Today I will briefly write about the next two possibilities for managing risk in the light of the Brexit referendum. Remember, the main point is to protect yourself British Pound assets from losses from further potential fluctuations in the value of the British Pound.
This post will discuss using contracts for difference (CFD) and spreadbets (SB). I will not discuss the method of using options/derivatives – as I am realizing the discussion would need to be overly lengthy for a reasonable introduction. Thus this will be the final post in the series.
Contract for Difference
A contract for difference (CFD for short) is a financial instrument offered by many brokerage firms in the UK. Firms that i have personally used are FXCM, CMC, Active Trades and LMAX. My experience with all of these was good enough for me to potentially use them again in the future.
The first step is to open an account with a broker. You then deposit money into the new brokerage account. Often you can choose what currency you would like the account to be denominated in. If choosing something other than GBP, then the broker will convert your GBP deposit into the respective currency. I don’t know what kind of exchange rate the broker will give you (i.e. how far away from the real market rate – see Part 3 on how that works) because I have only used GBP accounts. Additionally, I am not sure whether the broker would be happy to convert the money for you and then just have it sit there without you doing any trades. If you go down this route, then please let me know how you get on.
In any case – having a brokerage account is a bit similar to an online bank account. With the balance in your account you now buy or sell CFD’s.
A separate CFD instrument should be available for every common exchange rate, such as GBPUSD. Recall the idea is to protect yourself from further fluctuations in the exchange rate. If you are concerned that the value would fall further, then you would SELL the CFD for GBPUSD – if you have £100k and want to protect yourself entirely then you would sell £100k worth of the CFD. If you only wanted to protect yourself for 50% of the £100k, then you would sell £50k worth of the CFD.
If the British Pound continues to drop then you would gain on the CFD position. However the broker allows you to trade “on margin” – meaning if you wanted to sell £100k of GBPUSD then you only need to deposit a fraction of the £100k into the brokerage account. The majority of the £100k savings (say £95k) could be maintained in the normal bank account. Thus the value of the £95k would reduce because the Pound has fallen, however this would be offset by the gain from the sale of the CFD contract. If the Pound rose, then there would be a loss on the CFD trade, but this would be offset by the increase in value in the Pounds held in the normal bank account. The gains and losses would only be crystallized once the CFD trade was closed.
The broker will charge you a daily financing amount, since they are allowing you to trade £100k of exposure with a deposit of only £5k (in many cases less).
Spreadbets operate in a very similar manner to CFD’s. The only difference is that one needs to ask for a SB account rather than a CFD account. With CFD the method is to sell £100k of GBPUSD – with SB the method is to “bet a certain amounts of £ per pip” – meaning betting £5, £10 etc per 0.0001 movement in the exchange rate.
Additionally, it is common opinion that profits/losses on spreadbetting are not subject to income tax in the UK. In contrast, profits/losses on CFD trading may be subject to income tax. This is because spreadbetting is regarded as gambling, whereas CFDs are not – even though in substance one is doing the same thing.
Again, I am realizing that these posts are getting quite long. I wanted to provide an introduction/overview of how one can personally go about protecting oneself from further currency fluctuations in the British Pound – but am quickly realizing that this might have been a slightly ambitious undertaking. Hopefully it has been helpful and informative.
So I will stop at this point – but please feel free to comment below if you have more questions on the above discussions.