Thursday, 29 October 2009

Contracts For Difference for Canadian Retail Investors: Beware!

Last Sunday, GlobeInvestor posted the news that henceforth Canadian retail investors in Ontario and Quebec would be allowed to open accounts to trade in Contracts For Difference (CFDs). As Wikipedia describes, CFDs have long existed in the UK, Australia and elsewhere but not in the USA.

In a CFD, the investor bets against a market making broker, in Canada's case CMC Markets, either that a stock or other security will go up, by going long, or that it will go down, by going short (see CMC's examples for how it works). The amount the stock moves away from the price at the time of taking the position/contract to the sale is the difference and that determines the investor's loss or profit. The key unique characteristic of CFDs is the huge amount of leverage they entail, which creates an enormous bang for your investment buck - good or bad. CFDs are essentially a way to get rich or go broke at warp speed. Due to the magnification effect of leveraging, unlike regular stock purchases, you can lose far more than your initial investment.

Since CFDs do not have an expiry date, unlike options which do expire, it might be thought that a retail investor with a long term perspective might for example, simply buy the TSX index long and hold on till the market eventually rises, making sure to keep plenty of cash around to meet the almost inevitable calls for extra cash to maintain margin requirements. However, there's a catch - long positions are subject to a daily interest charge as long as they are open. It is as if one has borrowed the whole amount (see section 2.1 of CMC's rates and fees). The interest rate on the notionally borrowed money is currently low - about 2.8% annualized by my calculation (just a bit less than discount broker BMOIL's 3.5% interest rate on margin debt and a bit more than the TSX 60's current dividend yield of 2.7% ... raising the question, unanswered on CMC's website, whether the Canadian version of CFDs pays out the dividend to the long investor as is the case for CFDs in the UK for instance) - but it still lowers returns and creates a disincentive to anything but short-term speculative day trading with CFDs.

The supposed hedging value of CFDs is minimal. If one takes an offsetting short CFD to balance against a long stock position one already holds, then one simply freezes the total value (excepting the inevitable costs) of the two holdings since a rise or fall in the CFD simply mirrors in the opposite direction the stock holding's movement. Most people think of hedging as downside protection, not both downside and upside. An investor is better off with a straight put option or a stop loss order.

About the only party sure to benefit from CFDs is the market maker CMC Markets, from collecting the bid-ask spread on buys and sells, the interest on open positions, trading commissions and other charges. It is ironic that CMC's website links to this Financial Post story which says that the founder and CEO of CMC Peter Cruddas is London's richest man (interesting isn't it that he is at the top of the Times 2009 online richest list just ahead of a some online gambling site owners). That's where you money will go folks unless you are one of the lucky few who play and win the CFD lottery.

1 comment:

Stephen Pinner said...

I found this somewhat of an insightful read, around with the online trading subjects in which it covered.

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