Contracts for Difference – Are the Dominoes Toppling?

Have you ever experienced the gloom of watching the stockmarket take a dive, but been unable to benefit from the fall in share prices? Or how about the opposite problem, spotting an undervalued stock that you think is going to shoot up, at a time when you can’t release enough cash?

Anyone who has ever wished they could have the potential to profit from rising or falling share prices, cannot fail to be excited by the potential offered by Contracts for Difference (CFDs).

To some people CFDs can sound rather complicated but in reality they are very simple and work in a similar way to ordinary share dealing with a range of additional benefits and features.

One benefit of trading CFDs is that you get the opportunity to take a larger position than you normally would if trading ordinary shares for the same outlay. When trading shares your broker will usually ask you to pay for the full amount of the transaction. With a CFD deal you will only be asked to make a deposit on the deal,which initially can be as low as 10% of the transaction value. As an example this means that you can access the equivalent of £10,000 worth of shares for an initial deposit of just £1,000.

CFDs also allow you to benefit from any market condition providing you deal the right way. Not only can you profit from a rising share price by ‘going long’ you can also profit from a falling share price by ‘going short’ (i.e. sell a CFD you do not own). In these volatile markets going short can enable you to make profits where trading ordinary shares may not.

The best part of all about trading CFDs is you don’t pay any stamp duty, which effectively removes one of the largest costs you face when trading ordinary shares.

A well kept City secret for the past decade, the benefits of CFDs are now being discovered by large numbers of sophisticated private investors.

They are now becoming so popular as a way to benefit from short term stockmarket volatility, that some estimates put the volume of CFD trades at more than a third of all London Stock Exchange share deals!

Are the dominoes toppling?

Borrowing to invest, known as “gearing” or “leveraging”, greatly magnifies the potential gain on derivative products such as contracts for difference (CFDs), but it also magnifies potential losses.
CFDs allow investors to borrow up to 20 times the collateral they have to invest. If the market smiles on the investment, the gains on the collateral invested are enormous, but the fallout can be equally as deadly if the market turns down.

CFDs are equipped with “stop loss” features, where an investor pays to put a floor under losses, but recent experience has showed many investors had become so complacent with strong markets they did not have effective stop losses in place. He said CFD brokers were making huge numbers of “margin calls”, or demands for money to top up funds to cover losses, in order for traders to hold their positions.

If you play the non-margined buy-and-hold game, you can pretty much sit back, take advantage of share price weakness and wait for this bad patch to end before reaping the rewards later on.

Well that’s the theory anyway

When trading on margined accounts and – for the purpose of this article – on contracts for difference (CFDs), you have to be on your toes during periods of high volatility.

Too many long positions and little in the form of a cash buffer can soon put you into the margin call territory, where your broker will contact you to top-up your account to maintain your portfolio in its current form.

Too many short positions in the earlier part of February could have placed you in a similar scenario.

Is it all Gloom and Doom?

You have to remember that a geared instrument is not for a chap that’s putting away his USD200 or his USD2000, planning for his retirement. It’s not for that type of person. A geared instrument gives one increased potential for return, but there is a price to pay. You have increased risk. So if one looks at the private individual that is saving for his retirement, there is a vast array of products out in the market that are suitable for that. A CFD is not suitable for that. If he has a large portfolio that he then wishes to hedge, because he thinks on a day like today the market’s going to fall and he wants to take advantage of that, instead of selling out his underlying portfolio he can now enter into a CFD, or a future or several other derivative contracts – he can enter into one of those derivative contracts to protect his existing portfolio. And it’s actually a key point to make.

Recently there was a study done in the States where they compared the returns of a portfolio of blue-chip stocks where, on a predetermined date, $1000 each month was put into that, versus a managed geared fund. And the portfolio that had the repetitive investment in that underlying product did far better than the professionally managed investment. So there are two sides to that coin, and as a private individual one needs to be clear what your objectives are. You do not want to be speculating with your mortgage payments. You do not want to be speculating with money raised on your mortgage.

Now this is exactly what was happening in China. China has looked back at the Japanese example. What happened in Japan in the eighties was that you had this massive rise and this massive run in property values. What people then did – corporations and individuals – they then used that increase in equity, they then withdrew that cash, used that cash to enter into geared instruments on equities, which then resulted in this massive exposure. What then happened is of course the property market unwound, the stock market collapsed, and you have the legacy nearly 20 years later that the Japanese economy is still trying to work out those bad debts, bad loans. I think they classified in the polite term as “non-performing loans”.

Working Capital Lines of Credit and Loans That Work – Not Just For the Bank!

When business owners and financial managers have successfully negotiated working capital facilities or term loans it should not be the end of the story. By that we mean that the business person needs to continually focus on what the bank or other financial institution requires, and more importantly, how they view the customer from a control point of view – i.e. are they in control or able to exert control on your business.

The balance sheet must be a top focus for the business owner – once a firm is over leveraged, i.e. borrowing too heavily, the bank generally starts positioning around their overall security or your ability to de-leverage.

Borrowers must be comfortable and knowledgeable about the use of ‘triggers ‘. Triggers are the implied actions the bank or institution will take when things aren’t working out. This can include everything from general poor financial performance to very specific pre agreed upon financial ratios. And the business owner must remember that he or she agreed to and concurred with these ratios.

Banks want to see cash flow ‘ flowing ‘ – flowing to repay their debt – so there many be triggers put in place by the bank to ensure that minimum cash flow standards are kept, and also that owners and shareholders do not withdraw excess funds.

Over time business owners will probably find, in our experience, that the bank restrictions either tighten up or loosen, depending of course on the overall comfort level the bank has with the firm. Clearly firms that seem temporarily challenged in profits and balance sheet quality will receive much more scrutiny.

Business owners can do some very solid and valuable preparatory work in negotiation of bank triggers. If they have a solid long term history of earnings this should be a very strong negotiating point with the institution. Simply by self introspection of the firm can the owner or financial manager focus on what is going to go wrong re sales, pricing, forex, etc. The owner needs to be able to talk to these issues and show how he could address them.

For a start calculate your own key operating ratios, if they are going to be discussion points with your bank or institution you might as well know your numbers now. Using ‘what if ‘scenarios help immensely and will position yourself as knowledgeable about your business.

Discussions with your bank need not be absolute and immediate on any time of loan negotiation – you can get a great informal sense of what the bank is thinking and work from that point forward. Try and read between the lines as to what is hot, and what a Vis is not with the bank Vis their perception of your firm, industry, etc.

In summary, business owners need to show maximum flexibility on working capital and loan negotiations. Negotiations should be from strength, accentuating the positive. Example – strong forecast sales and profits and potentially offset a weaker balance sheet. Trade-offs with the bank is also encouraged- and fewer triggers and covenants are better than more! And yes, there is more than one bank in the world, although business owners should be cautioned that shopping around is not optimal at all times, and can in fact backfire, particularly a small business. Business owner beware!