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Wednesday, July 1, 2015

Financial Products that suck - CFDs

Once you have been writing on a site for a while, it won't be long before institutions, brokers, newsletters, etc start bombarding you with partnership proposals for you to promote their products. Over time, I have received dozens of such proposals and in many cases it has been about products I didn't even know existed. Having this market disease I have, most of the time I end up researching these products, just trying to expand my horizons by learning new things.

Unfortunately, the amount of useless garbage in the financial universe is overwhelming and that's why I eagerly share the good stuff every time I see something that moves my soul and restores my faith in humanity. But, in the same way I have shared the good stuff, it is sometimes as valuable to outline the useless products as well. It is a never ending story so I try to just focus on those around which some confusion might still exist.

Contract for Differences - CFD

Here's how Investopedia defines CFDs:

"An arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than the delivery of physical goods or securities.

This is generally an easier method of settlement because losses and gains are paid in cash. CFDs provide investors with the all the benefits and risks of owning a security without actually owning it."

In English. CFDs are derivatives used to speculate on the price of an underlying instrument, usually stocks or indexes. You purchase a CFD on a given stock and you are promised to be paid the difference between the price of the stock when you purchased the contract and when you want to sell it. So, in theory, you obtain the exact same gain (or loss) as someone who owns the stock, but without the need for owning it and having so much capital deployed. So if you buy a CFD on a stock when the stock is trading at $50, and then a few days later the stock trades at $60, you make a $10 dollar gain (obviously multiplied by the number of lots you are playing with the CFD). Similar to a Call option, except you don't select strike prices and you only make money on price differentials of the stock (not extrinsic value of an option or time premium left in it, or implied volatility of the option or anything like that).

Promotional offers for trading CFDs have mainly come from Forex brokers, which allow retail traders to trade with 50:1 and sometimes up to 400:1 leverage, where you can open an account in many cases with just 100 bucks and trade away! Instead of the usual 25,000 USD needed to day trade stocks in the US, you can use CFDs as a vehicle to in theory obtain the same results, without the capital requirements.

So, it all looks great! Same result as if I actually held the stock! But with much less capital needed!

Think twice. This is where it gets tricky and why this product sucks.

The stock market has an inherent historical upwards bias, for different reasons (inflation, central banks support, etc). Actual value is created when companies deliver more goods and services to more people, materialized in earnings growth and higher dividend payments over time. It is a positive sum game.

The counter-party that sells you the CFD (the broker) is at a disadvantage, because overall, they lose money in the long run due to the inherent upwards bias nature of the stock markets. And....they are aware of it. So, it wouldn't make sense for them to let you bet on CFDs without penalizing you somehow.

CFDs have a daily interest associated with them. Every single day you hold a CFD you have to pay an interest for the right to hold it. This interest is known as swap. This swap fee by the way is usually tripled on Wednesdays to account for the days included in the previous weekend. This interest is designed to skew the odds in favor of the house and counteract the positive sum game nature of the stock market.

In addition to this, NO (Capital NO), owning a CFD IS NOT like owning a stock. When you own a stock you are entitled to regular dividend payments, which represent a huge part of the historical market returns and further improve the odds for the long term investor. Dividends that will allow you to purchase even more stock that will start spitting out even more dividends. You don't get that nice compounding effect with CFDs.

Buying a CFD also entails a Bid-Ask spread differential and you also pay transaction commissions.

Are CFDs totally useless then?

No. I guess if you find a good edge day-trading some stock or your level of conviction at one point is truly high, you can bet with a CFD with the plan in mind of just holding it intra-day (or 2 or 3 days) to avoid swap charges, and potentially benefit from a good move. This will allow you to play with leverage that stocks don't provide, much less capital and also typically smaller commissions than when trading stocks or options. You would also play it without Theta against you (time decay). Other than that, I don't see another scenario to make this a profitable and sustainable long term venture given that the odds have been arbitrarily stacked in favor of the house and your timing has to be almost perfect, limiting you to hold for short periods of time where the market noise and randomness is more pronounced.

Thanks for reading and stay tuned. I'll cover some other nonsensical products in the next chapters.

As usual, I may be wrong and I'm open to criticism. If your experience with CFDs is positive and you have a different opinion, feel free to share in the comments section.

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  1. I think CFDs do pay dividends when the stock does (you probably don't get this benefit with forex though, but I don't know that market too well).

    The other reason to use them is to go short, e.g. to hedge a long stock position since they have no expiry, unlike futures and options. Technically, they pay interest on the short side, but this is subject to a fee (2.5% being common) and with rates being so low at present, in practice, you do still pay even then.

    Where I live in the UK, CFDs are comparable to Spread Bets and the two instruments have similar characteristics. I'm not a massive fan of CFDs, but they do have their uses. Sometimes I've used spread bets to hedge straight long calls or puts, mainly because with liquid markets the bid/offer is usually tighter and it can work out cheaper rather than closing your options positions if you think the price action might turn around (as often happens). You're right though, the devil is in the detail over the costs and you need to check it all very carefully first. I suspect most people who play the CFD game end up losing at it - but that's true with all trading.

    There is a link below which describes them a bit more (I'm not affiliated with this, btw)

    1. This is great feedback and will be of help for many readers.
      Thanks a lot for your opinions and providing with all the extra information.

  2. From your research on the subject, is it possible to use smaller (custom) leverage?
    For example, if I want to use 4:1 leverage, but a broker offers 100:1, will I be able to select 4:1, or am I forced to use 100:1? For me, this kind of constraint (rigid leverage) is a significant disadvantage.

    1. Most retail Forex brokers impose a minimum, like 20:1 or 25:1 but I haven't used al the brokers of course. So, I guess it is possible to find the one that allows you to de-leverage more than that out there.