How Cfds Work

Sydney Morning Herald

Thursday November 15, 2007

SH

CFDs are simple products, says IG Markets' chief operating officer, Tamas Szabo. It's just the mechanics of them that can make them seem complicated.

A CFD is merely an agreement between two parties (usually an investor and a CFD provider) to settle the difference between the opening price of a security and that security's closing price, at some point in the future.

When you enter a contract for difference, you do not buy the underlying security. You only have to put up a small percentage of the value of that security - it may be as little as 5 per cent.

Say you want to buy CFDs over 1000 shares in Insurance Australia Group (IAG). The share investing advisory group, Fat Prophets, says IAG looks like good value at current levels ($4.79 at the time of writing) and believes the share price could move above $5.35 in the foreseeable future.

To buy CFDs over IAG shares, you'll have to put up 5 per cent of $4.79, or 23.95 cents, for each CFD. That's $239.50 in total for 1000 CFDs, providing exposure to 1000 IAG shares, and compares with the $4790 you would have to pay to buy the 1000 IAG shares directly.

One of the key characteristics of CFDs is leverage, or debt. When you put up 5 per cent of the value of the underlying security, you effectively borrow the other 95 per cent from your CFD provider, to gain full exposure to the underlying securities. In this example, you put up $239.50 and borrow $4550.50.

You have to repay these borrowings when you close your position, and you have to pay interest on the amount you borrow.

(There are costs associated with buying shares directly, including stamp duty and brokerage. There are also costs associated with trading CFDs. For the purposes of illustration we've ignored transaction costs - partly because they can vary considerably, depending on how you go about your investing.)

Over a period of time the share price of IAG will move. With a CFD you can invest in the expectation of a move being up or down - it makes no difference, so long as it goes the way you expect.

Let's say you expect the IAG shares to rise in value, in the direction Fat Prophets expects, and at some point in the future - it may be days, it may be weeks or it may even be months from now - the share price reaches $5 and you decide to take a profit.

At that point you close your CFD position. The 1000 IAG shares are worth $5000. Your CFDs are worth the same amount. You repay your borrowings ($4550.50) and you've made a gross (that is, before interest costs) profit of $210. That's the same profit as if you'd held the shares directly. But your initial outlay was only $239.50, so your $210 profit (before interest costs) represents a profit on investment of almost 88 per cent.

However, in the same way that the leverage effect boosts your returns, it can increase your losses if things go wrong. Were the IAG shares to fall in value instead of rising, the investment result would be quite different.

Say the share price fell 20 cents to $4.59. You put up $239.50, and borrow $4550.50. After some time you decide to close out the position; your CFDs are worth $4590, you have to repay the borrowings, and you have a loss of $200 ($4790 minus $4590).

Because your initial outlay was $239.50 the effect of gearing is to magnify your percentage loss from 4.2 per cent (if you'd bought and held the shares directly) to 83.5 per cent. Gearing, the investor's best friend when markets move the right way, can become a nightmare when the market moves the wrong way.

© 2007 Sydney Morning Herald

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