.