There is a relatively new form of investment gaining ground locally, which appeals directly to the sophisticated private investor who is looking for flexibility and a desire to maximise the use of capital.
It is called a contract for difference (CFD), which is simply an agreement to exchange the difference of a particular financial instrument between the time at which the contract is opened and the time it is closed.
CFDs were originally used by institutional investors to hedge their exposure to actual stocks, but they’ve become increasingly popular among retail investors. They boast some unique features that make them attractive to retail investors and institutions alike with the major benefits being transparency and pricing. When trading a CFD, investors need only put down an initial deposit, usually around 10% depending on volatility and availability, which provides a more cost-effective entry into the equity market. The product is therefore leveraged and the investor needs to be aware of the risks involved when trading derivatives.
The transparency of trading CFDs is also appealing. What you see is what you get; the price of the CFD is the same as the price of the underlying share as seen on the exchange. You pay commission on the trade and any interest deduction is charged separately and calculated overnight so that it is completely transparent. Other products such as SSFs incorporate the interest and dividend adjustments into the listed price which makes it difficult to simply follow live prices on the exchange and know where you stand.
Entering the equity market
In the case of CFDs on equities, a single contract equals one share or 1 223 shares depending on the investors’ requirements and that is a great way to enter the equity market. You can tailor positions more effectively when compared to other investments such as SSFs that limit you in this regard, where one contract equals 100 shares. Investors also have the option of going long or short when trading CFDs, resulting in considerably more trading opportunities than in the case of only buying physical shares. Companies like IG Markets also offer various contracts on the South Africa 40 index adding to the breadth of choice offered by this type of product.
When trading CFDs, it is critical for investors to research the company that they decide to trade with. There are a handful of major CFD providers operating on a global basis who have a proven track record as being secure, offering added controls to the investor such as Direct Market Access. It therefore makes sense to be confident that the company you decide to deal with has a sound business model, especially with regards to managing risk. CFDs offered by these types of companies are often backed by a Big Four bank — both Standard Bank and Nedbank are providers — and many of them are registered as authorised financial services providers and regulated by the Financial Services Board.
Finally, it is important to consider the technology offered by the company you choose. Taking advantage of the transparency that CFD trading offers investors is only possible if you understand the interface that the company provides. There are various platforms available to the market but some make it difficult for clients to monitor their open positions and follow overall portfolio performance — information critical to sustain success. Consider a company that understands that an investor’s focus is on the movement of the markets and provides the tools necessary for you to make calculated and intuitive decisions.
Remember that CFDs are a leveraged product and can result in losses that exceed your initial deposit. Trading CFDs may not be suitable for everyone, so please ensure that you fully understand the risks involved.