October 15, 2018
CFD are a form of derivatives which are attractive to traders because of the potential returns. You may have heard that these financial instruments are incredibly leveraged – meaning you can potentially make bigger gains proportional to the amount of money you put in (your margin).
Of course, the reverse is also true – you can potentially make a far greater loss as well.
For this reason, some people with a little money to invest, are drawn to CFDs – enticed by the prospect of huge returns. The rise of smartphone-optimized trading platforms is also attracting a younger generation of traders to them.
But whether money is actually “invested” in CFDs can be disputed. The extreme risks associated with CFD trading have led some to consider it as a method of gambling. An unsophisticated way of betting on the direction of a share price against your CFD broker.
So would you be better off only trading in stocks rather than CFD on stocks?
To know the answer to this question, you need to understand some of the key differences between CFDs and stocks. This will help you to decide if CFDs are suitable for you.
When directly trading stocks, you are buying and selling a small ownership of a publicly-listed company at prices determined by the market. Generally, if you make a wise investment choice, you can hope to make money by selling these shares in the company at a higher price than you bought them for. Provided you sell at the right time of course! Depending on the shares purchased, you may also receive an income stream in the form of dividends.
But when trading CFDs, you’re not actually buying and selling shares in a company. You’re making an agreement with a CFD broker to exchange the difference in the value of a contract which is derived from the price of a share/commodity/currency/index. So you never own the assets – you merely trade a contract between you and a CFD broker to pay or receive a price difference.
In buying a stock (without a margin loan), the cash you put in is exactly what you get in shares. So if you invest $2000 in a stock with a share price of $2, you get 1000 shares – so $2000 worth of that stock.
But when buying a CFD, you only have to put up a fraction of this value – yet you can achieve gains and losses as if you had bought the whole value. Essentially you are buying a product with the leverage embedded into it. For example, you can place an order to buy 1000 CFDs at $2 each. The total value of this contract would be $2,000, but the CFD provider might only require you to put up 5% of the value to execute the contract, so only $100. This amount is known as your margin. The CFD broker covers the rest of the contract’s value.
In this example, if the price of the CFD’s underlying asset rises 10%, say from $2 to $2.20, you make a gain of $200 (10% of $2000), so a return on your $100 margin of 200% (not including commissions, fees, charges or interest). But if it goes the other way, you can lose just as much – meaning you can lose a great deal more than your original deposit.
CFDs are not for the faint-hearted.
So in this scenario, by just buying the stock a 10% rise in the share price means a 10% gain, but in buying the CFD, a 10% rise in the underlying asset price means a 200% gain. This is how CFDs are leveraged.
The risks of trading in the stock market are apparent to most people, with the media often reporting about stock crashes and financial crises. But with stocks, the maximum amount you can lose is only the total amount invested.
CFDs take this risk to another level, because you can lose much more than your initial margin invested. Because of this, there is a high chance of receiving the dreaded margin call. There are many stories of people losing hundreds of thousands after receiving multiple margin calls, despite only putting up small amounts in CFDs. The risk is real!
Other risks associated with CFDs include counterparty, execution and gapping risks, so be sure to fully educate yourself about these before you begin trading them. There are things you can use to mitigate the risks of CFD trading like a ‘stop-loss feature’, but these are not guaranteed to be executed by the CFD provider. You can take out a ‘guaranteed stop-loss’ but you have to pay a premium price for these to the CFD brokers.
In essence, when trading CFD’s you are taking bets against your broker and your brokers will always have leverage against you because they can adjust the spreads on your trades, cause slippage in your entry or exits points or even pull you from a trade at any time. Do your own research and exercise due diligence when trading with a CFD broker.
With stocks, most people invest over the long term and let their shares grow slowly over time. As such, they are more of a ‘set and forget’ investment than CFDs.
In trading CFDs, lots of money can be gained and lost very quickly, so they are usually traded over short time periods. They are not a set-and-forget investment!
Although investing in stocks should not be done without the right knowledge and advice, far more expertise is required to trade CFDs.
CFDs need lots of attention and management because of the leverage and the fact you’re always competing with your broker. If you make money out of the trade, the broker loses. If you lose, the broker gains. Chances are the people you’re competing against may be risk managers for big financial institutions with years of experience and advanced knowledge of financial models.
While the share market is extremely regulated, the CFD industry is less so. So, you need to thoroughly investigate the credibility of which provider you trade CFDs with.
For example, CFD trading is not permitted in the largest trading market in the world, United States of America. Due to the Securities and Exchange Commission and legislation like the Dodd Frank Act, American citizens are barred from trading CFD stocks.
For many people who wish to learn the true aspects of how the markets fundamentally works, stock trading is far superior to trading CFD’s.
In a true market, buyers and sellers can exert real influences on the price of anything while trading in a regulated and protect environment. Unlike CFD’s, where the broke is simply taking the price of an underlying asset and allowing you to take a bet on the direction of the asset with leverage.