Case study: equities vs CFDs

Case study: equities vs CFDs

John is a Rivkin member who is interested in the difference between different methods of trading the Rivkin US Momentum Strategy. As John is trading international shares, there are a few additional considerations that must be factored in when deciding how to trade.

There is no right or wrong way for John to trade although he must be aware of the consequences of the different ways to trade international shares.

Currency Effects

The first major consideration for John is the decision of whether or not to hedge his currency exposure. The US Momentum Strategy buys stocks listed in the USA and therefore the stock currency is the US dollar (USD).

For an Australian investor, this means that (in the absence of hedging) John will be exposed to fluctuations in the AUD/USD exchange rate. For example, if the US dollar declines in value relative to the AUD, the value of John’s portfolio will fall as measured in AUD, independently of any changes in the value of the stocks.

Conversely, if the USD rises in value, John’s portfolio will experience a currency gain. The chart below shows the monthly percentage returns of the US Momentum Strategy in both AUD terms

(unhedged) and in USD terms (hedged). The results show that there was actually a large difference between the two sets of returns and therefore the impact of currency movements can have a large impact on the portfolio return.

Chart 01. US Momentum Strategy returns 2017: AUD vs USD




Trading using Contracts for Difference (CFDs) has the advantage of automatically hedging the currency exposure of the initial investment (subsequent P&L is subject to currency movements). This gives investors the certainty that they will receive something close to the actual return of the stocks they invest in. Investing using equities, however, will expose John’s entire portfolio to the impacts of changes in the AUD/USD rate. While this can work both in John’s favour and against it, it adds an additional layer of uncertainty into the final return.

Leverage and Financing

Notwithstanding the benefits from currency hedging associated with CFDs, they do come with certain other considerations that must be taken into account. The first is that CFD providers inevitably charge financing on value of stocks bought. In the case of Rivkin Trader (powered by Saxo Bank), financing on CFDs is currently 5.5%. While this can have an impact on the final value of a portfolio, it also allows leverage to be employed. For John, he is interested in what difference he would see in his portfolio value depending on whether he buys his international shares as equities or CFDs using leverage.

The chart below shows the change in John’s portfolio value on a monthly basis throughout 2017. As can be seen, the effect of the leverage magnifies John’s returns and leaves his portfolio significantly better off than if he had traded in equities. The chart below takes account of the financing charge as a result of trading CFDs.

Of course, leverage works both ways and therefore if John’s stock values had declined, the impact would be worse for the leveraged account than for the unleveraged account.

Leverage should be thought of no differently to having a mortgage when buying a house. John has a mortgage on his house on which he has borrowed 80% of the value of the house. He rationally decides that having leverage on his stock positions also makes sense for him.

Chart 02. US Momentum Strategy equities vs CFDs




Margin

The final major difference between trading with fully paid equities or with CFDs is the idea of margin. Fully paid equities have no margin requirement due to the fact that they have no inherent leverage. CFDs, on the other hand, require that you have sufficient funds in your account to cover the required margin.

In John’s case, he decides to use 2 times leverage which gives him a large buffer before potentially receiving a margin call. Using the Rivkin Trader platform, John would receive a margin call if his Loan to Value ratio (LVR) reaches 80%. LVR works in an identical fashion as it would if John was getting a mortgage to buy a house.

That is, an LVR of 80% means that the value of John’s loan equals 80% of the value of the house. The chart below shows the LVR of John’s 2 times leveraged portfolio throughout 2017 (yellow line) and the margin call threshold of 80% (grey line). As can be seen, John has a large buffer before he would receive a margin call.

Chart 03. US Momentum Strategy margin requirements



In order for John to receive a margin call, the market would have to fall 38% from its start of year value. Although this is possible, it would be a very large market move and would only be expected to occur very rarely.

Therefore, with prudent use of CFDs, John can increase his return potential while still keeping risk at a manageable level.

Summary

Ultimately, members need to make an individual decision about whether equities or CFDs is most appropriate for them. John likes the extra return that he can make from leveraged CFDs and is willing to bear the additional risk so he trades the US Momentum strategy using CFDs.

The low margin requirement of CFDs (15%) also frees up additional cash for him to park elsewhere. Members who still have questions about the differences between equities and CFDs can contact us at 1300 748 546.

Complex product warning

This article contains information about CFDs, which are considered complex financial products. Please click here to read ASIC's "Thinking of trading contracts for difference?" document before considering an investment in CFDs.
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