The strategy To work out whether CFDs are for me.

Sydney Morning Herald - 21st Jul 2010 - ANNETTE SAMPSON

The strategy To work out whether CFDs are for me.

What exactly is a CFD? They're formally known as Contracts For Difference. They are highly leveraged derivatives that allow investors to put down money to bet if the price of something (a stock exchange index, commodity, or currency, for example) will go up or down. If you get it right, the gains can be high with gearing levels of up to 95 per cent built into CFDs. But if you get it wrong, you can lose money fast and find yourself facing nasty margin calls. Think of it as margin lending on steroids, except that while you borrow to buy real shares or funds with margin lending, you don't actually own the underlying investment with a CFD.

Sounds risky. They certainly think so in the US, where CFDs are banned from being sold to retail investors. In contrast, they are heavily promoted to the retail market in Australia. The Australian Securities and Investments Commission has been looking at the CFD market here and concluded many retail investors are poorly informed of the risks. Consumer research found some investors were trading CFDs even though they were unlikely to be a suitable investment for them. It found about 15 per cent of CFD traders have between 50 per cent and 100 per cent of their investments in CFDs while others are trading CFDs within their self-managed super funds or using their retirement savings as trading capital. ASIC says these are cause for concern.

Are there other risks apart from the leverage? ASIC lists a whole raft of them in its report. Leverage is probably the biggest risk. ASIC uses an example of an investor who puts up $5000 to take out a $100,000 position. But a 10 per cent fall in the value of the underlying asset could result in them losing double their initial investment in just a couple of days.

In the worst-case scenario, investors with long positions (betting the price of the underlying asset will rise) could lose the full face value of the contract - or $100,000 in the above example. ASIC says short positions, where you are betting on a price fall, are even higher risk as the losses are potentially unlimited. CFD providers emphasise these risks can be reduced by the use of stop-loss orders (which you put in place to sell out at certain price levels to limit your losses) but while some providers offer guaranteed stop losses for an additional fee, many investors assume all stop losses are guaranteed - not so.

With CFDs sold "over the counter" or through a CFD provider, there is also a "counterparty risk" - the risk the provider may not fulfil its obligations. Other risks identified by ASIC include unanticipated or poorly managed margin calls, "price gapping" that can result from time delays between the placement and execution of orders, poor explanations of the key risks and operational features of CFDs in many disclosure documents and the risk that CFDs are likely to be an unsuitable investment for many retail investors.

ASIC found investors often don't receive sufficient information to make an informed decision about whether or not to buy CFDs and have difficulty understanding the information they do receive because of bias, poor presentation and subject complexity. Investors tend to rely on information provided by CFD issuers and ASIC says many retail investors seem overconfident about their ability to understand and trade them.

Is ASIC doing anything to better protect investors? It hasn't got the big stick out, though it is looking at ads, disclosure documents, seminars and other marketing material to ensure risks are better addressed. It is also working on enhanced disclosure standards for CFD issuers, a consumer guide to CFDs and guidelines for CFD issuers on handling client money. It will consider other regulatory actions if needed.