Tuesday 13 March 2007

Using Contracts for Difference (CDFs) to trade US stocks

I've been building up a portfolio of US stocks (my "Little Book" portfolio) since the middle of last year. One of the problems of trading US stocks from Australia has been the relatively high brokerage costs - using Comsec-Pershing it costs AUD$65.00 per trade. E*Trade Australia charges even more, and I haven't been able to find any Australian brokers that will trade US stocks more cheaply. Some readers have recommended US-based brokers which are cheaper, but before I take that route (with the associated hassles around transferring funds in USD to a US brokerage before making trades) I've decided to experiment with using Contracts for Difference (CFDs). These are quite a popular tool for day traders, as you can gain market exposure with low costs per trade (as little as $1) and trading CFDs has a built-in gearing effect (usually the trades are based on a margin of between 5% and 20% of the stock value being traded). I don't intend to try day trading (I think it's a zero sum game, which generally just transfers wealth from the casual day trader to commercial traders), but it looks like it may offer a cheaper method to implement by US stock portfolio strategy.

I applied online for an account with CMC Markets on Friday, and today their representative phoned to request a fax of some identification (drivers licence and a rates notice) to finalise opening my account. As soon as this is processed I'll be sent a login and can transfer the initial $1000 required to begin trading. Although there is a normally a monthly fee of around $40 to use their trading software with live stock price data from the ASX, as I only intend to trade US stocks this data isn't needed and I won't have to pay any monthly fee.

Trades of US stocks are generally on a margin of 5%, so I should be able to buy a CFD to gain equivalent exposure to a US stock as my Comsec-Pershing $5000 trade for only $250. The minimum fee of $10 is high as a percentage of the trade value (4%), but is very reasonable compared to the underlying stock exposure (0.2% of $5000). I'm not sure that all the US stocks I've picked for my "Little Book" portfolio would be available as CFDs - only 541 "constituents" of the US market are available from CMC markets.

There's also a fundamental difference between buying stocks and trading CFDs - in the case of CFDs you are basically buying a promise from the issuing company, in this case CMC Markets. The CFDs issued by CMC Markets are not tradeable by any other CFD company, and if CMC Markets went out of business my investment in their CFDs would be worthless.

Anyhow, to replicate my actual US stock trades with Comsec-Pershing over the next 12 months (US$60K worth) will only cost me around US$3K to buy the equivalent CFDs, so it's not going to be a hugely expensive experiment whatever happens. If it works out I could save US$600 a year in trading costs, which would add directly to the ROI of my "Little Book" portfolio.

Enough Wealth


mOOm said...

They sound a lot like single stock futures with no expiry date with except instead of having interest built into the purchase price you pay interest separately. I'd heard the term before but didn't know what they were.

What is the tax treatment of them in Aus? i.e. if you hold for a year can you get the long-term CGT rate?

enoughwealth@yahoo.com said...

Going by the tax information provided by CMC Markets in their FAQ (with the usual "all care but no responsibility" disclaimer) it seems that most CFDs are actively traded, and gains/losses should be treated as income. BUT it then goes on to say that CGT rules apply where the gains/losses aren't treated as income. I'm guessing that no many people hold CDFs for more than 12 months, but I can't see any reason why they wouldn't be treated as a capital gains if you aren't actively trading. You'd probably have trouble convincing the ATO to treat >12mo trades as capital gains/losses if you also did some shorter period trading.

As I only plan on doing small trades to mirror my Comsec-Pershing trades for the next 12 months (and see how the pricing/costs compare in practice) any gains realised in FY2008 will be very small. So I'll just list them as CGT events (if the ATO does an audit and decides they should have been classed as income the extra tax due would be miniscule) - but I'll ask the ATO for a private tax ruling if it looks like I'll end up moving all my US stock trading over to CFDs.

BTW - I didn't mention it, but the interest rate charged on positions that are open overnight is 3% on top of the "reference rate" - for trades denominated in USD that is currently 5%. So total interest charged on the margin value will around 8%pa, which is slightly higher than my portfolio loan (HELOC) rate, but about the same as I pay on my Australian margin loan accounts.

mOOm said...

Thanks for info. I asked because here in the US there is a special tax treatment of futures - 60% of the gain is at the long term rate and 40% at the short term rate irrespective of how long you hold the contract. No other country I am aware of does anything like that but maybe some treat these things worse even if you hold for 12 months. Another great thing about futures (and options/warrants) is that the built in interest is at close to the risk free rate - same goes for leveraged (geared) funds. But these charge 8% anyway you say... Anyway deducting interest from your income can have tax advantages in Australia but tends to be not very advantageous or even disadvantageoous in the US tax code.

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