CFDs, the smart derivative

Contracts for difference, or CFDs, are derivatives in the same family as futures, warrants and options, but unfortunately they are the only ones that have been bucketed mercilessly. Smart plays on the initials, such as Casinos for Delinquents, have been used in the press, and even ASIC describes them as “much riskier than a flutter or a night at the casino,” because potential losses are unlimited if the bet sours.

This emotional language is hardly helpful, as skilled CFD traders always set stop-losses, and in extremely volatile markets they pay a small premium for a guaranteed stop-loss. Trading CFDs without a stop-loss is akin to driving a Porsche flat out with no brakes – you just don’t do it – and the comments from ASIC are grossly exaggerated and less than helpful.

For years brokers have recommended that their investor clients purchase put options as a means of protecting portfolios in uncertain times. However, put options are a poor substitute for CFDs as a means of insuring portfolios. By way of example, let’s assume that you own 10,000 shares in BHP Billiton at the current price of about $40.40 but you are worried the price of oil is going to fall over the next few months, and sink BHP’s share price with it.

To hedge against this you purchase 10 BHP $40 put options (each covering 1000 shares) expiring in two months at a cost of $24,000 plus brokerage of $150. At expiration BHP has fallen to $34 and the options are worth $60,000 and you have choice of closing the options position or exercising them. You have a capital gains tax problem with exercising the options so you close the position for a profit of $36,000 before costs, but against this the value of your shares has dropped by $64,400. It’s hardly a great hedge and, worse, should you continue to hedge you’ll have to dip into your pocket to buy another 10 BHP put options.

Instead of buying put options you could have short sold 10,000 BHP CFDs at $40.40 for $404,000 less brokerage of $404 on a deposit as low as $12,120. In two months time you have the choice of closing the position or letting it run. Assume you close it by buying 10,000 BHP CFDs at a cost of $340,000 plus brokerage of $340 for a profit on the trade of $63,256 after costs, but there is more to come. Because you had a short position the CFD provider will pay you interest at the official cash rate less 2% on the balance calculated daily, which equates to about $3200 for a total profit on the CFD position of $66,456 against a fall in the value of $64,000 in your BHP stock.

In the above example, if BHP were to increase in price to $43.12 after two months the options strategy and the CFD strategy would approximate each other and anything after $43.12 the option strategy would be more effective. But when you insure your house for $500,000 you don’t expect to be paid $700,000 when it burns down. So it is when insuring your portfolio, and using CFDs for this purpose is vastly superior to options.

In addition to the foregoing, there are top 300 companies such as Mirvac, PaperlinX and Billabong whose options are so thinly traded as to be almost non-existent. Cabcharge, Forester Kurts and many other companies do not have exchange-traded options (ETOs). In contrast to this, there is abundant liquidity in CFDs in these stocks. Another advantage of CFDs over other derivatives is that you can hedge your exact position, so that if you own 3699 shares in BHP, you can short sell 3699 BHP CFDs, as opposed to buying 4 BHP put options covering 4000 shares.

If you have a portfolio that includes Newcrest or Lihir and believe gold is going to suffer a temporary decline, you could short sell gold CFDs to protect your position, but again this will not help you if a company-specific event adversely impacts one of the companies you hold. The safer but more painstaking course is to short sell CFDs over each of your holdings if you feel the market is going to continue its fall or you suspect one or more of the companies you hold could make an adverse announcement. This may seem far fetched, but only if you believe that the recent announcements made by NAB, ANZ, GPT and Mirvac are the end of the bad news is in this cycle.

A disadvantage of the above strategy is that if you get the direction of the market wrong and your stocks head north, you’ll be hedging in a rising market. In this instance your position will be neutral, but the hedging results in you forgoing profits on your stocks that you might have made. No one wants to be fully hedged in a rising market, so timing is critical. However this is not CFD-specific and relates to all hedging, but you need to remember that while hedging in a rising market is uncomfortable, taking the hedge off and watching the market collapse a few days after is calamitous.

One of my concerns regarding CFD providers is the security of my funds, and in most cases after reading the Product Disclosure Statements you will find that you are an unsecured creditor in the event that the provider fails. This is the same situation that clients of Opes Prime found themselves in, and is a reason those borrowing on margin have moved back to the banks for the security, and easy-to-understand vanilla-type margin loans.

It is worth checking out the reputation and financials of your provider to ascertain whether it has the capital resources to meet its obligations. As a trader I try and keep the bare minimum amount with my CFD providers. The ASX has an impeccable reputation and is financially strong, but unfortunately at this stage only offers CFDs over the top 50 ASX stocks, key global equity indices, selected commodities and a range of foreign currency exchange rates. Macquarie Bank, through MQ Prime, offers hybrid CFDs that are really flexibly margined loans over more than 950 stocks listed on the ASX. Clients have separate accounts.

In this instance, so long as you meet your obligations you retain legal ownership of the shares, and Macquarie has no right to loan or pledge your stock to a third party.

In this market it is easy to single out CFDs as the riskiest of all investment plays but they are not. In many ways they are like a highly geared margin loan and are easily understood, particularly when compared with other derivatives such as options and warrants.

Yes there have been huge losses sustained by those with long CFD positions over the past year, but this has not been confined solely to CFDs and those with long unhedged share and options positions have also suffered.

There is an argument, mainly promoted by share brokers and the media, that the average punter does not know enough about the market or CFDs to invest or trade in them.

As I write this I am looking at the December 2007 recommendations of one of the largest brokers in Australia: buy ANZ $27.46 (now $16.35), buy AXA $7.38 (now $4.40), buy Kagara $6.20 (now $3.11. I could go on, but my point is that the supposed professionals knew no more than the average punter. If this needs reinforcing, look no further than the debacles of Citigroup and Merrill Lynch in the US, and bear in mind these are the “professionals.” (For more on Merrill Lynch, see today's feature by Robert Gottliebsen, Are you going to be tapped?)

Buying a slightly out of the money call option is a high-risk strategy because if the underlying stock falls you lose, if the underlying stock goes sideways you lose, and if it goes up slightly but volatility falls you lose. Further, the spreads on the bid/ask on options are always wide, and it can be difficult to get set.

By way of contrast, when buying CFDs you will lose if the stock falls; you will lose if it goes sideways (but only interest and transaction costs); but you will profit if the stock rises slightly, and volatility has no impact on pricing. Spreads with DMA (direct market access) providers mirror the market and are usually tight for liquid stocks.

The long-term buy and hold investment theorists always rationalise that over time the market will have humps and dips, but if you hold long enough it will come back. Perhaps those who made long-term investments in Enron, WorldCom, HIH or One.Tel would disagree. CFDs are an extremely useful instrument for hedging, and trading but don't do it without stop-losses.

Peter Ralph is a share/derivatives trader and author. His latest novel, The CEO, is published by Melbourne Books.

nLong or short: How CFD traders are placing their bets *

1. BHP Billiton (BHP): LONG. Even a fall in crude oil prices could not dampen traders’ enthusiasm for BHP. BHP traded back above $40 during the week.

2. National Australia Bank (NAB): SHORT. Traders have been getting short NAB as it changes chief executive – from John Stewart to Cameron Clyne – in the middle of the credit turmoil. The massive writedowns and its appointment of the relatively unknown Clyne has traders believing it has further to fall in the short term before any recovery.

3. ANZ Banking Group (ANZ): LONG. Bargain hunters are buying up ANZ, giving it support at the $16 level. Traders are hoping that all the bad news for ANZ is on the table.

4. Rio Tinto (RIO): LONG. An announcement of a massive expansion at its iron ore mine in Brazil is a positive step. The expansion will assist Rio in getting new business out of the Latin American and the Middle East markets.

5. Macquarie Group (MQG): SHORT. The turmoil in the financial stocks has seen all the financials come under pressure. After recent buying by bargain hunters, Macquarie Group has come under pressure from short sellers and profit takers.

6. Woodside Petroleum (WPL): SHORT. With crude oil falling 20% from its highs, Woodside has continued to come under pressure from short sellers. Falling crude prices will reduce analysts’ earnings projections for Woodside.

7. Suncorp-Metway (SUN): SHORT. An already nervous banking and insurance sector did not take well to the news that Suncorp would see its profits halve. It is the latest bank to come under pressure due to the state of the credit markets.

8. Fortescue Metals Group (FMG): LONG. The weakness in Fortescue’s share price has proved to be an opportunity for CFD long traders. News that a ship carrying Fortescue’s iron ore had run aground only added to the weakness. This pain will be short-lived, with shipments recommenced rapidly.

9. Commonwealth Bank of Australia (CBA): LONG. This is one financial stock that has not released any surprise bad news. CommBank seems to be in a good position compared to its peers. CFD traders are happy to go long CommBank.

10. Westpac Banking Corporation (WBC): LONG. It seems the longer the Westpac bid for St George goes on, the better the position it puts Westpac in for a full takeover of St George. Westpac also enhanced its capital base with a successful allotment of just over $1 billion in stapled preferred securities.

* The most common long and short positions on the ASX for week ending Friday August 1.

Source: Harley Salt, associate director, IG Markets.