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Long and short of CFD

If you are experiencing high commission costs, tardy executions, wide bid/offer spreads and stamp duty, then equity contracts for difference are well worth considering as an alternative to conventional share-dealing.

CFDs have been around for some years but until rec ently were available only to institutions. That has changed with major growth in the number of individual inves tors using CFDs.

More and more IFAs with high-net-worth clients are finding this is a suitable product in which to invest a small percentage of a client&#39s portfolio as the returns can be very rewarding.

A CFD is a total return equ ity swap but do not be put off by the technical description. The reality is quite simple – a CFD is a straightforward financial instrument designed to replicate both the economic performance and the cashflows of a conventional physical share investment. All this is achieved without having to buy or sell shares. It is an agreement made between the buyer and sel ler to exch ange, at the closing of the contract, the difference between the opening and closing prices of a share multiplied by the number of shares – the contract value.

A buyer of a CFD (des cribed as going long) will see a profit if the contract value increases. Conversely, a sel ler of a CFD (described as going short) will see a profit if the share price falls.

Commission on a CFD is typically charged at 0.25 per cent on the opening and closing. No stamp duty is payable on the purchase as you are not buying shares, a saving of 0.5 per cent. Bid and offer prices match or improve on the cash prices and execution details can normally be given within moments of getting your instruction.

A CFD can be held for as long or short a period as necessary. There are no expiry dates. Maybe your expectation of a share price movement is realised in hours. Alternatively, your timeframe may run to days, weeks or months. All can be accommodated with a CFD.

Since a CFD is a margintraded instrument, you need only deposit a small proportion of the contract value – normally 20 per cent – to secure your obligations under the contract. One of the principal attractions of CFDs is this gearing, which has the effect of magnifying profits (or losses).

For example, an investor has £20,000 to invest. A CFD for 5,000 Glaxo at £20 per share would require use of the £20,000 as margin deposit. If the investor was long and the price rose to £22, he would see a trading profit of £10,000 – a return of 50 per cent on his capital. Conversely, if the price fell to £18, a loss of £10,000 would be incurred.

The cashflows associated with an equity investment are mirrored in a CFD&#39s dividend stream and interest income or expense. A long CFD holder will get a payment equivalent to the net dividend and a short CFD holder would be charged with the gross dividend. These payments are made on the ex-dividend date.

As the investor has effectively borrowed the contract value, interest is charged on a long CFD and is paid on a short CFD. The calculations are made on the day-to-day contract value. So what are the uses and advantages of a CFD?

Long positions

This is the most commonly used CFD. An investor simply uses the CFD&#39s gearing to multiply the potential benefits of a rise in the value of the underlying share price.

Short positions

Until now, it has been expensive and cumbersome to go short with a stock but with a CFD it is as simple and straightforward as going long. Here, the investor uses the gearing to enhance the benefits of a fall in the share price.

Hedging

This is a method of “insuring” against an adverse movement in the price of a share in a portfolio that the investor wants to retain, perhaps for tax reasons because the long-term outlook remains good or restrictions on selling. By selling a CFD for the number of shares held in that stock the investor is hedging against the predicted adverse movement.

FTSE Index

A review takes place every three months of the constituent members of the FTSE 100 index that can lead to significant price movements before and after the review. CFDs are a flexible means of taking adv antage of these opportunities.

Pairs trading

A technique where an investor takes both long and short CFD positions of equal contract value on a pair of related stocks. Changes in the opening ratio of one price to the other give rise to a profit or loss.

Arbitrage

At times of takeovers or mer gers, investors can exploit the relative differences in the prices of the two companies. Arbitrage is also sometimes possible with a company whose shares are quoted in, say, London and New York.

Finally, the gearing aspect frees up capital for other uses.

So, who might consider using CFDs and why recommend them to your clients?

By virtue of the gearing effects of margin trading, equity CFDs are not an investment that is suitable for everyone. Any customer considering using CFDs should expect to be asked to demonstrate their experience of conventional share investing or of other margin traded instruments.

However, any customer with that experience and an appetite for the additional risk involved or a requirement
to hedge their physical holdings should think about using CFDs. As an adjunct to a conventional portfolio the use of CFDs provide an oppor- tunity to maximize returns, reduce dealing costs and eliminate stamp duty.

The minimum required to open a CFD account is normally £10,000 (or other currency equivalent). Approa ches for introductory arrangements are welcomed.

More information is available at www.equitycfd.co.uk.

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