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CFDs and your portfolio

Created:
25 April 2008
Updated:
19 November 2008
Written by:
Moira O'Neill

Although contracts for difference (CFDs) are mostly used for betting on short-term market movements, they can also be used alongside your traditional investment holdings either to spice up returns or to reduce risk.

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For example, you can use CFDs within your self-invested personal pension (Sipp). Say you are bullish about stocks or markets, but lack the capital to put your money where your mouth is, perhaps because it's already tied up in other assets. In this case, you can use CFDs to borrow money to invest.

Because you only have to put down a fraction of the total value of the positions you can take, you can make big returns off small market movements. Most CFD brokers will let you establish positions on individual shares with deposits of around 10 per cent or 20 per cent. This equates to gearing of 10 and five times, respectively. For trades on indices and exchange rates, even smaller margins are available.

According to Inland Revenue rules, you can trade CFDs within your Sipp as long as the underlying asset is an equity traded on a recognised exchange. In addition, losses from CFDs in a Sipp must not exceed the portion of the fund allocated to CFDs. As a CFD trade can result in a loss greater than the amount invested, Sipp providers need to limit the liability to the value of the assets of the pension scheme. This involves placing a stop-loss order to prevent a position moving too far away from the entry price in the wrong direction. The facility closes the CFD trade once losses have reached a pre-set level.

"You have to be much more careful about how to utilise CFDs within a Sipp," says Kareem Khouri, managing director of Killik Capital. "You can't allow a Sipp to go into negative positions. There are various safety nets that need to be put in place. We wouldn't allow anyone to use CFDs in a Sipp if they had less than £100,000. And we insist that no more than 20 per cent of the value of the Sipp is used as a deposit on CFD positions."

For newcomers to CFDs, the idea of using such high-risk instruments in a Sipp may sound irresponsible. Understandably, they tend to get uncomfortable with the idea of gambling with their retirement savings using a derivative instrument that gives you significant gearing potential. However, if used carefully, CFDs can enhance your gains, in the context of a strict risk control policy. You mustn't overgear your account and expose yourself to big risks.

You could, for example, split your Sipp fund so that part is in a CFD, where you can enhance returns by magnifying your exposure to a particular share or index, and part is in a traditional portfolio of stocks and shares.

"As long as you are trading within limits, you could pairs trade within a Sipp," says Mr Khouri. Here you take advantage of price gaps between two shares that should go up and down in unison – GlaxoSmithKline and AstraZeneca, for example.

However, what you can't do as easily with a Sipp is extract cash to raise money. Only those drawing a retirement income from their Sipp, through a drawdown strategy, could do this.

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Hedging your physical positions

According to Mr Khouri, the best thing you can do with CFDs in a Sipp is to use them to hedge your portfolio. CFDs are a simple and cost-effective way for investors to protect a share position against a near-term downward movement in the share price. This could be particularly useful if you are nearing retirement and are fearful that market weakness in the near future could shrink your pension pot in the couple of years before you take an annuity.

During the market cycle, share prices will move up and down. If you've built up a profitable share portfolio you may face the difficult decision of when to take your profits. You may have a positive long-term view on a share in your portfolio but think that the share price will remain flat or fall in the short term.

Alternatively, a share price may have risen dramatically after the release of a set of results and you want to lock in the profit without selling the underlying stock. Or, if you're holding shares outside a Sipp, you may not want to sell them as it may trigger a capital gains tax charge.

It is possible to neutralise the effect of a fall in share prices by taking a short position in a CFD on the same share. A short position profits when the share price moves down and a long position profits when a share price moves up. If an investor has an equal quantity of long and short positions in the same share it doesn't matter what the price does – no profit or loss will be generated. The investor is therefore 'hedged' against future movements in the share price.

CFDs are particularly useful in hedging strategies because they have no minimum parcel size. This means you can hedge a position more accurately using CFDs than with other derivatives that do have a minimum parcel size. You can exactly match the CFD quantity with the number of shares you are holding.

CFDs also have no set expiry date, which means you are not committed to hedge for a fixed term. You can hedge a share position for any duration of your choice – to coincide with retirement, for example.

However, it is worth noting that if you are looking to hedge an entire portfolio of stock, then a CFD may not be the most appropriate instrument. FTSE futures or options may be easier to use and cheaper.

If you have constructed a broad-based portfolio of UK shares that mirrors the FTSE 100, then you can sell index CFDs to hedge your investments. But bear in mind that a broker offering CFDs on indices will normally cover himself by buying or selling FTSE futures. He will add a spread onto the bid and offer prices that he is charged, and pass them onto you. That means that you would often be better off dealing in futures directly.

Also, it is quite rare for a small portfolio to track the FTSE's performance, and there's no reason to make it the goal of your investing strategy. There are plenty of diversified portfolios of UK stocks that are less risky than the FTSE.

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