Profit from price falls

You can cover bases and hedge your bets by using an equity derivative tool called a contract for difference, or CFD – and you don’t even have to hold the underlying security. By JAMES DUNN.

By James Dunn

Most investors know that the sharemarket is one of the most reliable generators of wealth over the long term. But the wealth-creating power of the market can be compressed into a matter of days – even hours – if you have the stomach for the volatility.

Speculating on the sharemarket has never been easier. In the past few years a couple of new financial products have emerged that offer simple leveraged punting on the likely direction of share prices and indices, commodity prices and exchange rates.

The first of these is a contract for difference (CFD), an equity derivative that represents a theoretical order to buy or sell a certain number of shares. The price of a CFD is derived from the spread – the highest buying price (offer) and lowest selling price (bid) that is quoted on the Australian Stock Exchange (ASX) – so the value of the CFD mirrors the share price.

An investor buying a “long” CFD benefits from a rise in the share price, while a “short” CFD gains its benefit from a fall in the share price. The investor’s profit or loss is determined by the difference between the opening and closing price, with the difference paid in cash at the close of the contract.

In this way, CFDs allow speculators to “short-sell” (sell without owning) much more easily than on the stock exchange. CFDs allow traders to leverage an investment with a deposit of as little as 3%.

CFDs are much more transparent and easy to understand than existing equity derivatives such as exchange-traded options (ETOs) and warrants, and individual stock futures (ISFs). The problem with options and warrants and futures is that they’re all priced in quite a complex way, which is quite difficult for many investors to understand.

Options and warrants incorporate the concept of time decay: you’ve got to understand delta, gamma, theta and vega, which are all measurements of various aspects of the relationship between the price of the underlying asset, the price of the derivative, and time. Frankly, the subject is beyond most people.

A CFD doesn’t have any need for these esoteric concepts, nor does it have a built-in loan, as with warrants. A CFD is much easier for investors to understand. You buy it as you would a share, and it moves identically with the underlying stock.

CFDs are also cheap. On trades up to $10,000, providers charge commission of $10. Above $10,000, the charge is 0.01%. That makes CFDs just about the cheapest leverage available in the sharemarket. CFDs are offered on more than 400 companies listed on the ASX, but they are not a listed product or an ASX product.

CFD providers include IG Markets, CMC Markets, E*Trade, Macquarie, Man Financial, Marketech, L Quay, Sonray and Tricom.

Binary CFDs, introduced in March 2005 by CFD issuer IG Markets, are even simpler than normal CFDs. A binary CFD simply represents the probability of a discrete event – such as the market finishing up or down on the day.

IG Markets quotes a price on that probability of between zero and 100. If the event occurs – in this case, the S&P/ASX 200 Index closes higher on the day – the trade settles at 100; if the event doesn’t occur – the index closes lower – the binary settles at zero.

The binary CFD is a probability index that changes in real time: you’re punting on a simple probability of directional movement. Binary CFDs are also quoted on other sharemarket indices, as well as currencies and commodities.

Spread betting is even simpler, because our speculator is not even buying a derivative product – he is simply betting that the price of a share (or index, or commodity, or exchange rate) will go up, or down. The punter doesn’t transact on the ASX: the bet is made with the bookmaker. The bookie’s spread will be based on the current selling quote and a future buying price that it determines.

The investor uses this price to bet on the direction of the share price or index value. If he thinks the price will rise, he makes an up bet from the quoted offer (the selling price); if he thinks the price will fall, he makes a down bet from the quoted bid (the buying price).

The amount wagered can be as little as $5 a point (one cent), which is the equivalent of owning 500 shares. If the share price rises, the investor wins $5 for every point (or cent) it gains: if it falls, the loss to the spread bettor making an “up bet” is $5 a point.

Traders can take their profits, or cut their loss, at any time. Spread betting is leveraged speculation, with punters having to lodge a deposit equal to 10% of the full value of the underlying contract.

Spread betting allows investors to back their judgement in financial markets, without having to buy or sell the shares. You can place a “bet” on which way the price will move. You never actually own the shares: you’re only interested in the price movement. Clients can bet on shares going up as well as down.

No commission is charged on spread betting: IG makes its profit from the spread it charges. Clients can place a pre-determined maximum possible loss on each bet without affecting the ability to make unlimited profits. And the beauty of spread betting is that any profits made are free of capital gains and income tax – but nor are any losses tax-deductible.

The Australian Taxation Office says that the issue of the tax status of spread betting is “still being looked at”. IG Index – the only licensed financial spread betting company in Australia – recommends that investors seek their own tax advice.

IG Index says spread betting customers are typically retail punters betting $5 to $10 a point, but the bookmaker also has clients that bet up to $1000 a point: that sort of client is most likely using spread betting to hedge a share portfolio against price movements.