Rivkin Report - Module 06: Contracts For Difference

Introducing CFDs…

So what exactly is a CFD? Quite simply, a CFD is an agreement to be paid (in the case of a profit) or to pay (in the case of a loss) the difference between the price at which you open a contract and the price at which you close a contract, hence the term 'contract for difference'.

As an example, 'opening a contract' might be done by placing an order to 'buy 1000 CBA (Commonwealth Bank of Australia) CFDs at $52.00'. Once this buy contract has been opened, you can hold it for as long as you like, before closing the same contract at another price. If you close the contract at a higher price at a later date, you will have made money on the difference. If you close the contract at a lower price at a later date, you will have lost money on the difference.

The confusing aspect for many investors is that in the above example of buying CBA CFDs, you aren't buying actual CBA shares; so what are you buying exactly? You are buying contracts based on CBA and as such, the price of these contracts will move in line with the CBA share price. CFDs are a way of taking a view on a financial instrument, such as shares, without actually buying (or selling) that instrument. So why not buy the underlying instrument and forget about CFDs? We will get to the benefits of CFDs shortly! And so unlike shares, there isn't another investor as such on the other side of the trade. It is essentially you placing a bet on the direction of a financial instrument, and the CFD provider is the party taking the bet. The CFD provider may then choose to hedge their position by taking the same position in the physical market (ASX)… more on this later.

Beyond Australian equities, there are CFDs that offer exposure to the prices of domestic and international shares (e.g. Google, Microsoft, Royal Bank of Scotland), currency pairs (e.g. AUDUSD, GBPJPY, EURNZD), commodities (gold, oil, corn etc), bond markets (e.g. Australian 10 Year, Japanese Government, US Five Year T-Note), sectors (e.g. S&P Energy, US Banks, US Pharmaceutical) and domestic and international stock indices (e.g. ASX 200, Dow Jones, FTSE). CFD providers publish synthetic versions of these popular markets on their trading systems, which clients then use as a basis to open and close contracts.

The Long and Short of it…

CFDs offer investors the ability to not only trade 'long' (whereby you purchase a CFD and your trade will profit from an increasing price), but also to trade 'short' (whereby you sell a CFD and your trade will profit from a decreasing price).

'Shorting', or 'short selling', is a key characteristic of CFD trading, and is achieved by selling a position that you don't already own. For example, you might have a CFD portfolio that holds some cash but no open CFD positions. You might then sell 1,000 ANZ CFDs, in anticipation of buying back later at a cheaper price. The process involved is no different to buying ANZ CFDs, in terms of leverage and executing the order (it is different in terms of financing, but more on this later). This is all possible because the CFD provider will have-in the case of equities-stock lending agreements with third party institutions, known as Prime Brokers. So in contrast to the difficulties involved in shorting equities through a margin lender for example, short selling using CFDs is simple, fast and relatively cheap. This is an obvious benefit of CFDs.

Many investors query how one can sell something one does not already own. In terms of equities, this is true, and one can only do it through margin lenders who borrow the stocks from brokers and hence, pass the stock on to clients to allow them to sell. But with CFDs, since you are simply opening a contract and not selling a physical instrument as such, there is no problem associated with short selling, and hence taking the view that the price of your chosen instrument will go down and you will close (buy back) the contract at a lower price (hopefully).

Using CFDs for their leverage…

Another benefit of CFDs lies in their leverage. By nature, CFDs involve a client deposit plus leverage supplied by the CFD provider, which together make up the total exposure to a position. So one might want exposure to $50,000 worth of NAB; to achieve this (bearing in mind that a 10% margin is attached to NAB), $5,000 would be used from the client account and $45,000 would be supplied as leverage by the CFD provider. Just like a margin loan, an interest rate will apply (on the full $50,000 exposure, not just the $45,000 leverage) and, if the value of the security being used as collateral falls too much, the position might have to be sold down partially or fully to mitigate the potential for unmanageable losses.

Here is what the example above might look like in practice:

Stock: NAB

Order: Buy

Quantity: 2000

Price: $25.00

Total exposure: $50,000

Leverage provided: $45,000 (90%)

Initial outlay/margin: $5,000 (10%)

Interest rate: RBA Cash Rate (3.50%) + 3% = 6.50%

Overnight interest charged: $50,000 * 6.50% / 365 days = $8.90

As you can see from the above, as the margin on NAB is 10%, if one buys $50,000 worth of NAB, one will require (a minimum of) $5,000 in equity, and the leverage provided by the CFD provider will amount to $45,000. The interest rate with Rivkin Securities is 3% above the RBA Cash Rate (3.50% as at 25/11/09), hence the interest is 6.50%p.a. calculated daily. So 6.50% of $50,000 equals $3,250, which is then divided by 365 (days in the year) to arrive at the overnight interest charge of $8.90.

Important to note here is that if you are short a stock overnight, you receive interest as opposed to being charged interest when you are long a stock overnight. You would receive 3% below the RBA Cash Rate of 3.50% (so you would receive 50 basis points as at 25/11/09) on short positions:

Stock: NAB

Order: Sell

Quantity: 2000

Price: $25.00

Total exposure: $50,000

Leverage provided: $45,000 (90%)

Initial outlay/margin: $5,000 (10%)

Interest rate: RBA Cash Rate (3.50%) - 3% = 0.50%

Overnight interest received: $50,000 * 0.5% / 365 days = $0.68

If, based on the NAB purchase example above, you had $15,000 cash in your trading account before you placed the trade, the $5,000 deposit would be taken, leaving you with $10,000 in what is known as 'free equity'. When the share price starts to move, the dynamics of your trade can change swiftly, because you are using so much leverage. Below are two examples: one where the price has moved up and one where the price has moved down:

Initial deposit in account: $15,000 / $15,000

Order placed: Buy 2000 NAB @ $25.00 / Buy 2000 NAB @ $25.00

Margin required: $5,000 / $5,000

Leverage provided: $45,000 / $45,000

NAB exposure at purchase: $50,000 / $50,000

NAB stock price after 10 days: $22.00 / $28.00

Gross exposure after 10 days: $44,000 / $56,000

Margin requirement after 10 days: $4,400 / $5,600

Current free equity: $4,600 / $15,400

In the first column, the position has moved against you and if the position is closed out here at $22.00, you will be left with your initial account balance minus your trading loss of $6,000, leaving you with $9,000 from your initial $15,000 deposit.

In the second column, the position has moved in your favour, and if you close the contract at $28.00, you will be left with your initial account balance plus your gross profit of $6,000, leaving you with $21,000.

For simplicity, funding costs have not been calculated in this scenario; however, funding charges would amount to approximately $85 for the 10 days held.

Margin, Free Equity, GLV and LVR…

At this stage, it is worth explaining how margin requirement, free equity etc are calculated. Firstly, if, as per the example above, an investor opens a CFD account with Rivkin Securities and deposits $15,000 in the account, prior to opening any positions (buying or selling any CFDs), they have free equity of $15,000, as no money is required as margin to cover any positions. So the $15,000 is free and clear.

If they then buy the 2000 NAB at $25.00 ($5,000 of their $15,000 is required as margin as NAB has a 10% margin), while NAB's share price is still at $25.00, they still have a $15,000 gross liquidation value (GLV), but free equity has changed. As $5,000 of their $15,000 is required as margin, free equity is now only $10,000 (despite a GLV of $15,000).

If NAB then goes to $28.00, the investor is up $6,000 on the trade. The margin requirement has changed, as the gross exposure is no longer $50,000; it is now $56,000 (2000 NAB at $28.00). So the margin requirement is now $5,600, which is 10% of the gross exposure (which has increased). Free equity too has increased. Since free equity is the gross liquidation value (GLV) minus the margin requirement, free equity is now $15,400, as the GLV is now $21,000 (the $15,000 initial deposit plus the $6,000 profit on NAB) and the margin requirement is $5,600.

Some CFD characteristics…

It is important to remember that because you will simply own a contractual agreement regarding a price and never a part of a company, barrels of oil or index futures, for example, you won't have the same privileges that the holder of the underlying security or physical asset will. These differences include:

• Dividends are paid (if you are long) or payable (if you are short) in cash on the day that the stock goes ex, rather than roughly a month later as with most stocks
• No franking credits are attached to dividends
• You won't be on the share register
• You cannot vote at company meetings
• You won't receive annual reports etc.
• For OTC orders, you will not see them in the market depth when you place an order

The Different Types of CFD…

It's very relevant to outline the differences between Over the Counter CFDs (OTC) and Direct Market Access CFDs (DMA), and it will become apparent that there are advantages to both CFD types. Also worth noting is that the term OTC is a bit misleading, because it should be understood that regardless of which market you trade in, CFDs are always 'over the counter', as you are opening and closing agreements with an intermediary rather than trading on an exchange.

Let's look at DMA first. A DMA CFD market ought to be perfectly hedged, meaning that when you enter your order to buy 1,000 ANZ at $22.00, for example, an order to buy 1,000 ANZ at $22.00 will appear in the underlying market, in this case the ASX. It is the closest experience you'll have trading CFDs as though they are a physical equity, in terms of the trading experience.

The bottom line for DMA is that you get complete price and volume transparency. You can also make or take a price by placing your order in the market depth rather than being forced to be a price taker and having to hit the bid or the offer - this means you can trade the match price on opening and closing rotations, which you can't do on OTC CFDs.

Moving on to OTC CFDs… a more accurate way to describe what will be commonly referred to as OTC CFDs is Market Maker CFDs. Why? DMA CFDs take their prices, depth and volume directly from the underlying market. OTC CFDs are offered by a market maker, whereby a CFD provider makes their own market for CFD prices, which may or may not be exactly what the underlying security is priced at.

In addition to this, you cannot make a price on an OTC CFD platform; rather you must take the price that is being offered. So if Leighton Holdings (LEI) is $35.22 bid and $35.27

offered, you can't jump the lead bidder and advertise a new price at $35.23 like you can with DMA CFDs. You must either hit the offer at $35.27 or wait until the offer price moves down to $35.23 before you will be potentially filled at that price.

One of the most common misunderstandings about OTC CFDs is the way in which orders sometimes get filled. Because you might be watching the underlying market (e.g. ASX market depth on the Rivkin Securities website) but trading a synthetic market created by the market maker, there is a gap in the information you have access to. As referred to earlier, even though you might see 1,000 ANZ at $22.00 being bid for on the ASX market depth, there might be 25 stop loss/sell orders waiting to be triggered to sell at market if ANZ trades at $22.00. So if the price hits $22.00 and the CFD provider needs to hedge in the physical market in to fill those 25 sell orders plus yours, they may be required to sell down to $21.95 and you'll be at the back of the pack. Either that or the CFD provider might simply refuse to fill your order, depending on whether they requote or refuse.

It is important to understand how OTC CFDs work before trading them, as it's often the case that one bad experience caused by the difference between what you see in the underlying market and how your order is filled on the CFD provider's market will turn people off these CFDs for good!

Retail CFD clients will invariably be subjected to a large level of opinion about whether DMA is better than OTC, or vice versa. This is because each CFD provider tends to have a particular focus on one platform. Rivkin has a fortunate philosophy that relates to our very simple mandate of making members money. So if we believe we can achieve positive absolute returns from a product that sits in a DMA environment and not an OTC one, we'll trade the DMA. If a market exists on an OTC platform that we can't find on a DMA platform, we'll trade the OTC.

Below is a comparison between the two CFD product types. This should be used as a general guide, as different CFD providers cover different markets and use different platforms.

Tradeable markets

DMA: Chiefly ASX, but theoretically any exchange traded security

OTC: Includes but not limited to: domestic and international equities, currency, bonds, commodities and options.

Trading platform

DMA: Chiefly WebIRESS (between $80 and $160 per month, depending on CFD provider)

OTC: Proprietary web-based and executable software, differs between providers (around $50 per month, depending on market data being sought)

Commission

DMA: Generally between 10 and 15 basis points of the total exposure size + overnight funding charge

OTC: Generally between 10 and 12 basis points of the total exposure size OR a spread issued by the market maker + overnight funding charge

Margin/deposit required

DMA: Anywhere between 10% to 100%, depending on the size and liquidity of the ASX stock

OTC: 3% and upwards on shares, 0.5% and upwards on products such as indices and FX

Trade match price on open/closing rotation?

DMA: Yes

OTC: No

Can I make and take a price?

DMA: Yes, you can make a price and offer it to the market or take the price that the market is making

OTC: No, you can only take the price offered by the market maker

Trade 'long' or 'short'

DMA: Yes

OTC: Yes

Initial deposit to open an account

DMA: $5,000-$10,000

OTC: ~$500

Summary…

CFDs, while not the instrument of choice for investors seeking to build a long term portfolio of stocks and make use of franking credits, certainly have their place in an investor's arsenal. The ability to trade hundreds of ASX shares using only a fraction of your capital to fund your full exposure, as well as the opportunity to short sell and hence hedge certain holdings as per The Rivkin Report's recommendations, make CFDs quite a compelling investment tool.