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CFD Accounts - The Mechanics, Advantages & Disadvantages
GillenMarkets is a subscription-vased website offering both investment training and independent advice on all matters surrounding stockmarket investing. In that regard, we have put together a summary of the opertaions, advantages and disadvantages of CFD (Contract-For-Difference) accounts.
When you open a CFD account you then have to fund the account. If you are a Euro-based investor, you will probably fund it with Euros. Likewise, for UK or US investors, they are likely to fund a CFD account with Sterling or Dollars respectively.
It's a Margin Facilty For Trading....Not the Same as a Mortgage on a Property
You deposit your Euros (or Sterling or Dollars) as margin. That can be to cover the full cost of your purchases in which case you are choosing not to use any borrowings (or leverage). If you deposit less than the cost of your purchases the CFD provider will top up the balance by way or a margin facility (same as a loan). The CFD provider will require a minimum level of margin to cover future price declines at all times. The level of margin required will differ depending on which stock(s) you buy. I think it is probably safe to say that on average a 20% margin is required but the margin requirement does vary from one provider to the next and can be influenced by factors such as the liquid in the stocks or funds (ETFs or Investment Companies) you are dealing in i.e. if you bought €20,000 worth of CRH shares but only deposited €4,000 into the CFD account, then you have a 20% margin in place and are leveraged five times against your position. If the price of CRH starts to fall, however, you will be required to top up the margin. If the price of CRH keeps declining you will have to keep topping up the margin or sell the stock out for a loss. If you take the margin calls to their ultimate, then for a stock that keeps falling in price you might as well have paid for it up-front. Hence, a margin facility via a CFD account should not be compared to a mortgage on a property. A margin facility is, in effect, a facility for short term trading i.e. gambling.
You can sell a stock or ETF or Investment Company short using a CFD account and the margin requirements are exactly the same in reverse. But if the price of the stock or fund rises then you will have to either top up the margin position or buy the position back.
You Will Pay Interest Either Way
If you use the margin facility within the CFD account then it will be in the currency of the stock or fund you have transacted in. For example, if you buy €20,000 worth of Coca Cola shares into your CFD account but intend to pay for the whole purchase with case, then your €20,000 will go on deposit with the CFD provider and you will earn something 1.0-1.5% below the relevant central overnight interest rate. The dollars required to buy the Coca Cola shares will be provided by the CFD provider and you and you will be charged circa 1.5-2.0% per annum above the relevant central bank overnight interest rate for what is in effect a borrowing facility. CFD providers, then, make their money mainly on the provision of the margin or borrowing facility. And even if you have transferred sufficient resources in to cover the full cost of the transaction, you will still be charged an interest rate margin i.e. there is no offset for monies on deposit.
When you go to sell your positions or buy back your short positions, the euros, dollars or sterling receipts go to pay off the euro, dollar or sterling facility. You can then withdraw the margin you lodged in the first place.
Covering the Foreign Exchange Risk
Because of the way a CFD account operates, it provides a natural currency hedge for you. For example, if you deposit €20,000 into a CFD account and then buy Coca Cola shares in dollars you are not exposed to the movement in the Euro/Dollar exchange rate. As the CFD provider has provided a dollar facility to fund the purchase of Coca Cola shares and you repay that dollar facility with the proceeds whenever you sell then in effect there is minimal exposure to the movement in the dollar compared to the Euro.
However, you can see from above that such a facility will cost you between 2.5-3.5% per annum even if you have lodged the full amount of Euros required at the outset.
Some Tax Advantages
For an Irish resident, all gains and losses can be offset with a CFD account. Hence, losses on ETFs can be used against gains on shares. This is not the case outside a CFD account.
Summing it Up
CFD accounts offer the facility to leverage but it is not the same as a mortgage on a property. Hence, the leverage facility offered is only suitable for short term trading. And as it is my long held view that few private investors can trade and make money then I must conclude that most investors should avoid CFD accounts. The ability to borrow in the currency that you are buying or short selling the stock or fund does provide you with an effective currency hedge...but for investors this hedge will cost you around 2.5-3.5% annually over the central bank overnight interest rate. For an Irish resident investor dealing in funds, then there are some tax advantages to consider. But you should also make enquiries from your CFD provider to make sure you are fully briefed on all aspects of a CFD facility before opening such an account.
8th August 2010