Last Updated Mar 29, 2009 7:35 PM EDT

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(16min 40) CFDs (Contracts for Difference) are a way to trade in global commodities, including shares, in a highly geared way. If you’re used to trading in shares this could be a useful next step so long as you’re aware of the risks.

On today’s BTalk Australia Phil Dobbie talks to Tamas Szabo, the Australian CEO of IG Markets. one of Australia’s fastest growing CFD providers.

Do you trade? Add your views on the pros and cons of CFDs in the Talkback section at the end of this post .

View all BTalk Australia podcasts here.

• Today’s Transcript

Phil Dobbie: Hello I’m Phil Dobbie and welcome to BTalk Australia. Today, we look at trading with CFDs, the beginners guide.

CFD is an acronym for Contracts for Difference. It’s a way of speculating on movements on share prices without actually holding the shares yourself. It’s a way of trading that could potentially make you very rich or very poor, if you’re not very good at it I guess. And one of Australia’s fastest growing CFD providers is IG Markets and their Australia CEO is Tamas Szabo. He’s on the phone. First of all Tamas what can you trade on? It’s not just shares, is it? You can apply CFDs to a wide range of commodities can’t you?

Tamas Szabo: That’s right, we originally offered predominately CFDs on shares and it was by far our most popular product but over the past year we’ve seen clients diversify into a full product range and one of the most popular products that we now see business on is actually index trading, foreign exchange trading and trading on commodities so shares are no longer the gleaming light of our offering. It’s very much moved into other fields.

Dobbie: But if you are trading in shares you can trade in foreign shares as well as those on the ISX?

Szabo: That’s right. With an account with IG for example, from the one account you can trade global indices, you can trade any liquid stock that’s available, is generally available, in our platform. So you’re right you can trade stock indices around the world and also individual quantities in different products available.

Dobbie: Now there’s a lot of risk there, particularly when you start venturing overseas because you’re almost doubling your risk. You’ve got the price of the commodity and you’ve also got the exchange rate which in today’s market couldn’t be going anywhere.

Szabo: That’s right, CFDs themselves are trading on margins so you put up a percentage of the full value of the investment that you are interested in and by the nature it’s a geared investment so one of the potential pitfalls is the gearing. You can, if you’re on the wrong side of a position you can lose more than you put up on the account and as you say there is a potential currency risk there as well. But I think that’s an interesting point because the nature of CFDs allow us to get around some of these risks that we just talked about. For example IG Markets offers trading on foreign indices in Australian dollar denominations so you can basically trade the Dow, the DEX in Australian dollars to remove the currency risk. And that’s again absolutely unique to CFDs, something that the versatility of the product allows us to do.

Dobbie: So in other words you’re really looking at the percentage variation ignoring the variation with the foreign currency.

Szabo: That’s right, that’s correct. When you talk about the risk of the product in terms of the leverage, again a feature unique to CFDs, is a guaranteed stop loss which most CFD traders know all about but it basically allows you to place a stop loss on a trade. Incidentally about 75 to 80 percent of all oppositions that clients have with us have a stop loss on them. So, for example, if you have a trade on a particular product it starts to move against you, you don’t want to have the full open-ended risk that’s presented to you when you trade. You want to be in a situation to liquidate your position or close the position out when you’ve lost an amount of money that you’re comfortable with. And that’s where in our stop loss it automatically initiates a trade for you and close position out before it’s gotten any worse than you expect. And the problem with traditional stop losses is the gap risk. For example, if you have a hold position on BHP for the sake of argument and the Dow Jones falls 5 percent overnight, you’re expecting BHP to open considerably low the following day and you’ll only be able to get out of the position at the best available price on the open which is going to be a lot lower than where you wanted to get out, for the sake of argument. So a guarantee stop loss will actually cut you out at the price you wanted to irrespective of what the other line market is doing. But that’s a unique feature again that gives CFDs some sort of element of risk protection and sort of counterbalances the leverage available.

Dobbie: So does that apply as well if you’ve got, for example, a company goes into a trading halt and then comes off the trading halt considerably lower than it went in?

Szabo: Exactly, that’s a very good example. A guaranteed stop loss will allow you to underwrite in effect a position. There’s a small premium charged on a guaranteed stop loss and that gives you the protection of not having to sort of suffer the full loss if a company goes into liquidation for example.

Dobbie: So what’s the difference between using CFDs as margins and what you traditionally term margin trading?

Szabo: Yeah margin trading, you still own the underlying stock. You still receive share certificates. All the admin and paperwork that’s required with holding shares, you hold or you are subject to with that margin of trading. But when it comes to CFDs you don’t actually own the stock. The stock is hedged out by companies like ourselves through our brokers through equity swaps so it does go into line-to-line market but it’s not the end client that owns the position. And the reason we do that is really to allow ourselves to take advantage of economies of scale when we have tens of thousands of clients trading we’re basically getting wholesale rates from the brokers. We can then pass on those rates to our clients. So if you look at the rates available in CFD trading Australia it’s significantly lower than if you traded physical stock with brokers. There’s an $8 minimum commission on shares and generally 0.1 percent is the outgoing rate for CFDs which is extremely competitive when compared to physical stock trading.

Dobbie: Right but you are paying. Even though you’re not holding the shares there’s still a financing charge on those CFDs which I would presume adds up daily. So is it really suited to short-term rather than long-term investments?

Szabo: Yeah it’s predominately short term. I’d say that the average hold period in Australia on Australian shares, it’s not so much our main product but we did the analysis on this a number of months ago and it’s approximately three days. If you compare that to the average hold period in Singapore, for example on CFDs, it’s more like 25 days. So different countries have different characteristics but in general it’s a short-term trading strategy. It’s not sort of let’s buy some CFDs, tuck them under the mattress and forget about them. That’s absolutely not what it’s about. It’s generally seen as either a complement to a physical stock holding to basically get some more leverage, more power out of it. So some people may want to allocate some money on the side to trade CFDs that they’re actually willing to take a risk on. The other amounts of money they can place a physical stop which again isn’t that risky but it’s not as risky as trading CFDs.

Dobbie: Now there’s still a ban on short selling which must be impacting your business a little bit because presumably you can use CFDs. You can speculate down as well as up, can’t you?

Szabo: Yeah that’s one of the main benefits of CFDs is the ability to take advantage of the stock market movements either up or down. For example on the FX index we see a balance short and long book generally but when it comes to individual stocks we predominately see people going long. We don’t see an awful lot of shorting. And as the stocks product has become less attractive in general because I think people are looking more about the macro picture, the economy, they don’t want to get into the fundamental individual companies because a big move on the Dow could wipe out a week’s worth of research out the window when the Dow falls 200 points. So people are more about concentrating on the index. The short selling rule that came into place a number of months ago now, I have to say hasn’t had a huge impact on our business because people are generally using other products to short. For example you can short the index, you can short commodities, you can short these other products which still gives you the same benefit from when the market falls.

Dobbie: Right so because I think it used to be like racehorses, well there’s a lot of analogies with the racing industry isn’t there really? But if you really looked and studied a horse and you really knew your stuff you could make money. And I think that used to be the same with share trading but do I pick up that what you’re saying is less easy to tell that these days because you really don’t know which way companies are going to turn.

Szabo: Yeah you could have a very sophisticated piece of analysis on an individual company. At the end of the day what causes the company to fall is not your analysis, which you got correct. It’s the overall market falling. So that kind of thing why we’re seeing people tend to move away from stocks at the moment to try to trade indices and currencies which influence by overall economies rather than individual reports by companies. People look at the sort of sectors and the bigger picture type things is what we’re seeing at the moment.

Dobbie: So about being smarter, I was using CFDs six months ago and I’d put my money into gold I’d be looking pretty right by now.

Szabo: Absolutely and again you’d basically been exposed either in US dollars or Aussie dollars so again there’s no currency risk to take into account. But you’re right, really our less popular product is generally what’s in the news, what’s moving and what’s sort of the in thing. Gold is talked about a lot at the moment. It’s just tipped at $1,000 so we’ve seen quite an interest in gold. In the past few months they’ve been really quite attractive against currency so it’s whatever happens to be the fashion is what’s driving the clients.

Dobbie: Right, so how popular is CFD trading in Australia?

Szabo: There are approximately I think the last numbers that we saw there are approximately 30,000 clients in Australia actually trading CFDs and a further 30,000 people considering to trade CFDs. So there’s always as many people wanting to trade them as there are trading them but I think people are being held back slightly by what we’re seeing in the current financial market. The turmoil people feel that they want to wait until there’s been more thirst in the market. My argument is that the current market is ideal for trading CFDs because it’s about making short-term gains which the current market is very well suited to. Globally we’ve got offices all over the world and the overall market is huge and growing very rapidly. We reported a 47 percent jump in revenue to November last year which is pretty much the middle of the credit crisis. Admittedly it’s actually probably getting a bit worse at the moment but it’s become extremely popular product. I think the reason for that is that it all sort of gets away from our perspective but we think it’s because people are becoming less happy with what their fund managers are doing for them, less happy with funds and they feel they can take better control of their own investments and have a go at it themselves.

Dobbie: Well there might be a few more people at home who’ve got the time to do it. As well might be another aspect of it.

Szabo: Well absolutely, if you look at the finance sector in the UK it’s been decimated in terms of job losses and I think a lot of those people are very skilled to be trading the markets themselves so I think those people are losing their jobs, not the best thing for them but they see trading CFDs as not a leisure activity but actually a money making exercise. So they’re going to be sitting in front of their screens during the day seeing if they can make some money out of the stock market in the short term with the extra time they have on their hands.

Dobbie: Now do you think there’s also a lot of people who are scared off by the fact that they’re looking at how people have come unstuck by leveraging themselves too far and thinking gee this looks like a risky strategy to me?

Szabo: Yeah there’s no doubt it’s a risky product if it’s not understood and used correctly. And I think that is one of the main hurdles that is holding people back from trading the product. As I said earlier, approximately 75 to 80 percent of our clients have stop losses on their positions and I think if you went into this blindly and leveraged yourself too far you may well come unstuck. So it’s important that people understand the risks involved and that’s one thing that almost every CFD provide in Australia. in fact. in most countries a new account comes with quite a hefty education process as well. We offer a number of online seminars for people. We offer education pack when they come onboard and we start them off slowly. We have a very good trade sense program where we start people off with very small trade sizes and sort of move them up when they get a better understanding so that’s something that we very much recognise as a hurdle and we want our clients to get it for the long term so we want to give them all the tools that they can possibly have and then try and educate them through the process.

Dobbie: And the obvious question is how far can you leverage and does it vary depending on the commodity?

Szabo: It does. Shares, for example, you’re going to get probably 10 to 20 times leverage, it depends what share you’re looking at, when you’re looking at foreign exchange currencies you can get much higher levels of gearing because simply a stock can fold by 50 percent relatively easily depending on where you are in the index. Whereas currency moving high in value is relatively unlikely although it has happened recently with a number of currency so it’s very much determined on the product that you’re trading and even the bigger type products on the index I can’t see that much higher leverage than say a stock but that simply reflects the likelihood of it moving that far. So in real terms, in terms of risk reward, it’s not actually that much different for different types of products.

Dobbie: Now CFDs are traded all over the world but interestingly not in the US as yet. What’s different over there? They’ve managed to leverage themselves successfully over there without it so maybe they don’t need it.

Szabo: Yeah in the states it’s a very different regulatory regime. In the states you have the exchanges that are protected by the government. They have a very strong lobby there as well. So a retail client has to trade a product listed on an exchange. The only exception to this rule is the foreign exchange market in the US which there is no regulated list of exchange for foreign exchange. So if you look at what you can do in America you can actually trade currencies in exactly the same way that you can trade them here in terms of the CFD full risk that’s involved in the product. But if you wanted to trade gold, oil or shares you have to trade them on an exchange. And the argument that we’ve got and probably one of the reasons why our product has become so popular is because being able to trade them off exchange gives you the versatility and the basic cost saving that is really driving people to the off exchange products.

Dobbie: Now people are using CFDs. They could be leveraging money which they’ve already leveraged, couldn’t they? They may have equity in their home which they’ve borrowed against to undertake CFD trading. They would really be laying themselves open to huge risk, wouldn’t they?

Szabo: Absolutely. If someone is leveraging a house on a CFD we would highly advise someone not to do that that would be the wrong thing to do. CFDs should be looked upon as money that you’re willing to sort of have a go with in effect. You don’t want to be in a situation where you lose that money. What we do when we accept new clients here at IG is we actually make sure that they have the correct amount of understanding of the product before they come on board, they have to have some training experience with shares. We have a minimum level of earnings and savings before we let someone come on board. So we do our duty to our clients to make sure we’re not getting someone who doesn’t understand what they’re doing and very little money. They have to be reasonably sophisticated investor and that’s very much a target, someone who is relatively in tune with what affects the financial markets in effect rather than someone who’s, well I’m going to have a go at trading some gold, I’ve never traded before in my life, I don’t know how it works. We can’t educate those types of people but again they have to have some understanding of what they’re doing.

Dobbie: Absolutely and enough time on their hands obviously to pay attention to it.

Szabo: Absolutely.

Dobbie: Tamas thanks so much for your time today.

Szabo: You’re very welcome.

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