Risks of Trading CFDs

The Risks of Day Trading CFDs

In this section we will look at the operation and risks of trading contracts for difference (CFDs). In the equity market the instrument that has had the greatest impact over the last six years is the Contacts For Difference: the CFDs. Investors are less satisfied with building up portfolios over the long term, taking the ups and downs as they come. They are looking for instant gratification.

». One of the more common species of this new mammal is better known as the ‘day trader’. »

One of the more common species of this new mammal is better known as the ‘day trader’. The day trader seeks to make returns from short-term movements in equities and will often trade relatively large sizes for only a few pence worth of profit. The most prolific day trader I know trades some 250 times a day which translates to one trade every two minutes. When one considers that there is relatively little activity in the first hour of the open market and over lunch, that’s someone who is trading almost constantly. He achieved this by concentrating on less than half-a-dozen stocks — the most popular of which was Lloyds TSB. He was only able to achieve this through the use of CFDs; low commission charges, no stamp duty, and gearing on his funds. This combination gave him the return on his capital that justified his efforts.

The changing attitude towards better returns in shorter time was significantly fuelled by the greed of the dotcom boom. This provided the perfect fertiliser for the emergence of Contracts For Difference (CFDs). Not content with above average returns from TMT stocks, speculators geared up for maximum exposure. Then the markets began to fall from the beginning of 2000 and fund managers were exposed for the sheep they mainly are and investors suffered ‘asset erosion’. Finally another key feature of the contracts for difference kicked in: the ability to go short.

». So given the bearish characteristics of the equity markets at the moment, the Contracts for Difference is a particularly powerful tool. »

Indeed the CFD is at its most efficient when employing the short play. While on the long side the CFD holder is obliged to pay financing on the notional capital employed, on the short trade the CFD holder earns interest. Of course, in these times of low interest rates, it is a modest sum. The level of interest paid is the net of the interest earned on money received from the market for the delivery of the stock plus the cost of borrowing that stock to deliver in the market. So given the bearish characteristics of the equity markets at the moment, the CFD is a particularly powerful tool. The fact remains, however, that most people still have a natural aversion to going short, or ‘selling things you don’t own’ as a client once said to me.

Considering the spectacular collapse of Lehman Brothers (above) and Bear Stearns — which — traders should be aware of the counterparty risks involved. Moreover trading data like daily CFD turnover is not disclosed publicly.

Hedge funds don’t have that aversion so it’s no surprise that they are at the cutting edge of fund management now — and probably for a long time to come. But that’s another story.

». CFDs can now give you that roller coaster ride that you’ve always dreamed of. »

Forex trading has much more cache, greater volatility, and the ability to lose huge amounts of money. You can almost see the advert: See your friends gasp with awe and marvel at the size of your cojones when you tell them about your trading loss on dollar/euro. Well the good news is that CFDs can now give you that rollercoaster ride that you’ve always dreamed of in equities.

CFDs are designed to give you the same economic value as holding or being short of an equity position. CFD houses now offer gearing of ten times on the constituents of the main equity indices. On the buy side, because it’s a derivative, you don’t pay stamp duty. So what you end up with is a geared long/short equity derivative that is ideal for speculative trading in equities. As is the case with most financial instruments, the choice for the investor/ hedger/ speculator/ gambler is ‘What return do I want over what time period?’ If the answer is ‘reasonably high over no more than a few months’ then CFDs will suit you well. Of course one is taking a higher risk profile than one’s stockbroker is likely to suggest, but we knew that didn’t we?

There are clearly many other benefits of CFDs: short-term hedging of portfolios, for instance. But it’s no coincidence that CFDs are the preferred day trader’s tool. Their proliferation is such that statistics suggest around 30% of trading on the LSE is derived from the broker firms offsetting their CFD driven business.

Like all derivatives, CFDs can be employed recklessly or sensibly. But CFDs are first and foremost an incredibly powerful tool, once the domain of institutions only, now available to the retail market. Fort hose people who have never used them before the advice is to starts lowly and in relatively small size. Judicious use of ‘stops’ (from all good brokers near you) will also help to mitigate the potential sting in the tail of any position. The speculator’s foot is on the accelerator, happy journey or speeding fine: that’s entirely up to you. There are also particular risks involved in trading CFDs, including counterparty, investment and liquidity risks. Whatever you do make sure you understand the risks before making a decision about trading CFDs.

A graduate of City University and holder of an MBA from Cranfield University, Patrick leads a large team of traders in both CFDs and spread bets (under the Finspreads brand) in IFX’s America Square offices.

His career began at Tullett & Tokyo and, before joining IFX, he was at GNI for fiven years, both as Head of CFD Trading building a large institution CFD operation as well as Head of European Sales.