Only Short-Term Investment Tools?

Despite the many advantages over more tradition investment tools, CFDs are clearly not suited to some forms of trades. One obvious example is that, although CFDs are an ideal tool for short-term investment, they do not appear to be particularly suited to long-term trading. If an investor wishes to they can hold a position forever, but the simple truth is, on the long side, that if the costs involved are examined there is a finite period of time before it is financially advisable to hold the underlying stock outright. Dominic Connolly, an analyst has found that (it commission is assumed to be the same for both normal shares and CFD dealing) there is a definitive point in time whereby holding the underlying share becomes cheaper than trading a CFD. He explains that when an investor buys a share there is the 0.5% stamp duty cost up front and how ever long they run the position it has cost them 0.5%. With a CFD, he points out, it’s a sloping line upwards because it’s a margin product and the customer is borrowing money to finance the position. So although CFDs can be used for long term holding as part of a buy and hold strategy, one has to keep in mind the financing charge which is the is the interest on the amount that you are effectively borrowing in your margin account – which albeit not a lot can add up over the long-term.

This means that the price of CFD trading adds up and at some point that funding will amount to more than the stamp duty. He found that the cross over point is always 11 weeks, because stamp duty is 0.5% for normal shares and City Index charges 3% over base rates on the 80% of the value of the shares that are being borrowed for the CFD. “If you intend running a position for more than 11 weeks, you are better off buying the normal share and paying the 0.5% stamp duty up front.” Connolly said.

Though they are best known as tools for short-term market speculation, up or down, contracts for difference can also be utilised for taking a trade over months or even years, which is made easier by their lack of an expiry date. CFDs also offer a way way for private investors to hedge existing shareholdings.

Naturally, people have held positions on the long side for a greater length of time than that. One potential reason why someone might hold it for longer may be if they have not got the free capital to take up the contract within the 11-week period. Another key reason why investors may want to hold onto a stock longer than the advised period is because of the flexibility benefit CFDs offer. Often when a position is opened, the investor will not be sure how long they are going to keep it open for. What this means, practically, is that once a position has been opened through a normal share purchase, the 0.5% stamp duty must be paid at once. If the shares are sold before the purchaser anticipated, they cannot recover the financial hit from the initial 0.5%. However, as CFDs operate on an increasing cost scale over time the CFD investor is in a more flexible position to decide when to sell. If a CFD trade goes right after one day than the contract can be sold incurring hardly any costs. If the trade takes longer to reap benefits then at least the CFD trader has had the flexibility to be able to close their position if they had wished to without taking the 0.5% charge.

As City Index’s Daniels notes, one of the major advantages of CFDs can also be construed as a disadvantage. 1t’s exactly the same as your profits. If your profits are magnified your losses are as well,” he pointed out. He went on to say how City Index only allow its CFD products to be used by non private clients, so they’re deemed as experts in the market place. They have to speak to its compliance area and are asked a set of questions to judge their experience of trading. Clearly, CFDs are not for people with a few pounds lying around who fancy a go at playing the markets, the FSA has regulations to ensure only, what was known as expert investors and now known as intermediate customers may trade CFDs. IG Index’s Sinden does point out though those CFD losses can be capped by offering customers a guaranteed stop loss. This means that at the outset of the trade the investor can set their level of maximum risk (usually 10% below the current price) and their exposure will automatically be stopped there no matter how far the share price eventually drops.

Another factor to be aware of with CFDs is that they are an over-the-counter contract and so there is a slightly higher credit risk as you’re relying on an exchange traded product backed by the clearing house. Obviously, this means that an investor’s security depends on the credit worthiness of your provider. The significance of this point is debatable, as it would appear unlikely any major providers of CFDs will collapse, but it is certainly a factor worth considering when comparing CFDs to standard shares.

There is much uncertainty in the present financial climate and investors have to be flexible and react quickly. This is where CFDs come in…