Most traders are risk-seeking, and one attraction of CFDs is that they allow sizeable economic exposure with relatively small amounts of capital, because their inherent leverage.
But longer term investors or those seeking diversification can use CFDs as well, in a different way. Investors with limited resources can use them to ensure they get adequate diversification.
All the literature on CFDs focuses on how you can use gearing to jack up profits (rarely mentioning that leverage exaggerates losses as well, of course). But instead, turn this idea on its head and look on gearing as a way of releasing capital. Because you can buy a CFD on, say, 10 % or 20% margin, you can achieve the same exposure to an individual stock with a fifth or a tenth of the capital you would otherwise use.
So, say as a long term portfolio investor (rather than as a trader) you have four stocks bought in the cash market with £10,000 invested in each. You want more stocks to get better diversification, and some cash in hand if other opportunities come along. Assume all your holdings have CFDs available, all with 20% margin required.
Using this ‘cash extraction’ method of trading, you can simply substitute CFDs for your shareholdings in the same proportions. After doing this, you would have £40,000 worth of economic exposure to the stocks in your former portfolio at a cost of £8000 in margin, and have released £32,000 in cash.
For simplicity, this ignores dealing costs and the daily interest debit that you would be obliged to pay on the CFDs. Interest rates are low at present anyway. We do, however, need to be careful about margin.
Just because as an investor you have retained your original economic exposure for a fraction of the capital previously employed, you can hardly go out and spend the cash on a Porsche. If any of the stocks in question fall in price, extra margin will be called.
This means that cash extraction trades like this need safeguards in place. One is to use stop-losses to give protection against sharp adverse movements that could cause you big losses. That’s a pretty wise move in any sort of CFD trading.
The other essential is to keep some of the cash released in reserve to more modest margin calls. Keeping some cash in reserve also means that you could earn a bit of interest that can be set against the daily interest debits on the CFDs.
You won’t, however, need all of the cash to cover this liability. But let’s say that of the £32,000 in cash that you originally released, you keep a further £8000 in reserve to meet any possible margin calls. What you now have is the £40,000 economic exposure represented by your original share portfolio, but at a capital cost of £8000. You have a further £8000 in reserve to meet margin calls, and £24000 of freed up capital that can be invested elsewhere.
Where you invest this remaining £24000 rather depends on your view of the market. A UK 100 ETF or gilts might be a possibility. Or even gold bullion to cover the disaster scenario. It doesn’t really alter the main objective, which is to achieve real diversification with limited resources.
There is another interesting point here if you feel your stock picking skills are good. Using the CFD market to free up capital that is then invested passively is really what is known in asset management as a ‘core and satellite’ approach, or sometimes termed a ‘barbell’ strategy. If the stocks picked do well, outperforming the market is all but guaranteed.