Serious Money: CFDs and similar trading products can be heaven- sent but beware the risks, writes Chris Johns.
The financial pages of many newspapers these days often contain numerous advertisements for companies that offer "low-cost", online share-dealing services. As well as plain vanilla buying and selling of shares, more esoteric products such as "contracts for differences" (CFDs) and "spread bets" are also on sale.
For some investors, CFDs and similar trading instruments are a heaven-sent method for placing large bets on equities (and some other asset classes) without having to find as much capital as is normally required for orthodox trading. Other investors have discovered that the newer instruments simply offer greater scope for losing even more money.
Most aspects of financial market behaviour offer a light and dark side. When stock markets operate efficiently and legally, they provide a near-perfect method of matching savings with investment - that's what the text-books say anyway.
Various scandals and the obvious inefficiencies (think stock market bubbles and exchange rate behaviour) mean that we must always look at financial product salesmen with a sceptical eye. Indeed, the different ways in which the same product is sold is often revealing.
For example, one online dealer advertises spread trading as offering "freedom, excitement and true independence... \ a small amount of risk capital can get you started".
This particular dealer also offers "the secrets of how precision-timed trades in leading stocks, commodities and indices can make you very wealthy".
And, inevitably, we hear about "how one trader went from £15,000 \ to £1.7 million in just over 12 months".
All of this may be perfectly true of course. But, if it is that easy, one always wonders why the authors of get-rich-quick schemes don't simply follow their own advice rather than sharing it with others.
A much more balanced invitation to trade CFDs comes from the UK financial services giant MAN. It begins by explaining a simple (or even simplistic) investment: you, the investor, decide to buy, say, 5,000 Halifax shares at £6 each, something that would normally cost £30,000 plus various expenses, most notably stamp duty and brokerage commission.
But MAN, in this example, asks you only to deposit a 10 per cent margin, so your capital commitment is only £3,000, plus expenses (more of which in a moment). When, fortuitously, Halifax rises to £8, your profit is £10,000; it's as if you laid out £30,000 on the original purchase and sold the shares for £40,000. All for an initial stake of £3,000, which is refunded.
CFD providers sometimes argue that their costs are both lower and more transparent than spread trading, with the latter's costs often being hidden in the spread between buying and selling prices. But CFD trading is not costless: there are commission and interest payments (interest can be charged on the implied capital "borrowed" to finance the larger trade).
MAN allows you to "gear up" by up to a factor of 10. It is this gearing, or leverage, that is key to understanding what is going on. Real-world CFD trading is often more complex than our elementary example, but the underlying principle of leverage is just the same. You can place big bets for relatively little initial outlay.
Again, keeping things overly simple, it's a bit like a bookie allowing you to place €100 on dog number four in the second race at tonight's meeting, but only asks for a €10 cash up front. If the dog comes in at two to one, you win €200 plus your €10 back. If the dog loses, the bookie will expect you to stump up another €90 after the race has been run. While no self-respecting bookie is likely to offer such terms in practice, you get the general idea. Indeed, many different forms of spread betting are familiar from the modern world of sports gambling (although always more elaborate than our simple examples).
Some investors will see similarities with the world of margin trading, common in the US and in one or two other countries. But whatever label we put on these investment styles the common theme is leverage: people finding ways to take more risk while using as little capital, and incurring as little cost, as possible.
For investors who know what they are doing, all of this makes perfect sense. In particular, the efficient use of capital and reduction of brokerage and other fees (including, in some cases, capital gains tax) can make huge differences to returns.
Trading expenses eat up surprisingly large amounts of money, no matter what kind of investor you are. Even the use of leverage can make intrinsic sense: basic finance theory can be used to show how gearing can, in certain circumstances, improve the risk/return trade-off. But even here we should remind ourselves that we are always increasing the absolute amount of risk that we are taking on board.
Before using spread betting, CFDs and other ways of leveraging your bets, you should always ask "what kind of investor am I?" If the words "amateur", "small" or "inexperienced" form part of your answer, you should have no hesitation in turning your back on these investment styles.
Simply think of leverage as a neat way of almost guaranteeing bigger losses than you can bear (although some firms do offer "stop-loss" facilities, which try to mimic the risk-management strategies of the professionals).
If you are convinced you know what you are doing, these techniques increasingly offer viable ways into the markets that can save you money. And, notwithstanding the two overseas examples discussed here, there are a number of Irish-based providers able to offer increasingly sophisticated products; in some cases these firms offer both sports and financial betting services.
Spreads and CFDs are, in a sense, examples of financial derivatives. Many people run scared as soon as they hear the word "derivative", with thoughts of Nick Leeson and other disasters immediately coming to mind.
Some people refer to them as weapons of wealth destruction. That's why they are not for the faint hearted. Nevertheless they should be part of any serious investor's toolkit.
