Recent years have seen the emergence of a product that has changed the face of share trading, hedging, and speculation. A product previously available only to institutional investors but now available to the investment public. It is powerful, flexible, simple in build, and still benefits from price increases and dividends for a fraction of the cost of buying the underlying security. This is CFDs trading, like spread betting, it allows you to invest in a share or index without owning the underlying property.
The CFD was designed to encourage other market players to open short positions and stop paying stamp duty. At 0.5 percent, stamp duty made short-term trade using normal methods nearly impossible. Returns are typically expressed in low quantities. By the time the government nipped up its share, the gains left over were too low to be considered worthwhile.
But as the stamp duty loophole expanded across the City, more brokerages started offering CFD services. With companies such as IG and City Index being the first to sell the commodity to the investment public.
The procedure includes a deal with the CFD broker to ‘purchase’ the security at the present price and to pay the discrepancy in pence or points determined by the number of contracts bought.
Individuals seeking CFDs trading need to be able to show to their preferred vendor that they have the correct expertise to do so. Investors do need to be mindful that the way the product is organized changes from firm to firm. Thus, there is no right way or wrong way: it is also better that you choose a business where you are confident with the process.
Unlike other equity derivatives, CFDs are transparently priced and represent existing market values for the underlying securities. This arrangement helps to exchange CFDs because the broker can cover anything inside the underlying cash market. Although legally still the counterparty to the client, the arrangement is, in practice, that the private client has bought directly from the organization.
That is the beauty of online trade, before which none of this would have been feasible. CFDs trading is the same as regular equity trade-in that when the stock is purchased or sold, the hedging deal takes place. It happens on the provider’s accounts and not on the investor’s behalf – thus the opportunity to stop paying the stamp duty.
Some companies, as part of their operation, track pricing in the underlying market and deliver ‘risk prices’ from the information obtained. Each form of deal is limited in size and does not permit buying or selling within the scope of the spread.
Many companies do prefer to offer a commission-free service. This is a scheme that does not work explicitly with the underlying market, and the instant-execution option that is essential to everyone is not a guarantee. If you plan to invest in CFDs, you must deposit the sum of money known as the initial margin. This then opens the position that is measured as a percentage of the valuation of the transaction.
CFDs trading gives people the space to take financial action that was historically in the domain of big corporations.
The average percentage rate for FTSE 100 shares is 10%. Customers who buy 40,000 Royal & SunAlliance shares, say, at a price of 77p, would have to deposit £3080 into their CFD account (40,000 shares x 77p price per share x 10% initial margin rate).
There are no fixed expiry or settlement deadlines so that the role will remain available for as long as the client wishes. Customers will go long or short of stock depending on whether they expect it to rise or fall.
A condensed example of a long position, overlooking interest and fees, can be seen below. This is focused on investor trading on the FTSE 100 at the level of 4001 and expects it to rise further:
CFD broker quote = 3999 – 4001
Buy to open at 4001
Client agrees to £1 per point = £1
Value of investment (£/point x index value) = £4,001
10% margin = £400.10
Six days later, the index has risen to 4050:
CFD broker quote = 4049 – 4051
Sell to close at 4051
Value of investment (£/point x index value) = £4,051
Trading profit (£4,051 – £3,999) = £52
Profit margin on initial deposit (£52/£400.10) = 13%
Different companies have different rules on the scale of the CFD position they are prepared to join. If they buy more than 3% of the company to hedge the sale, additional disclosures must be made. That is why some companies have a tradition of not owning more than 2%, while others do not fear transparency and take even greater stakes.
Profits will also accumulate during this process, but note – losses can, too. That means that if you spend £1,000 in shares and they decline by 10%, then you’ve lost £100. However, if you use the £1,000 as a deposit to prop up a £10,000 CFD fund, a 10% decline will wipe out your whole stake. It is also essential to stay completely vigilant and concentrated, cutting losses easily and without regret. Experience is crucial due to the sheer uncertainty of these markets. It’s always a smart idea to use a stop-loss system. This means that the expenses are limited to a fixed sum, typically between 10% and 20% below the price you pay. If your positions reach this point, they will close automatically.
If you don’t run a stop-loss device and your situation deteriorates, one of two things will happen. You will either receive a margin call, which is usually a phone call from your broker asking for more money, or your broker will close your position for you.
Despite the complex demeanor of these valuable trade instruments, businessmen and developers have used them on a variety of occasions. At the beginning of 2002, Shami Ahmed, founder of the Joe Bloggs jeanswear group, used this tool to set up a major stake in Moss Bros. At the time, Moss Bros had lost his way, struggling from weak sales and a dropping share price. Which was rapidly falling even further when the scale of Ahmed’s place was realized.
The stakes he had built had been relatively easy achieved and had totaled about 20 percent of the Moss Bros retail chain. Not only did Ahmed have a significant stake, but he also decided that he held the company’s voting rights by means of a side letter from the CFD broker.
Ahmed ultimately withdrew from his bid, but subsequently sold his CFD position and voting rights to Kevin Stanford, co-founder of the Karen Millen apparel chain. He now basically controls about 28 percent of Moss Bros and, due to the increase in the company’s share price, has contributed a tidy sum of 3 million GBP to his CFD stake.
There has been another more recent example of the use of CFD through mergers and acquisitions. It happened during the bidding war between Philip Green and the M&S that had just taken place during the summer. It was projected that up to 20% of the M&S stock was secured by CFDs. This resulted in a much higher degree of uncertainty for both Philip Green and M&S, as the level of support for the proposed acquisition was much more difficult to determine.
In addition, CFDs have been used as part of the merger and acquisition process for some time now. About 10 years ago, when Trafalgar House was competing for Northern Electric, it took out multiple CFD positions in Northern’s rivals. Why? It hoped that the upward ranking of the sector would be the result and that some of the pressure will be eliminated from its bid rates. Did it work? No, not really, as all the push did was to draw attention to the fact that CFDs are a very powerful tool in anyone’s armory. As a result, changes have been made to the United Kingdom takeover code.
Without complex settlement processes, CFDs trading is a cost-effective option, ensuring ease of implementation for investors and speculators alike. Could you afford not to use it?