Published in Money Magazine, August 2010 by Pam Walkley
CFD providers and clients both need to raise their game so trading is more than just a gamble.
Make no mistake, trading contracts for difference (CFDs) is a risky business.
I know from experience how easy it is to lose money, after registering with several demonstration sites to research this article.
Even though I have been trading and writing about shares for longer than I care to remember, the experience taught me not to even try to trade CFDs with my own money without extensive study to learn the ropes.
No one should trade CFDs unless they are prepared to put in the time, and perhaps the money, to educate themselves on the subject.
This is the only way to give yourself the best chance of success.
Patersons Securities stockbroker Marcus Padley was spot-on when he wrote in the Age newspaper that there is nothing wrong with the CFD product - the problem is with the way people use them.
"For such a turbocharged product you should really have some qualification to trade these things. But instead, people are clicking past all those terms and conditions without reading a word," Padley wrote.
"CFD trading is not gambling, but many of those attempting to trade CFDs are gamblers," says Dale Gillham, chief analyst and director of Wealth Within, which runs government-accredited independent courses on CFD trading.
It appears that the corporate watchdog, the Australian Securities & Investments Commission (ASIC), agrees, but it wants to make CFD providers responsible for vetting potential clients on their suitability to be CFD traders.
ASIC threatens that if this, plus other recommendations it has made for CFD providers, does not happen it will lobby the federal government to regulate the industry.
"CFD issuers need to lift their game to make sure investors understand how CFDs work and are aware of the very significant risks when trading these complex financial products," says ASIC commissioner, Greg Medcraft.
After conducting a health check of the CFD market in 2009, ASIC found many retail investors were oblivious to the risks of trading CFDs.
It also found many do not seek financial advice before investing and often do not receive enough information to make informed decisions about trading CFDs.
Independent statistics back ASIC's fears, with 38% of the 9644 traders surveyed for Investment Trends' 2010 CFD research report saying they lost money in CFD trading over the previous 12 months, including 12% who lost more than 50% of their investment.
The average percentage of winning trades over the last 12 months was 44%, with 41% losing and the rest breaking even.
As well as continuing to monitor advertising by the industry to make sure risks are clearly disclosed, ASIC plans to publish a guide to investing in CFDs.
Its health check report makes clear it is concerned there is a "lack of independent, clear, assessable information of CFD features, operation and risk.
This inhibits the education of retail investors and causes them to rely disproportionately on issuer marketing materials for information."
"Worldwide statistics report that around 90% of traders don't make money, and so the key to being successful trading in any market is to be different," says Wealth Within's Gillham.
"This essentially means it is not wise to get your education from those that provide the market or the product that you are intending to trade.
It may appear to be cheaper upfront, but it will cost you in the meantime."
ASIC is also critical of so-called "educational" seminars hosted by CFD providers, after ASIC staff attended a selection and found the risks were downplayed in relation to the potential benefits.
"We found that while most CFD seminars were advertised as educational, they were primarily directed at marketing the issuer's products," says the ASIC report.
CFD providers argue that they have done a lot to educate clients but agree CFDs should not be traded by everyone.
Most also welcome ASIC's involvement. "We believe a well regulated industry is in everyone's best interests and that strong, clear regulation benefits both the consumer and the industry," says Barry Odes, managing director CMC Markets, one of the two biggest CFD providers in Australia.
"CFDs are not for everyone and we strongly recommend that clients should have a sound understanding of how the product operates and the risks associated with them prior to investing.
We will continue to work with ASIC and through our industry body, AFMA [Australian Financial Markets Association], to ensure that any new recommendations and benchmarks stemming from the ASIC report are implemented into our business."
Comprehensively vetting and testing the suitability of potential traders is not something that all CFD providers currently undertake.
Australia's biggest online broker, CommSec, does. "The testing and checking we do helps us better understand our clients," says Peter Tardent, head of international and derivative markets at CommSec.
"Questions around the risks of margin calls, and the understanding that you can lose more money than you invest, as well as the speed of trading, do mean some potential clients are deemed unsuitable."
IG Markets vets its potential clients and rejects about 10%, says CEO Tamas Szabo.
Trading experience, savings and earnings plus understanding the product are all included in the suitability test.
"We welcome the ASIC report," says Szabo. "We are doing all that is recommended but are concerned that some are not.
We think there should be a level playing field so the 10% we reject cannot just go elsewhere."
Etrade also boasts stringent suitability criteria for would be over-the-counter CFD traders.
Potential new clients are questioned on their trading experience, income and net assets and quite a few are rejected, says senior product manager Corey Thompson.
Likewise GFT questions potential traders about their financial situation and trading experience.
Those that cause concern, mainly for financial reasons, are subject to extra disclosure to make sure they really do understand the risks, says Brendan Gunn, head of GFT in Australia.
"It's always been our philosophy that educated customers are educated traders," Gunn says.
Online webinars - nearly 30 a week ranging from live market analysis and macro-economic outlooks to risk management - is the latest way GFT is educating its clients.
CMC Markets has a trader health check as part of its education.
This helps the company determine the level of education - beginner, intermediate or advanced - that clients require.
It also has a quiz that allows clients to test themselves on the material they have read.
Most CFD providers do have a range of services and material for their clients.
The key question is how many traders or potential traders make use of what's on offer.
An insight into this comes from Investment Trends' 2009 CFD report, which found that only 24% of people intending to trade within 12 months had opened a demonstration account.
"You cannot do too much in the way of preparation to trade CFDs," says David Land, chief market analyst with CMC Markets.
"And it does not all have to be about CFDs. It should also encompass trading strategy, risk mitigation and trading psychology."
Land adds: "Practice trading allows you to test your strategies in real time.
And when you do start trading, use small amounts and gradually ratchet it up.
"It's a strategy that GFT's director of currency research, Kathy Lien, approves.
"One technique is to breakup risk capital into pools, and spread risk further by using more pools (ie 50 pools of $100 each, rather than five pools of $1000)," she says.
"The more pools you have, the more you spread your risk."
City Index also offers a demo trading site where you use paper money.
You can then move on to its trader's academy where you can trade commission free for four weeks to test that you have the skills required, says Michael McCarthy, head of dealing.
McCarthy also recommends guaranteed stop losses for new traders. "With these you know the maximum you can lose, giving you the 'sleep at night' factor," he says.
For traders with limited time to trade and watch markets, risk management is even more crucial, says McCarthy.
You can start the day with a specific entry order, picking the level to enter the market.
You can then place orders contingent on this, including a stop loss or guaranteed stop loss to cap potential loss.
Be aware without the guarantee, if the market moves quickly or "gaps", your position may not be closed at your desired price.
You could also place limit orders, instructing your provider to trade if the price moves to a more favourable level, locking in your profits.
Of course these extras do cost. Another strategy is trend trading, where you can adjust positions and take new positions less frequently, says CMC's Land, who adds:
"You cannot be a day trader with a full-time job."
NEED TO KNOW
How CFDs work
The two types of CFDs are over the counter (OTC) bought from CFD issuers, the main focus of ASIC's research, and exchange traded which are listed on the ASX.
CFDs are agreements between the trader and issuer to exchange the difference between the entry price and exit price of an asset.
The trader has the benefits of owning a stock without paying the amount needed to buy the actual shares.
Being highly leveraged downside risks are great. For example a $5,000 investment leveraged at 95% exposes the trader to a liability of $100,000.
CFDs allow traders to take a short position, betting the price of the underlying asset will fall, or a long position, betting the price will move higher.
ASIC ACTION PLAN
The regulator, ASIC, sets out solutions to some risks for retail investors in over-the-counter (OTC) CFDs.
Risk Potential for big losses due to high leverage: ASIC is monitoring and addressing compliance issues in advertisements, disclosure and conduct to ensure risk is clearly communicated. It will also publish an investor guide highlighting the risk that investors can lose much more than their initial capital.
Risk Unanticipated or poorly managed margin call ASIC: is monitoring that this is communicated clearly to investors in all material, plus there's an enhanced product disclosure statement (PDS) benchmark encouraging issuers to explain their margin call policy.
Risk Counter-party - the issuer or another party fails to meet their monetary obligations to the investor: ASIC has issued a guide on how it expects issuers to comply with client money provisions of the Corporations Act, monitoring that the risk is communicated clearly to investors to encourage issuers to disclose how they manage liquidity so they can meet obligations to clients.
Risk CFDs are inherently unsuitable for some retail investors: ASIC is aware of only a few OTC CFD issuers with clear and consistent client suitability policies. It strongly encourages all issuers to develop such procedures.
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