Equity-based Contracts For Difference are slowly but surely appealing to the sophisticated investor, writes Caroline Madden

Although a relatively new concept to the Irish investor, Contracts for Difference (CFDs) are slowly but surely capturing the imagination of high net worth individuals tempted by the possibility of making very high returns within a short time frame.

Previously the preserve of institutional traders, CFDs are now available to private retail clients of major Irish stockbrokers such as Goodbodys and Davys, as well as Quay Capital Management, an IFSC-based commodities broker.

"The Irish investor is getting more sophisticated," says Vincent Crimmins, head of trading at Quay Capital Management. "There's no doubt Irish people love their property, though we're way below other countries like the UK or US in terms of share ownership - but it's changing.

"The smart investors realise that it makes sense to diversify their portfolio, so they're looking at other asset classes such as equities and equity CFDs."

While CFDs can cover almost any asset type, the vast majority are equity-based, and enable investors to gain maximum exposure to the stock market without having to physically own the underlying shares.

"CFDs offer many advantages over traditional share dealing and ownership," Mr Crimmins says. "You don't own the shares that you're trading. You own the right to the profit or loss on the position."

The investor speculates on the price movement of a share by opening a contract with the CFD provider and their profit or loss is based on the difference between the share price at the beginning and end of the contract.

"One of the advantages CFDs offer is leverage," continues Mr Crimmins, referring to the fact that only a margin of the total value of the investment has to be outlaid initially. Margin trading, as this is known, has the effect of magnifying relatively small moves in the share price, and so large profits can be made from a much smaller investment than that required to actually buy the underlying share.

"That's why successful property investors and developers often prefer CFDs to direct share ownership. They understand using leverage."

The downside, of course, is that losses can be similarly magnified.

Unlike traditional share traders, CFD investors can profit in a falling market by going short, ie speculating that the price of an equity will drop. And for investors wishing to trade in foreign markets, for example in sterling or dollar-denominated equities, CFDs offer significantly reduced currency exposure.

Apart from speculation on the movement of stock prices, CFDs can also be used to hedge a long-term shareholding. For example if an individual has purchased shares in a particular company as part of a buy-and-hold strategy, and anticipates a fall in the share price due to poor results, rather than incurring the costs of selling the shares and buying back in after the downturn, he can simply hedge his holding by going short using a CFD.

CFDs are generally viewed as a short to medium term investment strategy because of the financing costs involved - interest is charged for long positions held overnight making a longer timeframe unattractive.

While the majority of CFD trades are exempt from stamp duty, others may attract a 1 per cent charge depending on the exact circumstances.

Profits made through CFDs are subject to capital gains tax, whereas gains arising from spread betting, another derivative product gaining a following in the Irish market, are completely tax-free.

Derivative investment vehicles in general, and CFDs in particular, are not for the novice investor. Leveraging is a double-edged sword - investors can lose several times their initial margin deposit within a very short space of time. Providers are prohibited from allowing inexperienced clients to open a CFD account, and investors are generally advised to allocate only a small proportion of their total portfolio to derivative products.

The collapse of Elan's share price last February brought the high-risk nature of CFDs sharply into focus. It was estimated that more than €50 million was lost within a matter of hours after Elan announced the suspension of its multiple sclerosis drug Tysabri, and investors trading through derivative products were believed to have borne the brunt of this loss.

It emerged that many investors were overexposed to this volatile stock through highly geared long CFDs, and forced to close out their positions at a loss when the share price plummeted.

Mr Crimmins stresses that investors must understand the mechanics of how CFDs work, and emphasises the importance of risk management - for example the careful use of stop losses, which automatically close out a contract if the share price hits a certain level. "Successful investors know how important it is to manage risk - putting in stop losses, position management, that whole side of things. Shares have a different dynamic to property and react far more quickly to market events.

"With CFDs the risks involved can be magnified with the use of leverage. Investors should always be made aware of these risks," he says. "An investor should look at a CFD broker's experience with derivatives and not just their stock picking ability.

"I suppose we're a little different to most Irish brokers in that we come from a background in the hedge fund industry where the primary emphasis is on risk management and control."

Although the spread-betting market is currently unregulated, CFDs sold through a regulated entity such as a stockbroker or commodities broker are covered by the provider's existing code of practice.

However an EU draft directive, known as the Markets in Financial Instruments Directive (MiFID), is due to be introduced in 2007, (replacing the Investment Services Directive currently in place in Ireland), and will bring the regulation of derivative products such as spread betting and CFDs within the ambit of Irish Financial Services Regulatory Authority. It is anticipated that this increase in regulation will strengthen investor confidence in the derivatives market.