Janine Starks deconstructs contracts for difference in simple terms; cautions would be investors to be careful.

Janine Starks deconstructs contracts for difference in simple terms; cautions would be investors to be careful.

By Janine Starks* (email)

A question from my mail bag:

Recently I received some information regarding dealing (trading) in Contracts for Difference (CFDs) and despite having read all the information I am still not much wiser about them.

Are you able to explain exactly what they are and how trading in CFDs differs from other types of trading. Would you recommend CFD trading? I look forward to your thoughts on this matter.

If you whittle it down to the core concept, there are a few rough parallels with a house purchase.  The analogy certainly helps to break down the jargon.

Most people take out a mortgage to buy a house. You put down a small amount of your own money e.g. 10%-20% buy the rest with someone else’s money (the bank).  If the house price goes up, you can sell and take all the gains. You don’t have to share your gains with the bank, even though you used their money. 

They only earn interest from you. If the price goes down, you can sell and will take all the loss (not the bank).  So you are risking all your deposit on the price movement of a much larger asset. Think about your deposit as an ‘investment’. 

Have a question for Janine? You can email her directly at starkadvice@gmail.com, subject line: Financial Agony Aunt.  Anonymity is guaranteed.

You put down $20,000 and buy a $200,000 house.  If prices rise 10%, the house is worth $220,000.  Your ‘investment’ has doubled in value from $20,000 to $40,000.  That’s a 100% gain from a 10% rise in the asset.  Borrowing magnifies all the effect of a small change in value (up or down).  Likewise a 10% decline wipes you out.  It’s the same with CFDs.

Take that basic concept and speed things up dramatically and add in a few gymnastic tricks.  Imagine you could buy or sell any house on any street in a matter of minutes and you could do it over and over multiple times a day, with mortgages being instantly approved.  The houses don’t really change hands, so you can buy a house that wasn’t for sale.

You also need to start using the right lingo. So, replace the word ‘mortgage’ with ‘leverage’ (it all just means borrowing) and replace the word ‘deposit’ with ‘margin’.  Next, stop saying you are buying a house – you are ‘long’ one house. Visualise a borrowing cost which is 2% over the short term cash rate.

Now for the gymnastics trick.  You can flip things around and sell a house you didn’t own, before you’d even bought it. That’s right, if you thought a house would fall in value, you could pretend to sell it and then buy it back once it had dropped (the jargon is ‘going short’).

In this case rising house prices would create losses. Even better, there is no borrowing cost and you will be paid a small amount of interest for shorting.  It’s quite handy that you don’t need to own the title of the house or get the front door keys. Because of this, the only money that needs to change hands is the difference in the value.  That’s why CFDs are called ‘Contracts for Difference’. 

No one ever parts with the cash for the cost of the house; they simply pay each other gains and losses.  You can take a punt on the price and take your profits or losses when you want. CFDs differ from normal investments or physical trading, because they don’t involve the exchange of the full value of the asset.

As you can imagine, it would be easy to lose sight of the real value of the assets you were trading.  Add in the speed and the gym tricks and the average person would find it very difficult to control their level of risk.  CFDs are only for the financially savvy and experienced.  You only play with ‘margin’ you can afford to fully lose.

To finish off the tale, you need to replace the ‘house’ with a more liquid financial asset.  You can use any financial asset – foreign exchange, shares, or commodities. 

You need to learn about stop-losses and be aware that the platform can demand more margin from you, or close out your trade if the losses get too big.  Potential traders should visit websites such as CMC Markets.  Take out the trial where you can trade with monopoly money, to get the feel of things.  It would pay to do this for many months, before putting up any of your own money.    

CFDs involve smaller deposits and higher borrowing than something like a house, so the risks are even more magnified.

The Australian financial regulator (ASIC) says on their website “Because of this borrowing, it's much riskier than a flutter on the horses or a night at the casino. Your losses are potentially unlimited and can far exceed the money you've wagered.”

They give some good tips on who CFDs might be suitable for.  Here’s what they have to say:

Experience: You've extensively day-traded shares, options, futures or other short-term derivatives, especially in volatile markets.

Knowledge: You know how CFDs work, and know the trading rules and trading platform backwards. You've read the product disclosure statement and discussed the risks with your financial adviser.

Risk control: You've got fail safe trading systems set up to stop unacceptable losses.

Financial capacity: You can afford any losses that your trading system cannot avoid.

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Janine Starks is Co-Managing Director of Liontamer Investments. Opinions in this column represent her personal views and are not made on behalf of Liontamer.  These opinions are general in nature and are not a recommendation, opinion or guidance to any individuals in relation to acquiring or disposing of a financial product.  Readers should not rely on these opinions and should always seek specific independent financial advice appropriate to their own individual circumstances.

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You forgot to mention the counterparty risk. CFDs are an OTC derivative product, so if the provider goes under (several small ones have in recent years), you're left holding worthless contracts. I don't understand the ASIC saying that an investor's "losses are potentially unlimited" - you can certainly lose more than your deposit on a contract, but if you buy a long contract for some shares, for example, then the most you can lose is the number of shares represented by the contract multiplied by the spot price. Potentially a large amount, but unlimited it certainly is not. (The underlying can't go below zero.) Writing calls, where you expose yourself to the losses as an underlying increases in value, can in theory have unlimited losses, but not so much for CFDs. [And there, folks, is my answer to the ASIC's statement - you can go short with CFDs, so if the underlying skyrockets, you're suddenly about as un-rich as Terry Serepisos....]

Can be useful for protecting the value of shares you already own when they are falling. If the company is large enough then a short will compensate you for the loss of the head shares. Shorting is often only available for large cap shares that are very liquid.

If you feel brave then short a greater number of shraes than you own..

I have used CFDs on shares that have a large dividend yield where the borrowing cost of the CFD long contract is lower than the dividend return. Especially good when you would like to buy the shares but are short of immediate capital.

Bernard I am surprised that you allow the plug for CMC Markets. My understanding is that during they last GFC that this company froze the accounts of investors.

I also understand that their trading margins and stops are quite unfavourable. My guess is they are more or less a ponzi scheme, where the profits come from new and naive investors.

It has not escaped my attention the increasing advertising from these sorts of companies, last desperate throw of the dice is the way I read it.

I am just surprised because it is this sort of leveraged behaviour that is part an parcel of the financial irresponsibility you advocate against.

We may not like CMC or one of their competition but this article shows up enough barbs to give an indication of the risks, Equally any forex broker is also profitting and even the banks that lend against shares. Shorting is a valid undertaking and only readily available for small risk takers using CFDs.

(From the left - to the right)......Mr. Scarfie  - "your understanding....of this matter" Can I ask just 'where on earth' you source these 'erroneous' facts from!? Firstly you compare CMC or CFDs to a 'failed Ponzi' scheme and then add an equally 'brash'  comment  - the subsequent 'freezing' of CMC client accounts throughout 'GFC'.

Erm.....ok? ;) 

I have held an account with CMC Markets for 5+ years now and completely understand the facet of highly geared leverage and 'Yes' - to some Mum and Dad investors -  using any form of derivative should be thoroughy investigated (risk strategies and professional advice sought) before use. Afterall any high risk trading on margin comes with consequences if not used correctly or with caution - but CFD providers (CMC primarily in NZ) I've had dealings with, did outline the 'fineprint' alongside providing workshops, 24hr freephone numbers and seminars to have assisted my understanding of these financial tools...... Albeit - CFDs provided me a natural hedge against adverse movements in the marketplace for my portfolio of NZ Shares (Telecom and FBU) throughout GFC and still do so now. 

Lets be honest here - CFDs are not for everyone and trading CFDs does carry an element of risk (especially in the wrong hands). Infact I've made and lost money trading CFDs but have learned from my mistakes (too large a position size, no stop losses etc..). And so now use CFDs with a personalised risk and trade strategy (you need to have a plan of attack with extreme market volatility). So now this now greatly diminshes my losses.

To use an analogy - You can't fly a Helicopter first time off - you need lessons and guidance - Likewise you cant step off the deep end to trade CFDs... Its takes time and due diligence to understand the intricaies of just how they work and  more importantly.... just how they can work for you! After all, CFDs are definitely not trades you can 'set and forget'! 

And although there have been some 'cowboys' in the industry, you surely cant tarbrush every provider with illicit accusatory lies? -  Or are you simply trying to provoke an irrational reponse 'interest' readers here....?

Ps - My CMC Markets account was never 'frozen' as you state.... ;) 

 

 

CFD's are only a part of their business and my comments are in regard to their television advertisement that are clearly targeted at the unsophisticated investor. To me promoting money trading in this way screams desperation, and lets face it money trading is not exactly an enterprise that is productive or beneficial. Yes hedging yourself against currency moves has a sound place in business, but it has become a retail scheme. So I stand by my comments of Ponzi scheme.

Now as to their trading platform, I do have knowledge of that and stand by me comments regarding that also. I am aware of far more reputable companies that conduct this sort of activity.

For me I am short the NZD, but not leveraged.

As to freezing accounts in 2008, I have not substantiated that.  But given that you elude to some sort of problem in your comment, perhaps you can enlighten us.