Iseq fall hits CFD holders hard

Anybody who invests in the stock market should know by now, particularly in light of the past fortnight, that shares can move down as well as up.

And nobody should know this better than holders of contracts for difference (CFDs), the derivative products that have become fashionable over the past couple of years. The premise behind CFDs is that they allow investors to put a certain amount of money into the market and then borrow a multiple of this to raise their exposure to a particular stock.

It works simply enough: you have, say, €100,000 and you leverage this up 10 times to create an exposure of €1 million. This then goes on €1 million worth of a particular stock, which is borrowed from the underlying holder for an agreed period. No stamp duty is paid, although this is under review. In theory, the holders of CFDs can bet on stocks moving down just as easily as putting money into them going up. In practice, however, the preferred wager will be on a positive move.

If the stock goes up, the investor gets a multiple of the benefit they would have got if they had just invested €100,000. Likewise, they can get badly burned if the stock goes down.

Since CFDs were introduced in the Republic in 2002, stocks have generally been moving in a positive direction. But since the second week of this month, the Iseq has lost about €6 billion in value, which is sure to have hit CFD holders harder than others.

Brokers need to be careful about who they sell CFDs to. Applying caution will see brokers selling CFDs only to well-informed and prosperous investors who have substantial assets to back up their exposure. This should mean brokers turn down investors at least as often as they take them on. But the nature of the business is that some always take more care than others.

"If you're borrowing to speculate, you'll definitely lose," says a market insider. The better scenario, he argues, is to treat the CFD borrowings as you would a mortgage, paying off the interest and debt as time goes on.

Brokers agree that most Irish CFD investors tend to stick to blue-chip names, such as major banks, which can offer some protection because the dividend yield will cover interest costs. They also tend to be less volatile.

Recent weeks have shown the banks to be vulnerable on occasion too, however, with Anglo Irish among the hardest hit.

There will always be investors who want CFDs in more volatile stocks, thereby increasing their potential return or loss. Experience with Elan last year showed this to be a risky strategy, with millions lost to CFD holders when the stock collapsed.

"The temptation is to continue to gear up," says one stockbroker, who says bigger wins often lead to bigger exposure. But he says the rising markets of the past months and years will have been good to most holders of CFDs, who should have built up a cushion to protect themselves.