It seems like constantly we are reminded that CFDs are risky instruments not suitable for the ‘average’ price investor. This time we present to you a paper titled ‘Contracts for Dummies? The Performance of Investors in Contracts for Difference’.
CFDs are an important innovation in the design of futures contracts and their adoption by private investors has fuelled significant growth in the derivatives market and has also generated some controversy, but to-date there have been no detailed academic studies examining CFD markets. In 2007, the Australian Securities Exchange (ASX) introduced exchange-traded CFDs on individual stocks and other financial instruments.
Lee, Adrian D. a Post Doctoral Fellow and honours student Choy, Shan both from the University of Technology (Sydney) examined the performance of investors who utilised ASX-listed stock contracts for difference to see if we are being taken for a ride. The two scholars used the S&P/ASX 200 Accumulation Index as a performance measure to compare traders’ performance on long (i.e. buy) trades in relation to short (i.e. sell) trades and reached a conclusion that individual CFD trades net modest but ‘statistically significant’ positive returns over daily trade horizons (daily price against closing price and next day’s closing) and lose on average when holding positions from one week to one year.
The research is hypothetical, in that trades held for weekly, monthly, half-yearly and yearly periods are assumed based on the available data. Having said that, the better returns were noticed over the two shortest holding timeframes. The findings show that inclusive of the bid-off spread but before other costs such as financing fees, investor CFD buys outperformed sell CFDs by 5.85 basis points per day over a one day holding period, with no statistically significant performance for longer holder periods of up to one year. Investors who continue holding positions to extended periods are unlikely to come ahead because of the financing costs. A fee is charged for holding CFD positions overnight (typically RBA cash rate + 1.5%) which can add up in the long term. Sellers on the other hand earn interest at the cash rate – 1.5%.
Good stock picking was also observed as investors in aggregate turned into shares with a high beta (which is a measure of a stock’s volatility) before the stock market rose, so as to beat the risk-free rate. If the scenario materialised, they would have demonstrated themselves to be good market forecasters.
The traders who took sizable positions ($20,000 to $50,000) experienced short-term outperformance suggesting that such traders are more likely to be sophisticated. The short-term outperformance was noted in both small (less than $10,000) and large trades ($20,000 or more) – even after financing fees.
The study also found out that ‘buy positions’ outnumbered ‘sell position’ by 2.47 basis points (0.0247 percentage points) per day (intraday) and by 6.10 basis points per day over a one-day holding period (measured against the next day’s return). The bid-offer spread for trading contracts for difference was an extra 3.46 basis points than when directly trading the underlying shares, the authors observed.
The report examined 270,584 trades spread over 71 exchange listed shares on the Australian exchange between Nov 2007 and Jun 2010. The Australian exchange nominates price makers to help boost liquidity to ASX-listed CFDs in periods where prices move away from the underlying share values. The paper admits that volume on the exchange is small compared to the wider market; the aggregate value of shares traded is almost 380 times greater than the value of ASX-listed CFDs over those shares. The number of deals traded on the Australian exchange is also a miniscule of the amounts traded in relation to its wider over-the-counter market rivals. CFD trade sizes average $21,734 versus $13,277 for conventional share dealing which is logical given that minimal execution fees and margins provide extra incentive to trade in larger size.
For the entire sample, the average CFDs trading volume is aggregately $7.8 million per day while trading on the underlying stocks is 382 times larger at almost $3 billion per day. Lee appears to conclude that traders who deal in CFDs traded on the Australian Securities Exchange don’t necessarily perform badly. ‘It’s a surprise finding that if you suspect retail traders using these ASX-listed CFDs are stupid, they’re not. Overall, they have slight trading ability on the day and the next day.’
There isn’t substantial research about private investors’ performance with derivatives trading although one European study by Bauer, Cosemans and Eichholtz noted that most investors lose money in options trading due to mainly poor timing and costs although the authors also suggest gambling and entertainment value as motivators.
The full text of the academic study can be found here [pdf format].
