The second main instrument used for short-selling individual stocks is the CFD, short for Contract For Difference. The name is not very illuminating, but suffice to say that it acts like a form of stock futures where the gain or loss is the difference between the opening price and closing price of the underlying stock multiplied by number of shares specified. Like futures, it is a leveraged instrument, meaning the trader/short-seller only needs to put up a small portion of total nominal amount as equity; the rest is broker-financed as implied by the nature of the instrument.
Before I started my survey in detail, I’d only known of one local house that offered CFDs and that was Phillip Securities. Turned out that Lim & Tan also offers this facility, and also foreign boutique houses like IG Markets and City Index.
Again, management of one’s margin position is important because it is tempting to put up the minimum equity (20% of total nominal amount) and leverage up to the hilt. This is not wise and really one should have sufficient cash to top up margin positions when the underlying price moves against him.
Unlike SBL, the trader does not actually trade in real shares on the stock market in the case of CFDs. It appears that the counterparty might be the proprietary account of the broker themselves. Some people are concerned about this, because there is a possible asymmetry of information here. It is difficult to say, but I guess the advantaged counterparties would have hedged their positions the way warrant market-makers do so.
My main issues with the CFD instrument are twofold. Once again holding cost is one of them. Financing cost for CFDs ranges from 4-8%/annum of the nominal amount of stocks short-sold, depending on house and individual stock. Commission is about 0.3%. However, CFD contracts differ from SBL in that they have expiry periods, typically one month, and if one wishes to extend his short position, he has to rollover the contract; every rollover incurs a new commission, hence a new commission is actually charged every month instead of per round-trip trade. Again supposing that one assumes a CFD short position on $100k worth of shares over three months, the financing interest will be $1000 (based on lowest 4% financing interest) plus $1200 round-trip trading commission (start buy, end sell, + 2 monthly rollovers), comparable to an SBL position of the same duration (see Part 2). For longer durations, CFDs become more expensive than SBLs because of this monthly rollover commission, all other costs remaining similar. And of course, the unsophisticated “buy-and-hold” investor will incur much less costs, as had been compared earlier.
Note that the 4% financing cost is limited to a small number of stocks. For Lim & Tan, they number about 100-odd. For Phillip, all short CFD positions require 8% financing. The problem with using CFDs to short is that there are limited counters for which this facility is provided, the second issue I have with these instruments. The foreign houses (IG Markets, City Index), being not so locally-focused, typically offer CFD contracts on STI/SIMSCI index stocks and miscellaneous other semi-blue chips. One might not find a CFD facility for the counter he wants to short-sell, a particularly vexing problem (at least to me, since I focus on mid/small caps). And another thing: the list of CFD-able stocks is often subject to review monthly. That means if one is holding a (short) CFD position for a stock which is taken off the CFD list at the end of the month, he is no longer able to rollover. Again that creates uncertainty, much like the issue of recall of borrowed shares in the earlier SBL instrument.
Generally, CFDs are marketed as being more convenient as the traditional SBL because of less administration process (no need to wait for share borrowing from CDP) and savings on settlement/exchange clearing charges (since the transaction is with the broker and never goes through SGX). Different CFD houses have varying rules on corporate actions; most facilitate dividend adjustments but some require the contract to be closed in the case of stock splits/bonuses (eg. Lim & Tan) while others simply make price adjustments to the CFD contract (eg. Phillip). Traders are advised to check these minor issues out before they become a major issue down the road.
In the next article I move on to put options and associated strategies.
Source: My Thoughts On Stock Investing