Gearing challenge

CFD trading is not for everyone and success requires application

STORY SUSAN HELY

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IF YOU HAVE A STRONG VIEW on where your investment is heading – either up or down – contracts for difference (CFDs) could be for you. CFDs are derivatives that allow buyers to bet on the rises and falls in Australian and overseas shares, ETFs, currencies, commodities, indices and other assets while only putting up a small amount of money. If you get the direction right, you can make money in a short time.

One of the best features of CFDs is that you don’t have to put up the full amount of money that you would for shares or exchange traded funds. You only need a fraction of the investment, enabling you to gain greater exposure by borrowing or leveraging the rest.

CFD traders often start out trading Australian shares before progressing to overseas assets or commodities, says Investment Trends senior analyst Pawel Rokicki.

The number of investors trading CFDs continues to hold up well despite a turbulent market, with 53,000 Australians trading at least once in the 12 months to December 2012, according to a survey of more than 13,000 traders by research group Investment Trends.

“Against a backdrop of challenging economic conditions, the market has shown considerable resilience,” says Rokicki. “Traders are adapting to the lacklustre performance of the local sharemarket.”

Recently CFD investors have been buying bank CFDs – particularly Commonwealth Bank and National Australia Bank – as well as defensive shares such as Woolworths and Telstra and pharmaceuticals such as CSL. As well there are indices such as the S&P/ASX 200, the ASX SPI 200 and the Dow Jones, plus commodities, such as wheat, barley and sugar. But more and more investors are trading currency CFDs such as the $A against the greenback or the euro.

“A lot of our clients like to trade the news, particularly if it’s hot,” says Chris Weston, chief market strategist at Australia’s biggest CFD and forex provider, IG. “If gold is on the front page, then it is being traded.”

What is surprising is that CFD trading has continued despite a 26% drop in market volatility as measured by the average value of the S&P/ASX 200 VIX index, says Rokicki.

CFD investors are typically attracted to volatility because wild market swings present opportunities to hedge against it.

Rokicki says foreign exchange or currency CFDs are on the rise while there is less trading in share CFDs.

But with a 20% rise in the Australian sharemarket over 2012, there is a renewed interest in trading in particular shares – particularly the high-dividend companies such as Telstra and the banks. The resource giants BHP Billiton and Rio have not been popular.

“Investors who don’t know which stocks to buy like the indices because they give you an overview,” says Stephen Luu, head of sales at Saxo Capital Markets. “Investors like the Dow Jones, the Nikkei and the Hang Seng.” Saxo, a Danish private bank, opened offices in Australia more than a year ago.

How do you start trading?

CFDs are not for everyone. Investors need to be comfortable with a high level of risk. CFDs allow you to go “long” if you believe the underlying asset will go up or “short” if you think it will go down. While this may sound straightforward, CFDs are complex.

What is unique to a CFD is that you buy a contract between yourself (the buyer) and the CFD provider (the seller). (Every CFD provider has its own terms and conditions.) The seller agrees to pay the buyer the difference between the current value of an asset and its value at contract time. CFDs differ from shares where you buy a unit in an underlying asset.

Learning how CFDs work – plus the risks – is key before you start. There are few independent places to go to learn about CFDs – most education is available from providers. Most of these offer a demonstration that allows you to trade a virtual account on the trading platform with play money. You can access some research and data.

How CFDs work

If, for example, you put up $5000 for a $100,000 contract, you are effectively borrowing the other 95%. This means that a 1% change in the share price can turn into a $1000 profit if the share price rises but a $1000 loss if it falls, (which is 20% of your investment).

The regulator, the Australian Securities and Investments Commission, stresses that CFDs are generally highly geared products. “This means the money you invest will generally only be a fraction of the market value of the shares (or other market asset) you’re ‘contracting’ for,” says ASIC.

“The leverage is a double-edged sword,” says Luu. “If you get it right you can do very well, but if you get it wrong you have to accept the downside risk.”

CFDs need to be managed constantly and trading can be time-consuming. They don’t suit set-and-forget investors who don’t know much about investing. You must develop a trading plan and be disciplined so that you stick to it. “We reject a number of clients on a daily basis because they don’t match the suitability criteria,” says Weston.

ASIC explains that the contract is a legally binding agreement, no matter what the market value of the asset. If the market turns against you, the issuer of the contract will require you to pay extra money and may close out your contract, for whatever it’s worth at the time, to recover some money.

If there’s not enough money in your account, you will be legally obliged to make up the difference. If the market value of your trade is negative, your CFD provider may demand that you put in more money in at short notice in what is known as a “margin call”.

ASIC recommends trading CFDs only if you have extensive trading experience and are used to volatile market conditions. Most importantly, investors need to be able to afford to lose all of – even more than – the money they put in.

When you want to do real trading, start small and build your experience. Avoid impulse trading and have a firm idea where you want to enter and exit a trade. Even the most experienced traders use tools to limit their losses – it is a good idea to use them when starting out.

The three main protection tools – for which fees are charged – are guaranteed stops (where you specify the price for closing out the CFD as a buffer against market moves), trailing stops and non-guaranteed stops and limits. You need to monitor your position. If it is going in the wrong direction, close it out. Ensure you have a sufficient margin in your account.

Rokicki says the CFD market is highly competitive. Consumers are the winners from falling fees, slick trading features, expanded research and innovative services. There is a broader suite of products to trade.

IG has recently launched new forex products: the $US to the Brazilian real, the Swiss franc to the Hungarian forint and the $US to the Taiwan new dollar.

Investors can stay abreast of the daily moves of their CFDs with smartphones and tablets. “We recognise that our consumers are going mobile and easy access to take advantage of market opportunities at all times is paramount,” says Tamas Szabo, IG’s head of Asia Pacific.

IG has launched Chrome Extension, which identifies and lists all available markets on any website. Users can click on the market and open a deal ticket instantly.

Which CFD provider?

There is much more to a CFD provider than the fees, commissions and spreads it charges. Rokicki says the quality of the platform offered by providers is the most attractive feature for investors.

A CFD trading platform must be fast and reliable so that you don’t miss a trade. You don’t want a trading platform that crashes. Tools such as charts and other technical indicators help you analyse and take a position on the world’s financial markets.

The provider’s education about CFDs in the form of online seminars is crucial for newcomers to CFDs. Most importantly, you must know as much as possible about the CFD provider. ASIC stresses investors should make sure the CFD provider is in a sound financial position and will be able to meet their obligations to you.

Counter-party risk came to light with the collapse of provider MF Global. CFDs are not permitted in the US, due to restrictions by the US Securities and Exchange Commission on over-the-counter financial instruments.

While some CFD providers are listed companies with public details of their financials, there are CFD providers that claim to have segregated accounts that can be tricky to confirm.

To check on the strength and security of the CFD provider, ask these questions:

• Is the CFD provider a listed company?

• What is the financial backing?

• Are the financials of the company out there for everyone to see?

• What is the provider’s level of debt?

• What is the cash on the balance sheet?

• Where does the provider hold your money?

This special report was sponsored by IG but has been independently researched and written.

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