Agony Aunt: Not for the faint-hearted

Dear Janine,

Recently I received some information on dealing (trading) in Contracts for Difference (CFDs) and, despite having read it all, I am still not much wiser about them. Are you able to explain exactly what they are and how trading in CFDs differs from other types of trading.

Would you recommend CFD trading?

ANSWER:

If you whittle it down to the core concept, there are rough parallels with a house purchase. The analogy helps to break down the jargon.

Most people take out a mortgage to buy a house. You put down a small amount of your money (perhaps 10 or 20 per cent) and buy the rest with someone else's money (the bank's). If the house price goes up, you can sell and take all the gains. You don't have to share your gains with the bank, even though you used their money. The bank earns interest from you. If the price goes down, you can sell and will take all the loss (not the bank). So you are risking all your deposit on the price movement of a much larger asset. Think about your deposit as an "investment". You put down $20,000 and buy a $200,000 house. If prices rise 10 per cent, the house is worth $220,000. Your "investment" has doubled in value from $20,000 to $40,000. That's a 100 per cent gain from a 10 per cent rise in the asset. Borrowing magnifies all the effects of a small change in value (up or down). Likewise, a 10 per cent decline wipes you out. It's the same with CFDs.

Take that basic concept and speed things up dramatically and add in a few gymnastic tricks. Imagine you could buy or sell any house on any street in minutes and you could do it over and over multiple times a day, with mortgages instantly approved. The houses don't really change hands, so you can buy one that wasn't for sale. You also need to use the right lingo. Replace "mortgage" with "leverage" (it's all borrowing) and replace "deposit" with "margin". Next, stop saying you are buying a house - you are "loaning" one house. Visualise a borrowing cost which is 2 per cent over the short-term cash rate. Now for the gymnastics trick. You can flip things around and sell a house you didn't own, before you had even bought it. That's right, if you thought a house would fall in value, you could pretend to sell it and then buy it back once it had dropped (the jargon is "going short"). In this case, rising house prices would create losses. Even better, there is no borrowing cost and you will be paid a small amount of interest for shorting. It's quite handy that you don't need to own the house title or get the door keys. Because of this, the only money that needs to change hands is the difference in the value. That's why CFDs are called "Contracts for Difference". No-one ever parts with the cash for the cost of the house; they simply pay each other gains and losses. You can take a punt and take profits or losses when you want. CFDs differ from normal investments because they don't involve the exchange of the full value of the asset.

As you can imagine, it would be easy to lose sight of the real value of the assets you were trading. Add in the speed and the gym tricks and the average person would find it difficult to control their level of risk. CFDs are only for the financially savvy and experienced. You play only with "margin" you can afford to fully lose.

To finish off the tale, you need to replace the "house" with a more liquid financial asset. You can use any financial asset - foreign exchange, shares, or commodities.

You need to learn about stop- losses and be aware the platform can demand more margin from you, or close out your trade if losses get too big. Potential traders should visit websites such as CMC Markets. Take out the trial where you can trade play money, to get the feel of things. It would pay to do this for months, before putting up your own money.

CFDs involve smaller deposits and higher borrowing than something like a house, so the risks are even more magnified. The Australian Securities and Investments Commission says: "Because of this borrowing, it's much riskier than a flutter on the horses or a night at the casino. Your losses are potentially unlimited and can far exceed the money you've wagered."

It gives good tips on who CFDs might be suitable for. Here's what they have to say:

Experience: You've extensively day- traded shares, options, futures or other short-term derivatives, especially in volatile markets.

Knowledge: You know how CFDs work, and know the rules and platform backwards. You've read the disclosure statement and discussed the risks with your financial adviser.

Risk control: You've got fail-safe trading systems set up to stop unacceptable losses.

Financial capacity: You can afford losses your trading system can't avoid.

Janine Starks is a financial commentator with expertise in banking, personal finance and funds management. Opinions in this column represent her personal views. They are general in nature and are not a recommendation, opinion or guidance to any individuals in relation to acquiring or disposing of a financial product. Readers should not rely on these opinions and should always seek specific independent financial advice appropriate to their own individual circumstances.