Bear market drives new CFD trend – BJM PCS
The equity bear market is driving a new trend toward defensive utilisation of contracts for difference (CFDs), a financial instrument traditionally associated with heavy leverage during periods of buoyant growth.
The morphing of CFDs from a bull tool to a bear ploy was highlighted this week (Friday, October 17) by Barnard Jacobs Mellet Private Client Services (BJM PCS), a firm that advises some of the country’s wealthiest individuals and families on value enhancement and protection strategies.
Rudolph Vermeulen, head of the CFD unit at BJM PCS, commented: “When BJM first offered a CFD platform a year ago, we emphasised that this type of derivative should not be viewed as a tool of casino capitalism, but as a flexible instrument that had an important role in various market conditions. You can leverage on the ‘up’ and hedge on the ‘down’.
“Sophisticated investors are increasingly adopting CFDs to mitigate risk in an increasingly uncertain market. Early successes in this role look certain to establish the CFD as an important wealth protector in what may be a lengthy bear market.”
CFD’s have the advantage over warrants and or options of not being bound by a fixed expiry date or set strike price. In addition it provides full participation in all corporate actions. A CFD thus offers the client all the benefits of owing the underlying asset, only at a fraction of the cost (the margin required).
Investors who ‘go long’ (perhaps leveraging capital by a multiple of five or 10 in hope of a rising market), pay the interest charge. When an investor goes ‘short’ anticipating a fall in values in a defensive play, he would receive interest.
Vermeulen added: “A few months ago, we advised that market risk was moving to the upside. Clients were losing their appetite for risk and multiples in ‘long’ strategies began to fall.
“More recently, the ‘short’ or ‘hedging’ strategy has come into vogue, particularly with some high-dividend stocks where a client is looking for a tax-efficient income stream from dividends while earning interest on the short position and protecting capital.”
The usefulness of the technique has been spotlighted in the resource sector, which has experienced falls approaching 50% in a year.
The CDF specialist at BJM PCS pointed to a transaction initiated in mid-August by the owner of a 1000 shares in a major resources group. He wanted to retain the shares at least until the dividend accrued in September, but had already lost about 17% on the shares’ value inside a month and did not want to risk further loss.
He retained the shares, but sold a CFD at an equivalent value on this same stock, buying it back four weeks later. In that period, his shares lost a further R29 000, but the investor made R29 340 on the CFD trade (R29 000 on the CFD plus R2 088 in interest less trading cost). In addition, he pocketed the tax-free dividends paid on the shares.
Vermeulen added: “These instruments are open-ended and sometimes run for some time, but a trading cost is attached. The CDF is usually deployed as part of a wider strategy with a specific end in view. Good market intelligence and sound advice are usually required to optimise the outcome.”
