Should I Trade Daily Leverage Certificates or Contracts For Difference?

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Jesse Livermore walked into a cafe and found a seat by the window.

The waiter was quick to spot an important man like him and walked toward him as soon as Jesse sat down.

"Sir, your usual?"

"Yes Alfred. What's the quote on Livingstone today?"

Looking at his notepad, the waiter replied, "it would be $9 3/8 sir."

"Write me an order of 50 shares."

"Right away sir, and I will get you the coffee."

The waiter hurried away while Jesse pulled out his papers and started reading, knowing that he would be making good money from the stock market that day.

Welcome to the Bucket Shop

This was a typical bucket shop in the early 1900s (although the interaction was fictitious) where individuals went to trade stocks and futures. 

However, these bucket shops operated independently from the stock or futures exchanges. They took in side bets on price movements of the securities (much like the illegal 'bookies').

The U.S. Supreme Court defined a bucket shop as: 

"an establishment, nominally for the transaction of a stock exchange business, or business of similar character, but really for the registration of bets, or wagers, usually for small amounts, on the rise or fall of the prices of stocks, grain, oil, etc., there being no transfer or delivery of the stock or commodities nominally dealt in."

At this point, you might be wondering - why would one even think of trading in a bucket shop?

Let's go back to the future and explore today's bucket shop.

Finding the Modern Bucket Shop

I used to do shorter term trading when I first started out. I traded stocks and forex pairs.

As a trader, I would go long (buy) and short (sell) positions to get the most out of the market in any direction.

Unfortunately, stocks do not allow me to take a short position over a long period of time. Plus, as an individual investor, I could not take a seat in the interbank foreign exchange market like the bank traders.

But not all is lost, one of the most versatile instruments that's available to the individual trader is the Contract for Difference (CFD).

It allows me to trade the forex markets as well as take short positions on stocks as long as I wanted. It has facilitated the dreams of many individual traders to trade a wide variety of assets which would have otherwise been inaccessible. Even recently, you can trade bitcoins using CFDs.

What are CFDs?

Originating from London, CFDs are contractual obligations to settle the price differences of a trade in cash. These are drawn out between the trader and the broker.

In simple english: You pay the broker when you lose and he pays you when you win.

This loose definition provides the flexibility to trade on anything in this world that has price quotes, without the need for the trader or broker to take ownership of the actual assets they are trading.

How CFDs Work

If you buy a CFD on 100 DBS shares at $20 each, you do not own the DBS shares.

The CFD would mirror the price movements of DBS shares in the stock market (but not exactly, more on this later).

Let's say you decided to sell the whole position at a share price of $21, the broker will pay you $100 profits* before fees are deducted. 

You and the broker have just settled the profit and loss based on the price difference.

*($21-$20) x 100 shares

The problem with CFDs

In the stock market, futures market or any open market, market prices are determined by the buy and sell transactions that participants make. 

Comparatively, CFDs operate in a closed system where the broker determines the prices of their contracts, with reference to the actual market prices.

The method to determine prices is not transparent and CFD prices may vary vastly from the real market prices because of:

  • Widening price spreads
  • Additional widening of price spreads during wild market moves
  • Latency on the CFD platform as well as the data delivery to your device (they would not be able to invest in their technology as much as an exchange can)

In finance speak, CFDs are over-the-counter (OTC) products. 

You would have picked out the fact that the broker have too much power over CFDs and that they could abuse it. You are right. 

Let me share my experience with you.

How I (almost) got cheated by the bucket shop

The weekend was round the corner, I logged into my account just to take a look.

Then, I noticed my buy stop order was triggered and filled at a price that was way higher than the highest price that day.

I was upset because it wasn't fair. So, I wrote in to the broker:

Luckily the broker agreed to void the trade.

Subsequently I had another instance of an erroneous price trigger for the same stock.

I was pissed. How can I trade confidently if I can't even trust the broker? 

So I wrote in and asked for an explanation:

The explanation the broker gave was that "the underlying market was volatile". 

The CFD pricings were generally okay when the markets are calm. But when the volatility of the actual prices increased, the CFD price spread widens so significantly, it can take out an unknowing trader.

This is because the CFD broker needs to protect his interests by buffering the prices a lot more.

Think of the incident that happened during Brexit. Even as the British Pounds was hammered, the money changer would quote an even lower price than the prevailing rate.

What is Direct Market Access and will it make CFDs safer?

Direct Market Access (DMA) allows CFD traders to place their orders on the actual exchange.

But, DMA don't stop the brokers really. It's always up to the brokers to hedge their positions. If there are two opposing trades done on their platform, all they need to do is to match them without going to the exchange.

The question is; would they choose to match up traders on the actual exchange and incur more fees?

I am not sure if things have turned better in the CFD scene since my incident, so it would be good if you can share some of your experiences too.

However, I do believe that it is difficult to behave properly if the system is structured and incentivised in a certain way.

DLC Trading - Leveling the playing field for small traders

Recently I came to know about a new product listed on the SGX. I had done a coverage on it: Daily Leverage Certificate (DLC).

The more I learn about the product, the more I think it is better for traders. It gets rid of lack of transparency that CFD traders have to fight with daily.

DLCs are listed on the stock exchange.

Many people may not appreciate this but allowing participants to trade with one another and allowing everyone to see one price is the essence of having an exchange. It shows you the price that the overall market participants gravitate towards, and the aggregate views of an asset.

I think this is the fairest way of setting prices.

As the prices are reported, we can extract the historical prices and check how the DLCs move with the indices, especially during periods of higher volatility.

I have charted out the day-to-day price changes of the DLC tracking the Hang Seng Index against the actual Hang Seng Index:

You can see that the DLC tracks the index pretty closely, given that the blue dots and the end of the red bars were very close to each other.

For short DLCs that allow investors to express bearish views, one can expect them to move similar to the above chart in terms of magnitude (scale depending on the times of leverage embedded), but in the reverse direction.

DLCs vs CFDs

DLC

CFD

Price Transparency

Price is published on the exchange and everyone sees the same price

Determined by the broker

Variety of Assets

Limited to stock indices (in SG)

Wide variety (from stocks to cryptocurrencies)

Leverage

Up to 7X

As high as 20X

Trading Fees

More expensive. Fees and charges are formula based and published daily

Relatively cheaper. Costs may increase due to the changes in spreads

It is natural for traders to compare DLCs to CFDs with other features besides price transparency. I can think of a few counter-arguments.

#1 - Variety of Assets you can trade

CFDs offer a wide variety of assets such as stocks, indices, forex, and cryptocurrencies.

DLCs are still in its infancy stage now in Singapore and are limited to a few stock indices.

I expect there would be DLCs on individual stocks in the future. And I'd expect the product range to increase overtime.

#2 - Leverage

CFDs can provide very high leverage, as high as 20 times for some indices. DLCs that are listed on the SGX currently are limited to 7 times.

Prudent traders would know that higher leverage also means your positions can get wiped out faster. Plus, it shortens your runway to a margin call.

DLCs on the other hand, do not have margin calls and the maximum you lose is what you have invested.

#3 - Commission

Some traders would complain about having to pay higher commissions on DLCs since they incur normal brokerage fees as stocks. 

Here are 2 ways to lower your commissions and narrow the differences between exchange-listed products and CFDs. 

  1. Use pre-funded accounts to lower your commissions from 0.28% to as low as 0.12%.  
  2. Use discount brokers like Interactive Brokers which charges minimal commissions of 0.08% or $2.50.

Comparatively, CFD brokers can offer zero commissions for some of their products. In fact, there are CFDs on indices with no commissions. 

As I have shared, they are cheap for a reason as they can eventually price the fees into the spread. This is the risk you'd have to take as a CFD trader.

If you are merely choosing to trade with CFDs due to the commission, then I would advise against being penny wise and pound foolish. 

Plus, the cost difference isn't that big anymore given the availability of pre-funded and discount brokerage accounts.

Why you should consider DLCs

My gripe with CFDs is that they are not transparent enough and it goes against the free market principle by allow brokers to dictate their own pricing.

To me, it isn't worth paying less commissions when the markets are stable, but really pay the true cost when the markets become volatile.

It is better to stick with transparently priced products such as DLCs, if you are serious about trading in the long run.

I hope this article can give you a good think about your choice of trading products.

Keep a close watch on DLCs developments because there may be something you would like to trade eventually as more products are launched.

If you are already trading Hang Seng or SIMSCI indices with CFDs, you can already take advantage of what DLCs has got to offer.

Jesse Livermore became well known among bucket shop owners because he made so much money. He was a common target of bucket shops and the prices he was quoted were always higher compared to other clients. It was no longer worthwhile for him to trade at the bucket shops. He decided it was time to move on and start trading at the exchange.

This article is sponsored by Société Générale. The views and opinions are of that of the author.

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