You may have heard of this thing called “CFD” when you read that someone “shorted a stock using CFDs” and have always wondered what that means.
How is a CFD different from the normal vanilla-flavoured shares of a company?
Read on for a short and simple primer to the world of CFD investing!
What Is A CFD?
CFD is short-form for “Contracts For Difference”.
A CFD is a derivative financial instrument – this means that it belongs to the same class of instruments such as forwards, options, futures, swaps and if you don’t understand what all this is, a simple explanation is that when you invest in a derivative of a company’s shares, you are basically buying or selling a “paper” contract of promises rather than an actual share of the company.
Well, technically, a share of the company is already a piece of paper, so that means a derivative is a “paper” contract over a piece of “paper”.
While a share of a company is backed by the company’s assets, a derivative contract is backed by just the contract between you and the party you are transacting with. This other party is usually called a “counter party”.
The name for CFDs came about because investing in a CFD simply means that you are betting that the stock price would be going up or down. The larger the difference from the original purchase price, the larger the gains or losses that you would be earning.
How Does A CFD Work?
The major differences between a normal stock investment and a CFD are that in a CFD:
1) You are transacting with the broker
The broker is the counter party you trade CFDs with. Major local brokerages offer CFDs for trading.
If you prefer cheaper transaction fees, you may consider the many online brokerages out there, but do run checks on their reputation and history before starting.
As the CFD market is not regulated as tightly as the stock market, be sure to read the fine print and consult a professional if needed.
2) You do not own the company’s shares when you buy a CFD
Owning a share means you are legally part-owner of the company you invested in. The owner of a share will, among other things, be entitled to dividends and allowed to vote in general meetings of the company.
In contrast, owning a CFD is merely a bet on the stock price of the company and nothing else. Do note that CFDs would usually reflect dividends or corporate actions by paying the investor cash into their account.
Using football as an analogy, buying company shares is like buying over a football team while CFDs is like placing a bet at Singapore Pools on whether your football team wins.
3) You are usually able to leverage by trading on margin (placing a deposit with the broker)
Unlike purchasing shares, where 100% of the share is usually paid upfront, brokers usually allow you to purchase CFDs on margin.
Assuming the shares of Company ABC is worth $10 a share, and you want to buy 1,000 shares betting that the stock price will go up in the short term. This would cost you $10,000. This means if the stock goes up $1, you make a gain of $1,000, or 10% return on your investment.
However, a broker offering 20% margins on CFD would allow you to have an equal exposure of 1,000 “shares” of Company ABC by placing only a $2,000 deposit. If the stock goes up $1, you still make a gain of $1,000.
Because you only risked $2,000 on the margin deposit, this is a whopping 50% return on investment!
Another way to look at this is if you used the initial $10,000 to buy CFDs instead of shares. This would allow you to gain exposure to 5,000 CFD “shares” of Company ABC rather than 1,000 normal shares!
This is called leverage, and in our example the leverage is effectively acting as if you had 5 times of the initial investment.
Margin trading incurs interest charges on the margin financing provided by the broker. These costs are usually deducted from the margin deposit automatically by the broker’s trading platform.
The Dangers Of Margin Trading
Now that you’ve discovered the advantages you can gain by using CFDs, you’d surely everyone else should be making use of this… right?
Here’s the thing about CFDs that highlights the downsides of using it.
Margin trading is risky business so make sure you read this next part carefully!
The 2 main dangers of margin trading is leverage itself and also counter party risk.
- Leverage – the double-edged sword
Just as leverage can work to your advantage, remember that in the world of finance there is rarely a free lunch for the investor. Leverage magnifies the losses when the stock price goes in the other direction!
Gains and losses made on margin trading will be added or deducted from the deposit you placed.
- Margin call
When losses exceed the initial deposit, the broker would issue a margin call to the investor which would require a top-up of funds into the margin deposit to match the losses.
Different brokers have different procedures regarding margin calls, but the outcome is usually the same.
If this margin call is not met, the broker would force sell the investor’s CFD trade, and the investor will still have to top-up the remaining losses not met by the initial deposit.
Hence, it is possible to lose more than your initial investment when trading CFDs!
- Counter party risk
Another danger is the risk that the counter party doesn’t fulfill its side of the deal.
Just like normal companies, the brokerages that you trade CFDs with might go bust one day and investors with that brokerage are likely to lose their CFD investments as well as their margin deposits!
Do note that trading with bigger brokerage firms does not mean that they are immune.
A less severe form of counter party risk here is when the broker defaults on payments. This happens when you need to withdraw cash from your margin deposit but you are faced with delays in getting the withdrawal.
The moral of the story here is – do some research of your own before deciding on a reputable broker to trade CFDs with.
For new investors, it is most advisable to try margin trading with CFDs on demo accounts if your broker allows it. Most online brokers have a demo account function where you are given virtual credits in place of real money to test out the broker’s platform and service.
However, do note that trading with virtual and real money are 2 different things altogether. The psychological stress that you would face trading your own money is definitely more than when you trade with virtual credits.
Trading CFDs can be very profitable… but very risky as well.
Do make sure you’re really ready before trading leveraged products like CFDs.
Be sure to consider all the points above and read up further before jumping into the world of margin trading!