It’s not easy making money. We all know that. Few of us discover until later in life that it’s equally difficult to hold on to.
As a Zurich Club member, you have made a valuable decision to join a network where you are privy to financial information unavailable elsewhere — to help make the most of your hard-earned cash. Investment, though, involves risk and sometimes that risk goes unrewarded, or worse, leaves you with a hole in your savings.
Successful business people and professional investors accept risk as a fact of life and a natural obstacle to overcome on the path to achievement. However, they take every opportunity to offset the risks they are taking without ever losing sight of their objective. The pros know that avoiding losing money is at least as important as making it. Such an approach is highly relevant to your investment strategy.
Have you ever owned a company’s shares over a considerable period and followed its ups and downs in the market? After a time you get a feel for when the price is falling behind (too cheap) and when it gets ahead of itself (too expensive). Sometimes perhaps the market ignores the company for a period and at other times it gets overexcited about its prospects. Have you ever thought how you can use this knowledge to further profit from the investment? Well, if you haven’t, here’s an idea to build into your investment thinking.
The idea I’m talking about is called Contracts for Difference (CFDs). CFDs have seen explosive growth in the last few years. When we last reported on them in October 2002 they accounted for 20% of the daily business transacted on the London Stock Exchange. Today they account for 35%.
How You Can Make Money When a Share Price Falls
This is a little complicated but well worth the effort.
CFDs are an alternative way of profiting from the rise or fall in the price of a financial instrument (share; index; currency; etc). Note the word ‘fall’. This is important as it is a key attraction. It opens the door for you to profit from falling stock markets as well as rising ones. Profiting from falling prices is called ‘short selling’.
A CFD is a type of financial ‘derivative’ and essentially a short-term speculative trading tool designed to make fast profits. This means the viable life of a CFD is measured in days and weeks rather than years.
With this useful tool you can bet on the likely direction of a price over a short period of time and decide when to enter and exit the trade. A profit is made from a favourable change in price (ie. betting the right way up or down) between the start and end of the trade.
As well as introducing the idea of short selling a CFD permits the investor to trade ‘on margin’ which we will return to shortly.
Before continuing, and to avoid any misunderstanding, we’re not endorsing you start a feverish day-trading operation. What we’re exploring is where CFDs might be used soberly either to manage risk or speculate on anticipated short-term price movement.
Professional Investment Strategy : How to Profit For A Fraction Of The Cost
Let’s assume you’re bullish on BP plc and want to buy 1,000 shares. BP’s current share price is:
Bid 559.5p
Offer 560p
Option 1 — Buy 1,000 BP shares
COST: 1,000 x 560p = £5,600
Option 2 — Buy 1,000 CFDs in BP
Value of the transaction: £5,600 (as above)
Required margin: 10%
Minimum cash ‘margin’ required:
£5,600 x 10% = £560
Five weeks later the price of BP has risen to 590p (bid price) and you sell — your shares or your CFDs. On either transaction, you have made 30p per share profit (ignoring costs), a total profit of £300 on 1,000 shares.
In Option 1 you used £5,600 to generate this profit, a return of 5.3%. In Option 2, you used a tenth of that sum — £560, a return of 53% excluding borrowing costs incurred while trading on margin.
Please note this simplified example excludes dealing costs and stamp duty.
The CFDs in Option 2 have captured 100% of the profit potential for a fraction of the capital allocation required to achieve it.
Short Selling Made Easy
This principle also works in reverse. You’re bearish on an investment and wish to profit from the anticipated fall in price by selling short.
You think the UK mobile operator Vodafone (VOD) is due for a slide. Using CFDs, you short-sell 1,000 Vodafone at 140p. This gives you a short position of £1,400 in Vodafone (1,000 CFDS x 140p entry price). In effect, you are selling something you do not own, in the belief you’ll be able to buy it back cheaper in the future.
One month on, Vodafone is trading at 125.75p/126p. You decide to close his position and buy back 1,000 Vodafone CFDs at 126p. The share price has dropped 10%, from 140p to 126p, so has made £140 (10% of £1,400) profit on the trade excluding borrowing costs. With CFDs it is just as easy to profit from falling share prices as it is from rising ones.
Getting More Bang For Your Buck By Using Leverage
In addition to being able to trade both long and short, the ability to trade on margin means a little can go a long way with CFDs. This feature means you need tie up only a fraction of your investable cash to make an investment. In the case of CFDs this is usually between 10-20% but can be as low as 5%. Leveraging your money in this way magnifies both profits and losses. Judicious use of this facility is essential and the use of stop losses a must.
As demonstrated in the example, the advantage of margin trading over traditional share dealing is that less of your capital is tied up in each individual transaction, meaning you can pursue a greater number of investment opportunities.
This facility, however, comes with a sizeable financial health warning. If a CFD position becomes loss-making you may be required to top up your margin to maintain your position ‘open’.
Cheap International Dealing
CFDs can trade internationally including UK, US, European, and Asian shares, indices, commodities and treasuries.
Other reasons CFDs are attractive to investors is for their cheap dealing costs. Unlike normal share transactions, deals do not pay stamp duty (0.5%) when buying and selling and often brokers charge no commission.
Using CFDs To Hedge An Existing Investment
Returning to our long-term investment hold. One way you can use this idea with CFDs is to hedge existing investments. This is something that is commonplace among large institutional investors, but has been a difficult thing for private investors to implement — until now.
Let’s assume you have a core holding in one of our recommendations, UK mining company BHP Billiton (BLT). You have 1,000 shares in this company but no intention of selling in the short-term. However, you know the company is due to announce end of year results in a month’s time so there is the potential for some news which may adversely affect the share price, reducing the value of your holding. You want a way of riding out what you perceive may be some short-term weakness.
You short sell 1,000 BHP CFDs at 715p. If the results come out and the share price falls, your shareholding will drop in value, but your CFD position will show a profit. If the results mean the share price rises, your CFD position will show a loss but your shareholding will balance this out with a corresponding profit. You are hedged whatever happens.
You may decide that if the share price goes through 800p then any risk of short-term weakness has been eliminated. You could set a stop loss on your CFD trade to close it out at 800p. At this point, the short is closed and the hedge is no more — the only position you have in BHP is your 1,000 shareholding. You may also decide that any short-term weakness will not go much lower than 650p. You could place a limit order to buy back the 1,000 CFDs at that level, realising a profit on that trade and again closing out the hedge.
Another approach you may take ahead of this announcement is to only initiate a CFD trade if the price moves through a certain level. You decide that if the share price breaks the 650p level they could drop a lot further.
You place a stop order to sell 1,000 CFDs at 649p. This way, if the BHP Billiton share price falls to 649p, you will be short 1,000 CFDs. If the share price continues to fall, the loss you make on your core shareholding will be balanced by the profit made on the CFD position.
CFDs are not just for highly active day traders, they should be an important part of any investor’s armoury.
What Else Do You Need to Know?
When it comes to dividends, long positions in CFDs will receive a credit to reflect receiving the dividend, short positions will be debited to reflect paying out the dividend.
Use stop losses to limit the downside. You may be confident you’re right but never expose yourself more than you need to. Both profits and losses can rack up quickly.
Profits from CFDs are, like shares, taxable as capital gains. This is good news as there is an exemption of £8,500 this year before tax is chargeable.
Although dealing costs are low, charges are incurred during the life of a CFD to pay for the borrowing costs incurred when trading on margin. You are effectively borrowing money from your broker and being charged interest on it. This is usually based at a rate linked to LIBOR (London Inter-Bank Offer Rate), recently 4.88%. As a result, there is a definitive point at around three months when it becomes cheaper to hold the underlying shares than the CFD.
CFDs used wisely can be a great way of making your investments work harder and capturing near term expected price movement whether shares are moving up or down.
