Riding the ups and downs

Published in the Herald Sun, October 2007 by Mike Hanely

Volatile times see investors run for cover but it’s possible to hedge your bets with contracts for difference writes Mike Hanley.

Things are pretty hairy in the markets at the moment. What with the sub-prime meltdown, the credit crunch, and an election just called, investors could be forgiven for wanting to hang up their gloves for the next few rounds and just sit and watch.

The Australian Securities Exchange is introducing a new line of products – CFDs or contracts for difference – that will help you do this without necessarily selling down your portfolio and exiting the market altogether.

CFDs are already very popular with speculators, because they can make – or lose – a motza by putting down a small proportion of the investment they are making.

Until now, CFDs have only been available through specialist dealers, and have been a bit of a niche investment product.

It is difficult to tell exactly how many people trade CFDs, but according to experts they are set to boom.

But CFDs are not for the faint-hearted. They are complicated, high risk, high reward investment products that are mostly used by professional investors.

Hedging

Imagine you’ve got a perfectly formed portfolio that took you years to build up and you don’t want to sell it all down.

Or maybe selling all your shares would trigger a big capital gain, and then you’d have all that tax to pay.

Or perhaps you simply don’t want to sell the BHP shares your grandmother gave you for your 21st, but you don’t want to seem them lose value either.

There are a number of things you could do.

You could hedge your exposure using futures or options. For instance, you could buy put options on your BHP shares which would give you the right to sell your BHP shares at today’s price at some point in the future.

But one problem with options is that they have an expiry date – if you don’t “exercise” your option before or on that date, they become worthless.

Also, the pricing of these derivatives is really complicated, because the price they sell for is related to the current price of the equity, the exercise price of the option, and also takes into account potential dividend cash flows and other complications.

Another option for hedging your position is to purchase contracts for difference, (CFDs) – a relatively new derivative product that has been gaining in popularity over the past few years.

A CFD is an agreement between a buyer and a seller to exchange the difference in value of a particular instrument between when the contract is opened and when it is closed.

Imagine when you buy one BHP share at $40.

If the price goes down to $39 the next day, and you sell that share, then you will have lost $1.

But if you were to sell a CFD against the BHP share when you buy it, and then “close” the contact when you sell it, the buyer of that CFD will have to pay you $1, so net-net you will be square.

If the value of the share goes up by $1, the value of the CFD will go down by $1 – so once again, you’ll be square.

Leveraged

Investors aren’t just attracted to CFDs because they are good for hedging. They are also good for speculating because they are “leveraged” products.

This means that investors get full exposure to a share or other investment for just a fraction of the price.

CFDs require only a small initial margin to secure a trade.

For instance, if you want exposure to $100,000 worth of a particular share, you would only have to pay between $5,000 and $10,000 up front, depending on how risky the share is.

If the price of the share moves against you, you will have to put up more money to cover potential losses. If you can’t meet these “margin calls”, the contract will be closed, and you will be liable for the full value of any losses the contract has made.

Because they are leveraged, CFDs are high risk, high reward investment products.

You only have to put up a small proportion of the total value of the investment, but when you close the contracts, you receive the gains - or must pay the losses – of the full value of the contracts.

Speculating with CFDs is for people who are comfortable with risk.

ASX enters the market

At the moment, you can only buy or sell CFDs through a specialist trader who fills your contract order through a market maker, or by hedging against your order on the underlying markets.

This is the “over-the-counter” (OTC) market.

But CFD products have proven so popular and gown so fast, that the ASX is launching a series of exchange traded products in November.

It will be the world’s first exchange traded market in CFDs, standardizing and bringing some transparency to the marketplace.

“The OTC market is not transparent” say Ken Chapman, general manager of new markets at the ASX.

“There is no market information. The key benefit of an exchange market is that contracts are standardized and we will publish all the information relating to trading volumes and the like. Traders will be able to see the activity on the market, volumes and prices.”

In all, 66 CFD products, including the ASX Top 50 major currencies, gold and oil will be traded on the exchange.

Major CFD brokers are not worried about the ASX stepping onto their turf – they think it will be good for business.

David Skilton, sales director at IG Markets, part of a $2.5 billion British-based trading group, reckons the new ASX products will be a big boost for his business.

“The ASX is out there educating the investing public with seminars and advertising,” he says. “And we think it will draw a whole new group of investors to the market.”

Indeed, the ASX has been on an education roadshow over the past few months, attracting more than 3000 people to CFD seminars.

“It will also have the effect of legitimizing the product,” Mr Skilton says.

Advisers agree 

Dale Gillham, chief analyst at share investment company Wealth Within says: “Some of the current CFD providers have run dubious market campaigns, workshops and seminars like snake oil salesmen to attract new accounts.

“The new ASX CFD product will go at least some of the way to cleaning up this market and help protect the retail client, by giving them a more independent and transparent market.”