THE tail end of last week saw reports that the Financial Ombudsman Service (FOS) had upheld a barrage of complaints surrounding transaction charges on Contracts for Difference (CFD). With this in mind, what should you look out for and what should you do to keep your CFD earnings intact?
Martyn Jones of the Financial Ombudsman Service stated that the FOS had upheld the majority of the complaints filed in recent months. This was usually in cases where consumers were not made aware by their advisers of the inherent risk involved in CFDs or in the case where the FOS had come to the conclusion that there was very little chance of investors making any kind of return from the service due to the rapid incurring of fees
Anybody who embarks on a venture into spread betting or contracts for difference will be hit with the usual disclaimer that “spread betting and CFD trading carry a high level of risk to your capital and you can lose more than your initial deposit”. That said, though a big loss on a CFD position may sting, it is one thing to see your investment wiped out by a gamble gone wrong, and quite another seeing your hard earned cash wiped out by charges racking up faster than a banker’s expense account in Spearmint Rhino.
The complaints in question relate to discretionary or advisory CFD providers, not execution-only services, and so it is important to differentiate between the various providers of CFDs. The most straightforward of those offering CFD brokering are those who offer an execution-only service. That is, you open an account, make your margin payment and take your position. A par for the course figure would be a 0.1 to 0.2 per cent commission on transactions, and a daily funding rate of one-month LIBOR +/- 2.5 per cent
On the other side of the fence are discretionary or advisory CFD service, and it is with these that there is a real opportunity for fees to spiral out of control. In this instance, you place your money in the hand of a service that manages your contract transactions on your behalf. The complaints uphelf by the FOS have stemmed from the break-neck speed at which these services have torn through margin payments, that is, the minimum deposit you are required to make by your CFD provider so you can open your CFD trade.
In relation to the dismal performance of many of the advisers under scrutiny, Tony Cross of IG Index clarified that “the problem seems to revolve around the fact that the ‘brokers’ who were managing funds for other people took a cut of each commission charged. By churning trades repeatedly, the brokers kept getting x per cent of the total commission charged. Naturally if you turn positions all the time in a market that's not moving you're not going to have any capital gain but your account value will be diminished.”
If you are going to go down the path of an advisory CFD brokerage service rather than striking out on your own, and given that you are being charged what is quite a premium for the management of your investment, it pays to be cautious as to your choice of financial soothsayer. Speaking to a former CFD trader, he advised that beyond the reading of the small print for charges that one is liable to incur, it is also important to do your homework on the quality of the advisory service offered by the broker. The fallout of 2007-2008 showed just how many poor advisers had been able to survive up until then without too much scrutiny. When doing your research, is he an experienced broker with a proven track record or getting his tips from a man at the bar in the pub?
Furthermore, you should negotiate with your broker as there is often leeway in the commissions and charges depending on the size and frequency of your trades. The best way to avoid the interest charges is to increase your margin deposit from the bare minimum required of 10 per cent up to 80 or 90 per cent. Should you have an initial margin covering the entirety of the deal, you should be able to completely negate the financing charge.
Above all, you should read what the warning says on the tin. CFDs do pose a risk for the investor, but if you do your homework and take an active role in the management of your investments you can take advantage of what can be a useful financial instrument without being stung.
CFD DOS AND DON’TS
DO BE AWARE OF ACCOUNT CLASSIFICATION
The way your account is classified makes a difference to how you can trade. Although your broker may prefer that you have an “intermediate” account, indicating a high degree of knowledge and experience, most should push for a private account. This will give you the best spreads and increase your potential profitability.
Although your broker may push you to over-leverage, stand your ground. Although leverage can increase your potential for profit making, it can also leave you exposed to the inverse.
DON’T PUT ALL OF YOUR EGGS IN ONE BASKET
You should utilise CFDs in conjunction with your overall portfolio, not as a substitute. CFDs can be used to hedge a long term investment. For instance, should a stock rise on the back of a recent factor, you can capitalise on this and reap a profit without ditching the underlying stock.