CFD Trading: The Logical Evolution

The rise of cloud computing, high-speed internet and mobile platforms has removed technological and institutional constraints to individual empowerment.

Since the dawn of the modern portfolio theory era, with its mantra of diversification, individual empowerment has been subject to institutional and technological constraints. Yet, with the ascendance of cloud computing, ubiquitous high-speed internet and fully hyper-functional mobile platforms, these limitations are fading as barriers to implementation.

Individual empowerment has been profound. Not surprisingly, “Computational Investing”, an online Georgia Institute of Technology course, has witnessed enrollment of over 170,000 (but only 5% completion). On a related note, online forums, Twitter feeds and access to academic finance research bring actionable insights to the masses.

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Unfortunately, existing institutions and marketplaces have largely proven to be insufficiently robust and dynamic to fully adapt to and allow individual traders to benefit. Furthermore, existing expenses and fee structures have proven to be insufficiently flexible to the new realities:

 

  • Traditional vulnerabilities faced by brokerage clients are only accentuated in the new technological realities. Only this week, a class action lawsuit was filed against Deutsche Bank for taking advantage of millisecond changes in exchange rates to give clients worse prices than they were entitled to. While in November, Barclays bank agreed to a settlement with the NY State Department of Financial Services on very similar claims.

 

  • High expenses still burden traditional investment channels. One example is special commodity funds, whose returns are largely uncorrelated with that of stocks and bonds. Yet, their long-run net alphas (the value added to the investment process after adjusting for volatility risk) are consistently negative, according to a recent academic Journal of Wealth Management study. This assessment characterized results from both funds dealing in physical commodities (storage and capital costs) and futures funds (limited shorting options). Issues of market illiquidity also adversely impacted performance.

 

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  • Established equity investing mutual funds have lost favour with investors. Last year witnessed the largest outflow ever and the first net outflow from traditional money managers since the 2008 financial crisis. This outflow occurred even as actively managed mutual funds overall performed better than their indexed competitors for the first time since 2012.

 

Accordingly, the client – broker – principal – market paradigm is facing renewed scrutiny in the increasingly asset-converged trader-empowered world. And herein lies the advantage of CFD trading, certainly over the most common alternatives.

Futures, though mature and exchange traded, are denominated in outsized basic units and feature less-than transparent pricing, particularly at the contract close.

Similarly, option pricing is complex and has price decay when approaching expiry

While academic research on CFD trading is scarce, one study in the Journal of Accounting & Finance has shown that for Australian Securities Exchange listed share CFDs (traded until June 2014):

“…market order CFD trades earn small positive returns at the daily horizon, with negative returns reported for one month to one year horizons due to financing costs. Market orders (are) also net sell positions, which suggests that investors use CFDs for shorting opportunities. Overall, (they) find that liquidity demanders in CFDs obtain favourable execution, which is inconsistent with the view that CFDs are used by naive individuals.”

Given that CFD prices are constructed from publicly available underlying instruments and no systematic distortion is introduced in the pricing process, CFDs truly represent a cleaner purer pricing process available to any trader today.

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