| Investors turn to CFDs for gearing |
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| Irish investors are turning to Contracts for Difference (CFDs) in increasing numbers for leverage, writes Martin Cass, as these instruments offer investors the opportunity to get anywhere between 5 and 10 times gearing at very attractive funding rates. Another advantage of trading CFDs is that they allow the investor to go 'short' on stocks, as well as enabling them to do a ‘pairs trade'. |
The emergence of Contracts for Difference (CFDs) in recent years has opened up a new vista of opportunity for sophisticated individual investors - by offering flexibility and giving access to trading strategies previously only available to institutions and hedge funds.
A CFD is simply an agreement to exchange the difference in value of an underlying security (typically a share or an index) between the time that the ‘contract’ is opened and closed (i.e. it gives an investor exposure to the profit or loss resulting from changes in the price of a security without ever actually owning it).
Unlike other derivative instruments, prices are highly transparent and easy to calculate as they simply reflect those of the underlying market. Contracts are also open-ended in that they have no fixed expiry date. In addition, CFDs have the same dividend entitlements as the underlying security (in fact receiving credit on the ex-date, rather than having to wait for the payment date).
However, attractive though the above features are, they are very much secondary, as they do not offer any compelling advantages to the outright purchase of the underlying security. Without doubt the CFD feature that has attracted the most attention is leverage.
With CFDs, investors are generally required to put up between 10 per cent and 20 per cent of the principal amount at the outset (known as ‘margin’). They are, therefore, getting anywhere between 5 and 10 times gearing, and at very attractive funding rates (1 per cent or less above the benchmark cost of funds). As anyone who has invested in property over the last decade knows, gearing can enhance returns on capital significantly. However, with investors having exposure to the full outstanding value of the overall trade, the opposite of this is also true, in that gearing can lead to increased losses on positions that go the wrong way. It is for this reason that CFDs are only appropriate for wealthier, experienced investors.
Before discussing some trading strategies, it should be noted that CFDs are not a panacea by themselves. The starting point is, and always will be, a well-conceived and smart idea. CFDs simply facilitate the implementation of these ideas. Also, ongoing funding costs mean that CFDs are generally more suited to shorter-term trading ideas.
In order to demonstrate some further features of CFDs and highlight different trading strategies, I am going to look at a couple of examples of actual trades that we have implemented for clients in recent months.
With the use of gearing magnifying gains and losses, we are very selective in the choice of stocks that we are happy to trade using CFDs – the idea being to stick to stable, relatively low volatility stocks and use gearing to enhance modest (though more predictable) returns in the underlying share. One good example of this is Tesco - which has offered a number of trading opportunities through results that have consistently beaten expectations. The use of CFDs in this case also meant a UK stamp duty saving of 0.5 per cent (as clients never actually owned the shares) and mitigated currency risk (as the initial margin did not have to be converted to sterling, whereas a traditional purchase would have necessitated conversion of the full consideration at the outset).
Traditionally, when investors have a negative view on an asset, they have simply steered clear of it. However, CFDs allow investors to go ‘short’ – i.e. speculate that a stock or index will fall in value. This has opened up many trading opportunities of late. Earlier this year, our technical and fundamental analysis highlighted the potential for weakness in the retail sector and clients who took short positions in names such as Wal-Mart, Next and Boots have profited handsomely.
Tesco is one of the few exceptions to this general theme (and indeed the only stock in the sector which we would continue to have a positive opinion of). This diverging view can be backed by executing what is known as a ‘pairs trade’ – i.e. where you go ‘long’ (buy) one stock and short another. Generally this is done to reduce sector or market risk (a form of ‘hedging’), or, in the case above, to take a strong view on the relative outperformance of one company over another.
A good example of a recent successful pairs trade would be ‘Long Bank of Ireland, Short AIB’, which we came up with on the back of AIB’s dramatic outperformance in the earlier part of the year, which was further stretched by share buying associated with AIB’s entry into the EuroStoxx50 Index. History has shown that such ‘squeezes’ tend to evaporate post such events and this proved to be the case here.
These are just a few examples of trading strategies that can be implemented through the use of CFDs and they clearly demonstrate the flexibility now afforded to the private investor in either rising or falling markets. |
Martin Cass is a director in NCB Wealth Management.
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| Article appeared in the September 2005 issue.
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