Contracts for Difference (CFDs) and financial spread betting have continued to experience strong growth, despite the recent down turn in the UK stock market, as both active traders and experienced investors have turned to alternative financial instruments. Institutions and hedge funds have utilised CFDs for more than ten years in the UK stock market as an alternative means of investment to traditional stocks and shares. With the introduction of the electronic order book in October 1997, stock lending and borrowing facilities were extended from marketmakers to other members, allowing the individual investor access to CFDs. As more people seek to take control of their own financial destiny, alternative means of investment continue to be embraced. Although still some way behind the mature US market, there has been a growing realisation that going 'short' as well as long are essentially two sides of the same coin, and short-selling is a legitimate and essential means of trading, in a market becoming increasingly difficult to profit from in the traditional sense. Stamp Duty of 0.5% on all UK share purchases has prevented 'day-trading' traditional stocks and shares from being cost effective; but both CFDs and spread-betting are currently exempt from Stamp Duty.
A CFD is an Over-the-Counter agreement between two parties to exchange, at the close of the contract, the difference between the opening price and the closing price of the contract, with reference to the underlying share, multiplied by the number of shares specified within the contract. CFDs are now the preferred means of investment by hedge funds in the UK over traditional dealing because of their low cost of dealing.
These are now the preferred vehicles for active traders, although they have somewhat different characteristics. Both products allow the user to go short and also, being margined products, the user can gear themselves up, in other words, take an underlying position that is a multiple of his funds. For example, if the margin rate for Barclays were 10%, establishing a £100,000 position would only require a deposit of £10,000. Any running profits can be used as margin to establish new positions, however running losses must be made good by either reducing the position or providing additional funds. This gearing effect clearly demonstrates the importance of trading discipline and capital preservation. Too many times traders find themselves in a corner by over committing themselves too early and missing out on other opportunities that they would otherwise have been able to take advantage of.
CFDs do not have an expiry date and being a margined product, a daily funding charge will be applied to the account for long positions held overnight. Short positions attract an interest rebate. No funding charge is applied for positions opened and closed in the same day. Spread-bets on the other hand have a premium already built into the price and will generally trade above the underlying share price, somewhat similar to a futures contract, which has an associated 'fair' value based on funding charge until expiry and any dividends payable. Corporate actions are generally applicable to both with the exception of dividends. With spread-bets, the anticipated dividend, if any, is built into the initial price, whereas with the CFD, the holder will receive a credit of the net dividend, or pay away the gross dividend if short over the ex-dividend date.
CFDs are liable to capital gains tax at the investor's marginal tax rate after the annual allowance has been surpassed, while gains from spread bets are tax-free. This can cut both ways however, as although no one ever places a trade intending to make a loss, losses at some point are an inevitability. Losses incurred through spread-bets are gone for good, while CFD losses can be offset against future profits for tax purposes.
The most important factor of all is the bid-offer spread. A spread-betting firm posts its own two-way price like a bookmaker, a take it or leave it price. Most CFD providers however, allow you to post orders within the bid-offer spread enabling the individual to become a price maker rather than a price taker. The bid-offer spread is the most significant cost of trading and is the main reason why hedge funds use CFDs and not spread- bets. Access to the main market also means access to real prices and the pool of deepest liquidity. At some point the trader will need to exit the trade and may find himself disadvantaged by dealing with a counterparty that not only knows his position but can quote a price that may more suit the provider than the individual.
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Despite the debate, there is probably no right or wrong instrument to use; both CFDs and spread bets have particular features, which will appeal to individual trading styles. Choice will be determined more by trading strategy, the time the trade is held and the liquidity of the instrument. Some traders will trade a small universe of more volatile stocks, while others like to keep their options open and go to where the action is, trading both SETs and SEAQ stocks in an opportunistic manner. Whatever the instrument, the trader will encounter at least one of the following costs:
Probably the most important, although the least tangible as it doesn't appear directly on a contract note. Hedge funds however are acutely aware of its importance and consider it the most important execution cost. As an example, it is interesting to consider a contrary strategy. If a trader wanted to lose as much as possible as quickly as possible, he would continually hit the bid and lift the offer of the most illiquid instrument he could find.
It is important to quantify what you are getting for your money when you pay a commission. On-line execution-only dealing services that 'slash' rates from £10.00 to £7.50 are somewhat missing the point. It is possible to trade for free, but that comes with incurring a different cost.
Stamp Duty prevents short-term active trading from being cost-effective. However, some have recently compared it to inheritance tax - somewhat voluntary. Prudent financial planning allows for structured avoidance tactics.
Trading on margin brings its own risks and demands additional discipline. However it also allows greater financial flexibility and freedom. Maintaining liquidity should also be a priority so that should a trading opportunity arise, the trader does not find himself 'out of the market', being over committed elsewhere.
All positions have to be funded whether traditional shares or CFDs. However the additional funding costs associated with CFDs are often over-stated. Assuming a margin rate of 10% and a funding rate of 3% over base rates the additional cost of maintaining the CFD is the extra 3% on 90% of the consideration. It can quickly be calculated that this additional cost reaches 0.5% of the consideration after about 77 days or 11 weeks. At that point, the additional financing cost of the CFD has overtaken the Stamp Duty saving, reinforcing the perception that CFDs re ideal for short-term strategies.
Often ignored (sometimes deliberately) is the cost of sitting in front of a screen. Unless fortunate enough to be financially secure, or to be able to pursue trading as a hobby, the full-time CFD trader ought to have some annual target in terms of return on capital. Spread betting is an excellent entry-level product where a stake can be anything from 1p a point upwards. However at some point a greater commitment may be sought. Most CFD traders trade in considerations of £10,000-£15,000 upwards (requiring a margin of £1,000-£1,500).
The advent of SETS on the London Stock Exchange in October 1997 and the introduction of the pre-, post- and intra-day auction processes in June 2000 has led to regular additional trading opportunities. Often the best prices for the day are achieved in the auctions. During the post-market auction, trading is suspended for five minutes from 16:30 to 16:35 and market participants can submit limit and 'at-market' orders. This can often create an imbalance if there is insufficient liquidity to fulfil the order, forcing prices up or down. The chart below illustrates clearly the trading opportunity when a seller of 6m shares of Marks and Spencer (MKS) temporarily led to the price dropping in the closing auction on August 5th. CFD traders took advantage, going long overnight and closing the trade the next day.
A similar situation can be seen to have taken place in Provident Financial (PFG), with the price rising up to 600p in the closing auction on August 29th on account of a big buyer and then another opportunity occurring the next day with the stock being sold down heavily to 560p and then reverting to its normal 575p range the next day.
It is important to remember that in the auction, all trades are conducted at the final 'uncrossing' price, so if your sell order was limited above the uncrossing price, you won't trade, whereas if it is below the uncrossing price you will deal at the improved uncrossing price. The reverse holds true for buy orders. The uncrossing price is calculated in real time throughout the auction process by the Exchange based on the orders submitted at that time, in such a way as to execute the maximum number of orders possible.
Although the new issues market is particularly quiet at the moment, CFD traders can often trade a stock from the first day of conditional trading, i.e. when the stock is trading on a 'when-issued' basis. This puts him on a level footing with the institutions, whereas retail investors often have to wait until a week later when unconditional dealing commences. This allows trading and hedging opportunities for a number of days, when private clients are prevented from trading.
There have been a number of new issues this year, despite the state of the markets, including William Hill (WMH), Punch Taverns (PUB), Intertek (ITRK) and Wood Group (WG). Opportunities can often arise six or twelve months later when private equity and venture capitalists are released from their lock-up obligations, resulting in a flow of shares into the market, depressing the stock price. Traders anticipating this flow can take advantage by shorting the stock in advance and buying back later.
Monitoring the activity of Directors' transactions and 'shrewd' investors (as highlighted by www.citywire.co.uk) can also prove profitable for those without the resource to do their own analysis and research. As well as providing long and medium term stock investment ideas, short-term trading opportunities can also present themselves when the newspapers highlight or write up the story. Stake building can often lead to a subsequent takeover bid.
With over two hundred index-tracking funds, compared to just six in 1990, passive tracking funds are having an increasing influence on stocks prices. Following the ins and outs of stocks from indices has been a popular and profitable pastime in the last few years. The FTSE indices are reviewed quarterly, although ad-hoc changes are sometimes made, and the MSCI and STOXX indices are also regularly reviewed. Details can be found at www.ftse.com, www.msci.com and www.stoxx.com
CFDs provide an easy way to 'short' stocks either as a hedge against an underlying position but also to back a negative view on a stock that the trader believes may experience some short-term weakness or general fundamental over-valuation.
More sophisticated strategies can be pursued by placing a performance trade, buying one stock while simultaneously selling an equal consideration of another closely correlated one, usually in the same sector. This market neutral trade will then capture the difference in performance in the two stocks with a lower overall market risk. These strategies are particularly popular with hedge funds especially during times of high market volatility.
Stock splits are generally viewed as bullish for a stock as although the value of a company is unaffected, the shares become more marketable. What generally happens in reality though is that the existing trend is amplified, so an over-performing stock will continue to do so, whereas the split may have little or no effect on an under-performing stock. Share consolidations (where say, a 10p stock is consolidated 10 for 1) can be counter-productive, and the stock will often quickly fall below its theoretical new price (in this example 100p). Companies and Directors are often restricted from dealing in their companies' shares in the two months leading up to either interim or preliminary results. Bullish signs to look for are clusters of Directors buying or selling just before or after this period. Where Directors will have an early indication of trading conditions in the new financial year since the results apply to. Stocks can also experience weakness if a buy-back programme is suspended duringthis time.
CFDs have become firmly established in the modern private investor's armoury of dealing instruments. Their flexibility and cost-effective means of execution are particularly attractive, but they are not a replacement or substitute for long term investment and saving. However with more than twelve CFD providers now offering a retail product encompassing both on-line and telephone trading, a competitive market has been established.
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