CFDs: Dangerous Liaisons

It's a bonanza! CFDs are the hottest new stockmarket product to hit the leverage business in a generation. More than 50,000 investors have already tried this latest advance on options and warrants: an estimated 5% of all ASX trades are now in CFDs and the turnover will grow even faster as sharemarket volatility is expected to increase in 2006.

Unless you've been locked in a woodshed you cannot have missed the saturation advertising from a string of new providers including Macquarie Bank, CMC, IG Markets and Man Financial. Earlier this year another new player, First Prudential Markets, became the newest player in the game.

There are many arguments put forward in favour of CFDs (Contracts for Difference): you can beat the market, you can be a one-person hedge fund, short-selling is much easier than ever, you can do some deft tax planning by arbitraging at year end '¦ But before you get carried away with the hype, consider this:

• Investments made over very short periods of time are pure gambling.
• Any attempt you make to soften a CFD gamble '” such as stop-loss trading '” is inordinately expensive.
• Without access to researchers and chartists who specialise in short-term trading, you are at a huge disadvantage.
• If the argument for leverage is to smooth out the ups and downs of investment, you could do that anyway by holding investments rather than trading. Longer-term investment patterns will smooth out returns, why risk losing huge sums of money to do so.
• The tax advantages are occasionally useful, but the tax office has not ruled comprehensively on this area yet so there is even more risk in this sector than you may realise.

UNLIKE the first wave of derivative products that came through the market two decades ago, CFDs are much easier to understand, much easier to use and you can buy them with a credit card. (Of course you should not dream of doing this '¦ but more on that later).

Eureka Report believes CFDs could be one of the biggest developments in the retail investment market in a generation. If that sound like an exaggeration it’s worth reporting that Britain's respected Financial Times newspaper has estimated that more than 25% of the daily turnover of the London Stock Exchange is now believed to be based on CFD-related trades.

In Australia the CFD business '” and a related product known as “spread betting” '” have captured the imagination of investors even though the tax aspect of these products remain unclear. CFDs do not attract capital gains tax; rather they are treated as a profit or loss against that affects your assessable income. Separately, the tax office is reviewing the tax status of spread betting; if a test case before the courts results in spread betting being declared gambling (And consequently tax free), this sector will flourish even further. (See panels below for an explanation of CFDs and spread betting)

As an active private investor, you may already attended one of dozens of seminars around Australia every week run by operations as diverse as IG markets or Macquarie Bank. But most investors have yet to fathom the scale of the CFD market.

WHAT ARE CFDs?
Contracts for Difference, or CFDs, are leveraged instruments; that is, they are securities that give you exposure to the peformance of the underlying share without owning it, allowing investors to bet on upward or downward movements. Your profit or loss won’t be a simple as the change in share price; you may also have to include variable costs relating to interest and fees.
Using an example offered by Macquarie Bank, you might buy a CFD for 10,000 shares in BHP Billiton at $13.06 on a “margin” of 5%; that is, you only pay 5% of their value. You hand over $6530, to have control of shares worth $130,600. That’s the leverage!
The second part of the deal is the time frame: when you sell your CFDs back to Macquarie. In the bank’s BHP Billiton example, you might have been lucky to pick up BHP dividends (although CFDs do not entitle you to franking credits). If, say, at the end of the contract the shares have reached $13.96, that means a rise of 90¢ a share, or $9000 for your 10,000 shares. Add dividends of $2400, then subtracting interest payable on the value of the entire parcel, of $1139, and fees of $540 and you “close out your position” with an overall profit of $9721.
Of course, had the share price dropped 90¢ the exercise would have cost you more than $1600:you’re your $6530 outlay, the $9000 drop, interest and fees. In essence you magnify your losses or gains through leveraging through CFDs: it means big wins or big losses. The essential point is that unless you have a stop-loss order, you could lost the equivalent of the entire shareholding, plus interest and fees.
In contrast to CFDs, trading in options limits your potential losses to the amount you are asked to pay in advance for the option. With options you basically pay a certain amount to take a bet. For example, you might pay $400 to get “leverage” similar to a few thousand dollars worth of stock; however, with options the most you will lose is the cost of the options, regardless of whether your shares drop 10% or fall though the floor.
On top of these elementary costs in CFDs, you must also deposit a minimum of $5000 in your CFD account to begin trading. Most CFD providers will offer a stop-loss service, which means your transaction cancels out at a certain level. Stop losses can prevent your account losing thousands of dollars. Of course, commission rates get much higher if you want to have a stop-loss service; if you are using a stop-loss service, it’s worth asking yourself why you are making the transaction in the first place. After all, leveraged trading is gambling by any other name. In general, the commissions charged by CFD providers is a percentage of the trades you make, the percentage dropping as the value of the trades rises, to about 0.08% for large trades.

WHAT IS SPREAD BETTING?
Spread betting is a spin on CFDs, except there is no leverage. Instead the broker acts as a bookie and nominates the price of, say, BHP Billiton at a future date. You take out a contract or bet against that price. Your profit or loss will depend on how far above or below the bookie's price BHP Billiton is when the contract closes. In the UK this activity is tax free. IG markets has put a test case before the courts to seek a ruling from the tax office on spread betting. The case is expected to be heard later this year.

ON MELBOURNE'S St Kilda Road, the head office of CFD provider IG Markets sits high overlooking Fawkner Park. Inside a busy trading room, professional traders sit hunched over multiple computer screens: They’re barking orders, answering requests, watching business television, and eating junk food at the same time. All in all it’s a typical trading desk, except this is not an equity dealing desk: this team only deals in CFDs.

In common with most CFD providers, the bulk of transactions relate to CFDs held over stocks in the ASX Top 300, but there is also turnover in stockmarket indices, foreign exchange, gold and other commodities. Turnover figures for the IG Markets desk '” or any of the several trading desks across Australia '” are not available because CFDs are “over the counter” securities based on the existing ASX turnover. In other words, CFD trading gets buried inside ASX turnover figures,

Matthew Wilson, the managing director of IG markets Australia, says the group has at least 10,000 private clients in Australia. He says CFDs are the perfect leveraged product for private investors because they are easy to understand and easy to use. “Unlike some other derivatives, you don’t have to do a course in How to Understand CFDs,” he says.

IG Markets is one of the biggest names in the CFD market; the other leading players include Mann Financial, CMC, and Macquarie Bank. Outside of those leading brand names, there is the newly established First Prudential Markets, while a number of companies, such as Sonray Capital, act as backroom providers for “white label” operations for other companies who then put their own brands on the CFD products.

At IG Markets, the head of sales, David Skilton, recently arrived in Australia from the British market where CFDs are easily the most popular leveraged products. (The UK market charges stamp duty on shares but not on CFDs, so CFDs are exceptionally popular.)

Skilton says CFDs are fast becoming the leverage product of choice for private investors. He estimates that about 5% of ASX turnover is now CFDs '” with about 100,000 trades a day on the market, that means about 5000 of those are in CFDs. Interestingly, Skilton says IG Markets seminars attract all age groups and sales meetings show that half the investors in these products are female.

Both Wilson and Skilton agree that private investors should think carefully about the risks inherent in dealing in CFDs. However, the advertising material put before private investors, in common with all CFD marketing material, concentrates heavily on the usual seductive promises of dealing successfully “at the click of a button” and “working with friendly and professional staff”. Most CFD providers also claim they credit-check customers, but in effect with 85% of trades online, the companies depend on what customers tell them in online checklists. Several CFD providers, notably CMC Markets, which claims to be the biggest operator (although no one was available for interview) offer credit card trading '” in effect offering credit on top of credit.

IN ALICE SPRINGS, Gerard Daffy is a bookmaker with Centrebet, one of the biggest betting agencies in the country. He’s not a stockmarket expert, being much more interested in horses. But after having the rudiments of CFD trading and spread betting explained, he “calls” the situation with typical clarity.

“It seems to me many people would have a better chance of winning on the horses,” he says. “I think an average punter could get a much better idea of the form in a horse race than the big complications of the stockmarket.”

Daffy has a point: over the tiny timeframes of CFDs '” typically less than a fortnight '” most of the trading activity can only be classified as gambling.

During the recent interim reporting season, many companies reported relatively predictable results; for example, BHP Billiton reported very strong profits on the back of the commodities boom; Telstra reported poor figures as it grapples with a new era in communications technology and evolving policy in Canberra.

But that does not mean the shares of either BHP Billiton or Telstra behaved predictably. It’s been widely reported that many CFD traders '” professional stockbrokers and a legion of private investors alike '” lost money because they “bet long” that BHP Billiton would power ahead after a strong results; rather, its shares traded in a relatively flat pattern after the results as investors took profits. On the other hand, investors who “bet short” on Telstra were disappointed the stock did not fall through the floor after its poor result. (Betting long assumes you can make money from prices rising, betting shot assumes you can make money from prices falling. Short-selling, or “shorting”, is particularly popular among CFD holders.)

What’s more, many of those professional traders wrong-footed by the ASX trading activity were working with the best investment advice, the best research, and they had chartists offering them sophisticated graphs. But for all that, none of them could see the future and many lost money. In the CFD, market those losses were magnified.

One of the standing refrains from the CFD brigade is that nobody knows the future anyway, and all investments are at attempt to purchase future value. It’s an argument elegantly phrased by Dan Semler, an associate director of Macquarie Bank and one of the most influential executives in the CFD market. But there are two flaws to this argument: buying “long” does not involve leverage so any loss you incur is straightforward, is largely predictable and you invariably have franking credits to compensate.

Second, it is true that any kind if investment means “buying the future”, but there is compelling evidence over almost every stretch of history (with some exceptions) that shares are the best investment class over the long term. In a steady, stable, predictable, relatively well-managed market like Australia, the risk in shares is minimised '” not maximised as it is in CFD trading.

You can't beat the market, you can't tell the future. Yes, CFDs are easier to use than options and warrants '” if your bet goes the right way they can be cheaper. But unless you are a trading genius, don't gamble with your money: invest it “long” instead. Nobody has ever put it better than Jack Bogle, the founder of Vanguard Investments: Buy right and hold tight! Don't cloud your returns with CFD gambling.