Advantages and Disadvantages of Contracts for Differences Trading

Advantages and Disadvantages of CFDs

No-one likes paying needlessly more for something than they have to. There are more than ten providers of CFDs to the private investor and it can be hard making direct comparisons. The first thing a potential user of CFDs must decide is whether CFDs are an appropriate instrument for that individual. CFD trading is predominantly based around short-term trading and a comparison must be made between the savings made in not paying stamp duty with the additional financing cost of the CFD. Indeed we can quickly calculate the break-even point if we compare these two costs directly, if we set aside commission costs for one moment for simplicity's sake.

The additional cost in running a CFD position compared with a traditional stock transaction is the funding cost associated with the CFD. The EXTRA funding cost of the CFD is the 3% on the 80% of the position that the CFD provider lends to the client. On the other hand, trading traditional stocks incurs a 0.5% stamp duty charge up front immediately. So the crossover point will be when the funding costs of the CFD overtake the saving made on stamp duty. The point at which the funding cost matches the 0.5% of the transaction value in days is (0.5/0.8) x (365/3) = 76 days i.e. about 11 weeks. In other words for trades that are less than three months it is economically more viable to trade the CFD rather than the underlying stock. Of course this is a crude measure as there are other costs involved but it is a useful comparison. For very short-term trading or even intra-day, where the financing costs would be zero, the argument is compulsive. Where the CFD also gains is when the position is traded more than originally anticipated or a target price is reached quicker than planned, as the drag on net returns incurred because of stamp duty are avoided and the financing costs are lower than originally catered for.

However this is not the only aspect as experienced investors will be aware. There are also other considerations. When placing an opening trade, whether on a stock or CFD, the investor should be aware of all costs and risks associated with that trade. Stock liquidity and bid-offer spreads are as important, if not more so, than low commissions and levels of stamp duty. One wouldn't buy foreign currency simply because it was commission free; the two-way exchange rate is just as important and is a good reflection of how competitive the provider is.

CFD providers are divided into two main types. Those that provide an 'agency' service, i.e. they hedge all underlying CFD orders in the underlying cash market and charge a commission, and those that 'make markets' in CFDs around the underlying cash market, charge no commission, but add on an additional spread with reference to the price of the underlying stock. All CFD providers make a proportion of their income on the financing of their clients positions.

It is up to the individual to make up his mind what relationship he is most comfortable with. The relationship is intrinsically different, although technically, as CFDs are over the counter derivative instruments, the CFD provider is counter party to the client in both cases. However, in the first example, where the provider hedges everything in the underlying market, the provider is in effect acting as agent on behalf of his client, probably via his regular account handler with whom he will have built a relationship. There is every incentive to get the best possible price for the client by dealing inside the spread. The client should also consider what else he gets; whether the company provides a good quality research product, with trading ideas, strategies, technical analysis and research on current take-over situations and forthcoming IPOs. Also the nature of the trading platform is important, whether he has access to Level 2 prices (full market depth), can participate in pre-market, intra-day and post-market auctions in the underlying stock and whether phone broking is also supported. CFD prices are based on the underlying stock and a reflection of underlying liquidity, and the individual must ask himself whether he wants access to the best local liquidity. The credit rating of the provider should also be given due consideration.

Advocates of the commission-free structure claim that trading costs are lower as spreads are no wider than the UK Sets system. This argument is somewhat flawed as spreads early and late in the day are always wider on Sets than during the more liquid mid-day period, making for an unreliable comparison. True, these commission-free prices can be competitive in the very liquid stocks such as Vodafone or British Telecom, which is fine if this is all you trade but if you want to trade a less liquid stock, surely you want direct access to the local liquidity rather than a variable two-way price made around the underlying. Trading and paying commission gives a fixed cost of entry, whereas trading commission-free with a variable spread around the underlying adds some uncertainty to this calculation. The ability to trade within the spread and place orders within the spread is as important, and good execution can easily offset the commission costs.

I also saw a recent claim that transactions through the London Sets system are only around 20% of the total Stock Exchange business. I decided to do a little investigation of my own and I took a visit to the London Stock Exchange website, taking the month of October 2000 as reference, the most recent month on which statistics were available at the time I visited.

Of the 2,283,101 bargains transacted on the LSE, 811,384 were conducted over Sets, giving a raw figure of 35.5%. However this is not the full story as the Exchange explained to me, non-Sets trades are double counted due to the reporting procedure so adjusting the figures gives a staggering 52%. Doing the same calculation for value transacted in £m gives a raw figure of 33%, adjusted to 49.7%. I took a look at October 1999 to see if I could judge if this figure was more or less static and discovered that twelve months previous, the relevant figures were 28.9% raw and 45% adjusted and 26.6% raw, 42% adjusted, by consideration. I anticipate the trend will continue, particularly in light of the recently introduced Central counter party system.

In summary then, the active trader will give due consideration to all these aspects and should be able to form his own opinion as to whether a CFD account is appropriate to his style of trading and investing. I personally believe that they are an invaluable tool, but should complement not replace more tradition normal stock trading accounts, ISA accounts and spread betting.

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