Contracts for Difference
Sooner or later, if you are a serious investor or trader in Australia, you will be confronted with a decision about whether to use an increasingly popular form of trading known as “Contracts for Difference” (CFD).
It is impossible in a brief post to do more than make a few points of importance and interest, that may be of significance to other retail investors. It is hoped that readers unfamiliar with the topic will undertake their own research.
London corporate financier Brian Keelan is credited with using his skills as a derivatives trader to develop in association with mathematician Jon Wood a product to assist the giant UK engineering and construction conglomerate Trafalgar House in its hostile bid for utility company Northern Electric PLC. This was in early 1995. The new product was used to lower the share-price from around the initial offer price $17.60, to $14.37 in the expectation that the target company would be forced to accept a lower bid.
CFD’s have become increasingly popular with retail traders in Australia, and in many other countries (not in the USA) since their introduction about a decade ago.. A major reason for their appeal is as the only legal technique for retail traders to exploit a falling market by ” going short”. In shorting strategies, securities not owned are sold in the expectation of being able to buy them back at a later date more cheaply.
Two arrangements are available from providers.
The commonest is termed “Over The Counter”. The Buyer and the Provider enter an agreement for profit or loss from the price movement from the time of purchase and the settlement time. The Buyer does not acquire ownership of a physical security, and there is therefore no transaction on any stock exchange. The beauty of OTC trading is in its flexibility, in enabling traders to trade almost any market, at almost any time of the day or night.
“Direct Market Access” in which every transaction is backed by the purchase or sale of the security on the stock exchange is available but is limited to only a few of the leading stocks here in Australia. This is the form of trading used by the ASX itself. The bid and sell bids then reflect the exact bids of the stock exchange,
The opposition to OTC trading in the United States dates from abuses that were rampant in the “bucket-shops” at the turn of the century. Another consideration is that OTC trading diverts significant revenue from the regulated stock exchanges.
My personal experience with CFD’s
I got off to a bad start with CFD’s, going long on banks in Nov 1987, just as the GFC broke, and hung on too long to loosing positions. I never quite recovered. I also got caught in the second down-turn of the ensuing bear market. The failure of MF Global was the last straw. I decided that CFD stood for “Capital Fleecing Derivative”
I developed a love/hate relationship with CFDs. The charts are magnificent, it is a true test of one’s trading aptitude, and it was a real blow to my pride to admit defeat. However record keeping is a nightmare, the rules are complex and a deterrent to holding positions for a long-time. I became frustrated with having positions that would have become profitable, constantly hit by short-term traders, closing out my positions.
Since I largely depend on the equity market for income, I felt I could not afford the losses, which often came just as I was savouring success. I was spending a lot of my time and nervous energy for little return, researching and following my trades. Another consideration for me was my age and some medical issues. I did not wish to leave my wife with a headache and a loss in the event of my passing or incapacity.
I’m sure I learned a lot from my dalliance, such as:
- how hard it is to be sure of the direction of market movement, and the duration of impulsive moves,
- the hazards of holding over-night positions in geared short-term trading.
- some of the strengths and pitfalls in using TA
- it made me more conscious of the need to take into account the needs of other market participants, and to be aware of their activities
- it was interesting to note the activities of short sellers entering the market fray often just after lunch, or before close. The share-price might be stable, perhaps just above support, when short sharp bursts of short selling push the price below support triggering further stop/loss selling.
- it made me aware of how difficult it is to profit from intra-day trading. With high frequency trading we now have institutions creaming off a few cents from trades, not adding a great deal to transaction costs, but beating day-traders at their own game, and diverting revenue from the stock exchanges. The strength of the retail investor lies in a willingness to be more patient for profitable moves.
- IG Tops CFD Market in Australia for Fifth Year Running (prnewswire.com)
- CFD Trading Is A Simple Way To Understand Stocks And Shares (cfdtradingeducation.wordpress.com)
- Over the counter, into the bucket – Buyer be aware. (technicality.me)
- CFD Trading For Dummies (cfdtradingeducation.wordpress.com)