The ‘long’ and ‘short’ of leveraged trading/media/Moneysense/News and Events/Media...
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Contracts for difference, or CFDs, are a form of leveraged trading that may appeal to experienced inves- tors. It is easy to see why. With CFDs, an individual needs to pay only 10 to 20 per cent of the costs of own- ing a stock in order to trade it. This means that he will be able to invest in blue-chip stocks such as Singapore Airlines or DBS Group Holdings without paying the full cost. But, if you can make fast and easy money from it, you can also lose big and quickly. It is certainly not appropriate for everyone. Another form of leveraged trad- ing is the extended settlement con- tracts. This works in a broadly simi- lar way to CFDs, except that the contracts are traded on the Singa- pore Exchange. You can visit www.sgx.com for details on this. We give you the lowdown on CFDs here. What are CFDs? CFDs are an over-the-counter deriv- ative. It allows investors to specu- late on the future market move- ments of the underlying asset with- out owning or taking delivery of it. These assets include shares, com- modities and currencies. An investor can “go long” by buying the CFD if he thinks a cer- tain stock or currency is going to rise. He will profit from it if the mar- ket moves up as the CFD price tracks the movements of the under- lying asset. If he thinks otherwise, he can “short” the market by sell- ing the CFD. CFDs are typically traded through a securities broker, known as a CFD provider. You open the po- sition with a trade through a CFD provider at one price and subse- quently close it out with a reverse trade at another price. There is usu- ally no maturity date and trades are settled in cash. How do they work? CFDs are traded on margin. In or- der to open a CFD position, an indi- vidual will need to pay a small pro- portion of the value of the underly- ing asset. This initial margin is typi- cally set at 10 to 20 per cent, though it can go up to 30 per cent depending on the CFD provider. No minimum account balance is re- quired. A CFD provider can act as the market maker to quote you a bid/ask spread for the CFD. The price quoted may not match the price of the underlying share or as- set on an exchange. This is called the “market maker” model. Alternatively, the provider can quote the prices from an underly- ing exchange, which means the prices and volume shown on the provider’s CFD platform should be the same as the exchange. This “di- rect market access” model is a more transparent way to obtain prices than the “market maker” model. Investors will need to pay a com- mission to trade CFDs and will have to check the rates with their CFD provider. There are also financ- ing charges, which may be pegged to Sibor or an internal board rate. When you hold a CFD position overnight, the broker will charge you a financing fee as you are effec- tively borrowing the underlying val- ue of the asset from the broker. There may also be a price feed fee so do check with your CFD pro- vider to see if this is applicable. An investor’s position will con- tinually be marked to market on a daily basis. To keep it open, he will have to make sure his margin ac- count is maintained. So, if the mar- ket were to head south, an investor would need to top up his account with more cash to cover the losses he incurs. This is to make sure his position does not fall below the margin re- quired. What are the risks? With CFDs, an investor can specu- late on whether the underlying as- set, a stock or a commodity, for in- stance, will rise or fall. This means he should be familiar with the un- derlying asset. Apart from under- standing the risks associated with the underlying asset, he should be aware of factors that may affect its price. If an investor’s view of the mar- ket turns out to be wrong, he can lose much more than the cost of his initial investment, which is the initial margin plus other costs. As CFDs are bought or sold on margin, the leverage has the effect of magni- fying the loss. Let’s assume an investor uses CFDs to buy two lots of company A at $2 a share. If the value of compa- ny A slips to $1.95 a share, the CFD investor will make a $100 loss. If he closes the account, he will lose $100 and other charges that he has paid. If not, the CFD provider will de- duct the $100 from his initial mar- gin. He will then need to make a margin call. This means he has to top up his margin account with cash within a short period of time such as two days or less as required by the CFD provider, so that the ac- count is kept at the level of his ini- tial margin. Investors should take note that the margin required is not static. It may change in extreme conditions when a broker may raise margin re- quirements substantially. If there is a margin call and the investor is un- able to top up his account, his posi- tion may be liquidated by the pro- vider without his consent or any notice. If the position is not closed, the investor could be exposed to sig- nificant or potentially unlimited losses. With CFDs, there is counterpar- ty risk as CFDs are not traded on an exchange but entered into with a provider acting as principal. Inves- tors should ascertain the financial strength of the CFD provider and how well capitalised it is. If the CFD provider goes bust, in- vestors’ CFDs will become worth- less. There is also currency risk if the CFD is quoted in a currency that is different from the currency of the underlying asset. Investing in the current climate Because CFDs allow for efficient use of capital, an investor may be tempted to overtrade, especially if the market presents many attrac- tively priced stocks. In the current uncertainty, the market risk is a lot higher as CFD prices are subject to volatility and your view of the security could turn out to be wrong. An investor needs to actively monitor and manage his positions at all times in order to avoid incur- ring losses that he cannot sustain. He must be prepared to top up mar- gins at short notice, which may happen often in a volatile market. In a worst-case scenario, he could find that a security may sud- denly be deemed ineligible for mar- gin because of extreme volatility. This happened in the midst of the 2008 financial crisis. If this occurs, the investor could be facing huge margin calls and he may have to top up the account by drawing from his other assets. Taking short positions can be risky and can potentially lead to un- limited losses. It is thus prudent to set a loss limit such as 5 per cent of your investment amount and to stick to it. Some CFD providers charge a fee for a guaranteed stop-loss facility. In a volatile market, the fee may be a small price to pay to ensure that your losses do not pile up should the market plunges all of a sudden. For more information on CFDs, you can refer to the MoneySENSE article “Making sense of Contract for Differences” at the website www.moneysense.gov.sg This column is sponsored by MoneySENSE, a national financial education programme for Singapore. This article is adapted from the MoneySENSE Smart Money article on CFDs published in The Business Times on Jan 22 this year. Example: Company A shares trade at $2 per share. Investor takes a ‘‘short’’ position – that is, he thinks the share price will fall. He then takes up a CFD to sell two lots or 2,000 shares. He pays an initial margin of $400 (10 per cent of current value of 2,000 shares) to do this. What happens if the share price falls or rises? Source: MAS Share price falls to $1.95 per share Shares are now worth $3,900; compared to $4,000 when investor took up the CFD Shares are now worth $4,100; compared to $4,000 when investor took up the CFD Shares are now worth $4,400; compared to $4,000 when investor took up the CFD Investor loses $100 Investor loses $400 (the initial margin he placed to purchase the CFD. His loss will be even greater if the share price rises further.) Lesson: Investor makes a profit because his view that the share price will fall turned out to be right. Lesson: Investor makes a loss when his view turns out to be wrong. The losses can be unlimited. Investor makes profit of $100 Share price rises to $2.05 per share Share price rises to $2.20 per share ST GRAPHICS Scenario 1 Scenario 2 Scenario 3 Going ‘‘short’’ can lead to unlimited losses The ‘long’ and ‘short’ of leveraged trading PHOTO: AFP Beware the risks associated with CFDs, including currency risk if the CFD is quoted in a currency that is different from the currency of the underlying asset.
Transcript of The ‘long’ and ‘short’ of leveraged trading/media/Moneysense/News and Events/Media...
Magdalen Ng
With the turbulence in the equity markets unlikely tosubside any time soon, banks have seen a rise in thenumber of fixed deposit accounts.
Many investors see this rather low-risk, low-returndeposit as a tool to hold their money relatively safelyuntil the next investment opportunity comes along.
Ms Carmen Chan, head of deposits at OCBC Bank,said: “In times of market volatility and downturns, in-vestors prefer to be more liquid, or hold more cash.Those who have cashed out their investments are like-ly to place the money in their current or savings ac-count or fixed deposit.”
A Hong Leong Finance spokesman echoed thisview, adding that more investors have preferred thefixed deposit tool in recent times.
“Fixed deposits offer a viable alternative for inves-tors who may be waiting for more market clarity orwho just want low-risk investments.”
The low risks also mean the returns are most cer-tainly not to die for.
Depending on the deposit amount and the tenorof nine or 18 months, Hong Leong Finance’s interestrates range from 0.45 per cent to 1 per cent a year.
OCBC’s promotion offers rates of up to 0.9 percent a year for an 18-month tenor.
To entice customers, the bank has also thrown infreebies as well as lucky draw prizes that include holi-days to the Maldives, Taiwan and Orlando in the Unit-ed States.
Standard Chartered Bank has special step-up timedeposits which offer clients the advantage of higherrates that usually come with a longer tenor and theflexibility of a short-tenor deposit.
For a 24-month, step-up time deposit, clients cantypically enjoy interest rates from 0.5 per cent to 1.2per cent a year. At the same time, they are given thefreedom to withdraw at the end of every three-monthcycle without any penalty.
One other benefit that comes with fixed deposits isthe fact that deposit insurance protects savings of upto $50,000 a customer a bank, said Mr Paul Arrow-smith, HSBC head of retail banking and wealth man-agement.
He cautions that it is important for investors toconsider the potential costs associated with the earlywithdrawal of fixed deposits.
“Fixed deposits are less liquid than equities andbonds, which can be sold any time in the open mar-ket,” he said.
That aside, most banks agree that fixed depositscome with few unforeseen risks.
“Besides inflation, fixed deposits have little down-side risk as investors are aware that the low returnscorrespond to the low risk of the product,” said theHong Leong Finance spokesman.
Mr Darrell Heng, head of treasury, wealth manage-ment, at Citibank Singapore, added: “If the fixed de-posit interest rate is lower than the rate of inflation, itwould mean that your money in the fixed deposit isgrowing at a slower rate than the cost of living.
“In this case, locking up your funds in a fixed de-posit may result in a net loss as you may be missingout on other investment opportunities which maygive much higher returns in the long run.”
The Monetary Authority of Singapore expectsfull-year inflation for this year to average between 4per cent and 5 per cent.
If you are wondering if fixed deposit is the way togo for now, Mr Dwaipayan Sadhu, Stanchart head ofconsumer transaction banking and online banking inSingapore and South-east Asia, advises clients to care-fully assess their risk appetites before making invest-ment decisions.
“Staying the course is critical to long-term wealthaccumulation for an investor. One does not want tobe a forced seller in a down market due to liquidityneeds.
“Second, determining your appropriate portfoliorisk profile is critical. This is as much about managingyour emotions as it is about your financial needs.”
Contracts for difference, or CFDs,are a form of leveraged trading thatmay appeal to experienced inves-tors.
It is easy to see why. With CFDs,an individual needs to pay only 10to 20 per cent of the costs of own-ing a stock in order to trade it.
This means that he will be ableto invest in blue-chip stocks such asSingapore Airlines or DBS GroupHoldings without paying the fullcost.
But, if you can make fast andeasy money from it, you can alsolose big and quickly. It is certainlynot appropriate for everyone.
Another form of leveraged trad-ing is the extended settlement con-tracts. This works in a broadly simi-lar way to CFDs, except that thecontracts are traded on the Singa-pore Exchange. You can visitwww.sgx.com for details on this.
We give you the lowdown onCFDs here.
What are CFDs?CFDs are an over-the-counter deriv-ative. It allows investors to specu-late on the future market move-ments of the underlying asset with-out owning or taking delivery of it.These assets include shares, com-modities and currencies.
An investor can “go long” bybuying the CFD if he thinks a cer-tain stock or currency is going torise. He will profit from it if the mar-ket moves up as the CFD pricetracks the movements of the under-lying asset. If he thinks otherwise,he can “short” the market by sell-ing the CFD.
CFDs are typically tradedthrough a securities broker, knownas a CFD provider. You open the po-sition with a trade through a CFDprovider at one price and subse-quently close it out with a reversetrade at another price. There is usu-ally no maturity date and trades aresettled in cash.
How do they work?CFDs are traded on margin. In or-der to open a CFD position, an indi-vidual will need to pay a small pro-portion of the value of the underly-ing asset. This initial margin is typi-cally set at 10 to 20 per cent,though it can go up to 30 per centdepending on the CFD provider.No minimum account balance is re-quired.
A CFD provider can act as themarket maker to quote you abid/ask spread for the CFD. The
price quoted may not match theprice of the underlying share or as-set on an exchange. This is calledthe “market maker” model.
Alternatively, the provider canquote the prices from an underly-ing exchange, which means theprices and volume shown on theprovider’s CFD platform should bethe same as the exchange. This “di-rect market access” model is a moretransparent way to obtain pricesthan the “market maker” model.
Investors will need to pay a com-mission to trade CFDs and willhave to check the rates with theirCFD provider. There are also financ-ing charges, which may be peggedto Sibor or an internal board rate.
When you hold a CFD positionovernight, the broker will chargeyou a financing fee as you are effec-
tively borrowing the underlying val-ue of the asset from the broker.
There may also be a price feedfee so do check with your CFD pro-vider to see if this is applicable.
An investor’s position will con-tinually be marked to market on adaily basis. To keep it open, he willhave to make sure his margin ac-count is maintained. So, if the mar-ket were to head south, an investorwould need to top up his accountwith more cash to cover the losseshe incurs.
This is to make sure his positiondoes not fall below the margin re-quired.
What are the risks?With CFDs, an investor can specu-late on whether the underlying as-set, a stock or a commodity, for in-
stance, will rise or fall. This meanshe should be familiar with the un-derlying asset. Apart from under-standing the risks associated withthe underlying asset, he should beaware of factors that may affect itsprice.
If an investor’s view of the mar-ket turns out to be wrong, he canlose much more than the cost ofhis initial investment, which is theinitial margin plus other costs. AsCFDs are bought or sold on margin,the leverage has the effect of magni-fying the loss.
Let’s assume an investor usesCFDs to buy two lots of company Aat $2 a share. If the value of compa-ny A slips to $1.95 a share, the CFDinvestor will make a $100 loss. If hecloses the account, he will lose$100 and other charges that he haspaid.
If not, the CFD provider will de-duct the $100 from his initial mar-gin. He will then need to make amargin call. This means he has totop up his margin account withcash within a short period of timesuch as two days or less as requiredby the CFD provider, so that the ac-count is kept at the level of his ini-tial margin.
Investors should take note thatthe margin required is not static. Itmay change in extreme conditionswhen a broker may raise margin re-quirements substantially. If there is
a margin call and the investor is un-able to top up his account, his posi-tion may be liquidated by the pro-vider without his consent or anynotice. If the position is not closed,the investor could be exposed to sig-nificant or potentially unlimitedlosses.
With CFDs, there is counterpar-ty risk as CFDs are not traded on anexchange but entered into with aprovider acting as principal. Inves-tors should ascertain the financialstrength of the CFD provider andhow well capitalised it is.
If the CFD provider goes bust, in-vestors’ CFDs will become worth-less.
There is also currency risk if theCFD is quoted in a currency that isdifferent from the currency of theunderlying asset.
Investing in the current climateBecause CFDs allow for efficient useof capital, an investor may betempted to overtrade, especially ifthe market presents many attrac-tively priced stocks.
In the current uncertainty, themarket risk is a lot higher as CFDprices are subject to volatility andyour view of the security could turnout to be wrong.
An investor needs to activelymonitor and manage his positionsat all times in order to avoid incur-ring losses that he cannot sustain.He must be prepared to top up mar-
gins at short notice, which mayhappen often in a volatile market.
In a worst-case scenario, hecould find that a security may sud-denly be deemed ineligible for mar-gin because of extreme volatility.This happened in the midst of the2008 financial crisis. If this occurs,the investor could be facing hugemargin calls and he may have totop up the account by drawingfrom his other assets.
Taking short positions can berisky and can potentially lead to un-limited losses. It is thus prudent toset a loss limit such as 5 per cent ofyour investment amount and tostick to it.
Some CFD providers charge a feefor a guaranteed stop-loss facility.In a volatile market, the fee may bea small price to pay to ensure thatyour losses do not pile up shouldthe market plunges all of a sudden.
For more information on CFDs,you can refer to theMoneySENSE article “Makingsense of Contract forDifferences” at the websitewww.moneysense.gov.sg
This column is sponsored byMoneySENSE, a nationalfinancial education programmefor Singapore. This article isadapted from the MoneySENSESmart Money article on CFDspublished in The Business Timeson Jan 22 this year.
Example: Company A shares trade at $2 per share. Investor takes a ‘‘short’’ position – that is, he thinks the share price will fall. He then takes up a CFD to sell two lots or 2,000 shares. He pays an initial margin of $400 (10 per cent of current value of 2,000 shares) to do this. What happens if the share price falls or rises?
Source: MAS
Share price falls to $1.95 per share
Shares are now worth $3,900; compared to $4,000 when investor took up the CFD
Shares are now worth $4,100; compared to $4,000 when investor took up the CFD
Shares are now worth $4,400; compared to $4,000 when investor took up the CFD
Investor loses $100
Investor loses $400 (the initial margin he placed to purchase the CFD. His loss will be even greater if the share price rises further.)
Lesson: Investor makes a profit because his view that the share price will fall turned out to be right.
Lesson: Investor makes a loss when his view turns out to be wrong. The losses can be unlimited.
Investor makes profit of $100
Share price risesto $2.05 per share
Share price rises to $2.20 per share
ST GRAPHICS
Scenario 1 Scenario 2 Scenario 3
Going ‘‘short’’ can lead to unlimited losses
The ‘long’ and ‘short’ of leveraged trading
Many see it as a relatively safehaven for their money until nextinvestment opportunity arrives
Fixeddepositmakesa return
Viable alternative“Fixed deposits offer a viablealternative for investors who may bewaiting for more market clarity orwho just want low-risk investments.”A HONG LEONG FINANCE SPOKESMAN
PHOTO: AFP
Beware the risks associated with CFDs, including currency risk if the CFD isquoted in a currency that is different from the currency of the underlying asset.
30 investthesundaytimes September 25, 2011
31investSeptember 25, 2011 thesundaytimes
