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’. 

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.