The recent market volatility has raised the question of whether Contracts For Difference (CFD) are simply dangerous weapons in the hands of unseasoned investors, un-used to market volatility, or a useful instrument to manage risk.
On one hand investors have been warned by Hobs Mojalefa, head of dealing at Barnard Jacobs Mellet Private Client Services, that those suffering equity losses recently, should avoid a casino mentality by using CFD to get their money back.
On the other hand, Charles Savage at Global Trader says that rather than single out one instrument, one should rather concentrate on the market conditions and events that have caused this volatility and sell-off, identify the opportunities and potentially profit or protect your portfolio from these circumstances.
There are a host of instruments including single stock futures, warrants and currency futures, to name but a few, that are open to similar misrepresented opportunities or avenues of guaranteed returns. “The message simply is make sure you fully understand the risks and benefits of what you are investing in or through.”
Savage says that since the October 2007 highs, to the January 2008 lows, the all share index (ALSI) has retraced 25%. During the same period the VIX (volatility index) has experienced an 85% increase.
With perfect hindsight investors could have purchased volatility as a hedge to long market uncertainty or alternatively shorted the ALSI or a basket of equity CFD’s that best represented your long only portfolio, the point is that with instruments like CFD’s the opportunity to profit from adverse or volatile market conditions or hedge long only portfolios through are real.
It is reported that CFD’s account for more than 30% of underlying volume on the LSE. This, according to Savage, bears testament to the intrinsic benefits of investors trading CFD’s that is transparency, lower execution cost, ability to go long and/or short, broader asset class coverage and simplicity.
Mojalefa echoes some of Savages’ sentiment when he says that “CFD as a defensive tool in a wider strategy, often makes a lot of sense, rather than the simplistic use of CFD as a quick fix, which then has the potential to multiply your losses.”
Savage notes that CFD’s like other derivative instruments come with a risk warning and adds that CFD’s are the least complex and therefore most investor friendly method of investing through derivates,
Savage added, leveraged instruments by way of their nature magnify the risks of investing in financial markets and as such should be carefully considered and fully understood before using.
Did you know?
A CFD is a geared over-the-counter product. The contract is a proxy for direct ownership of JSE shares. A key benefit is leveraged exposure to the equity market at lower cost than direct share dealings. Gearing (using borrowed money to multiply potential gains) can be as low as 8%, but might be much higher. Bare in mind that gearing can multiply losses as well as gains, however.
One CFD strategy is to take a contract that ‘shorts’ an underlying security. In effect, the contract owner ‘borrows’ a share and ‘sells’ it, with the view that the underlying price will fall so he can buy it back, return it and pocket the difference.