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Contracts for Difference (CFD) – Instrument to Short

When the stock market was falling the way it did the past few weeks and most of the call warrants becoming out-of-money, investors would have been very interested in products that allow them to short equities. Apart from the index futures products locally and put warrants in some stock exchanges, there are numerous types of instruments that investors can utilize to profit from falling share price.

 

One type of products which offers investors leverage in trading underlying shares both ways is known as Contracts for Difference (CFD). This means that investors can short sell some equities with CFD.

 

Exchange-traded CFD is a structured product that are listed either as a Bull or Bear instrument and tracks the performance of an underlying asset, which can be a single stock, an index or an Exchange Traded Fund (ETF). The London Stock Exchange is one exchange where there are listed CFDs. However, CFDs are more commonly traded over the counter whereby a broker or a CFD specialist provides the bid and ask prices to the investors. We would focus our discussion on CFDs traded over-the-counter for this article as they are widely available in Singapore and accessible to most of us.

 

CFD is an investment instrument that allows you to participate in the price movement of an underlying share with a fraction of the cost of buying the full share. It is somewhat similar to margin financing and they will usually expire at a predefined date. Some over-the-counter products can be rolled over for a fee.

 

A major benefit of trading a CFD is the fact that the investors can trade on margin. CFD trading means investors can trade a full portfolio of Shares, indices, or commodities without having to tie up large amounts of capital. For example, investors may only need to come up with as low as 2% of the price of the share depending on the CFD brokers and the type of shares that are traded.

 

CFD on major Malaysian shares are also available in Singapore. This allows investors here to actually short sell the share without owning it. While short selling is virtually impossible in Malaysia, investors can enter into Contracts for Difference with overseas brokers on Malaysian shares on the short side. The investors will get paid (in the case of a profitable trade) or pay (in the case of a loss) for the difference between the selling and buying back price of the share. In addition to trading commission, there is usually a finance charge for the number of days the contract is held running. Some brokers also impose a roll over charge if the contract period is extended. There are even brokers who offer investors interest credit for shorting the CFD. Nevertheless, this is not the case for Malaysian share CFD. Investors would in fact have to pay a higher finance charge for shorting the CFD due to the difficulty in borrowing the share.

 

So, what are the differences between warrants and CFDs?

  1. Warrants are listed on the stock exchanges while CFDs are mostly traded over-the-counter.
  2. CFD is a delta one product. This means that the price movement of a CFD is exactly the same as price movement for the underlying security. For warrants, the price movement in theory should follow the deltas. If a warrant has a delta of 0.5, it should move up 5 cents when the underlying moves up 10 cents.
  3. For warrants, the ‘financing cost’ is already built into the price in the form of premium. While listed-CFDs have financing cost implied their prices, over-the-counter CFDs generally have a separate interest charge.
  4. For warrants (and listed CFDs), you can only lose what you have already invested. For CFDs, there could be a margin call although the CFD may be automatically forced-sold before that.
  5. Most structured warrants and CFDs do have market makers providing the bid and ask prices. But for company warrants and some structured warrants, especially those issued by local brokerage here, there may not be any market makers.

 

CFDs is a good hedging tool for overall portfolio management especially if the portfolio consist of a lot of derivatives. It is also extremely useful when we know a particular share is going to fall due to company specific reason. Shares like Gamuda and Puncak Niaga which had their own specific uncertainties during the past few weeks would have been good candidates to short and the CFDs for these two shares are actually available.

 

Alan Voon

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March 19, 2008

This article is for information and education only.  It is not a recommendation to buy or sell any securities mentioned in the article. Please exercise your own judgment or seek professional advice for your specific investment needs. We are not responsible for your investment decisions. Our shareholders, directors and employees may have positions in any of the stocks mentioned.

 

 

Analysis

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