Contracts For Differences (CFDs) are one of the more popular derivatives in the financial world. That being the case, there are still many who do not understand how CFDs work, or even what they are used for.
Many people view them as highly complex products that only sophisticated traders or professional fund managers use. Others associate them to be the same thing as gambling in the financial markets. But are all these perceptions really true?
What Are CFDs?
As the name suggests, a CFD is a contract between two parties to exchange the difference between the price of an asset from its opening position to its closing position.
Since CFDs obtain their value from the underlying asset that they are tracking, they are considered a type of derivative.
Derivatives – An instrument that obtains its value from another asset that it is tracking
CFDs are a type of leveraged product. You put up an initial sum of capital and your CFD provider allows you to take up a much bigger market exposure.
CFDs For Different Asset Classes
One of the reasons behind why people are sometimes confused over what CFDs are is because CFDs can be used for different types of asset classes.
For example, CFD provider IG allows clients to use CFDs across a wide range of asset classes such as shares, indices, foreign exchange and commodities. That means even while the concept of CFDs applies equally across different assets (i.e. you pay the difference between the price at opening position and the closing position), the underlying assets that determine the value and volatility of the CFDs are drastically different.
Traders and investors can use CFDs to get the exposure that they are looking for in the financial markets. They also need to have a good understanding of the underlying assets.
What Traders Use CFDs For
Since CFDs are leveraged products that allow the holders to take up a much larger market position than the actual amount they have put up, they are popular among traders.
Generally speaking, most short-term traders are not looking to hold on to a long-term market position. Rather, they aim to make use of leverage to earn profits through short-term fluctuations in prices using their own trading methods such as technical analysis.
For example, a 1% increase in stock price would be a lot easier for a trader to capture compared to a 10% increase. With no leverage, a trader who takes up a $10,000 position would only be able to earn $100 from a trade.
With the use of a 10:1 leverage through CFDs, the same trader would be able to take up a position size of $100,000 and make $1,000 through the trade, thus giving him a 10% return. On the flipside, if the market goes against his favour, the losses will also be magnified.
Risk Management When Using CFDs For Trading
We cannot ignore risk management when we are investing, let alone, when we are trading. Both gains and losses are magnified when leverage is applied and hence, traders need to be very familiar with the products that they are trading, and have a risk management process in place that they stick to.
A good rule of thumb that many traders follow is to never risk more than 2% of their capital on a trade. If a trader has $10,000, then he or she should not exceed a loss of $200 on any one single trade. The idea is to let your profit run while you cut your losses quick.
Why Long-Term Investors Use CFDs For Hedging
Contrary to popular thinking, the use of CFDs is not limited to short-term traders. Long-term investors can also stand to benefit from them when deploying them in the right situations.
When you hold stocks over many years, there would be times where volatility is high, or when economic recessions are looming. Certain sectors that you have long-term positions in may even have uncertain futures in the short-run.
In such times, long-term investors may consider using CFDs to hedge their portfolio against the risk of their stocks declining without having to liquidate their holdings.
For example, if you had owned $20,000 worth of DBS stock, and its price fell by 10%, your stock would be only worth $18,000. However, if you had hedged your position by shorting the stock through a CFD, your losses arising from the stock would be offset against the gain in value of the CFD you bought.
Unlike options or future contracts, CFDs do not have expiry date. Hence, when you are more confident about the companies’ future, you can close your CFD position and enjoy the future gain that the stock makes.
If you are considering CFDs, it’s important to remember that the primary risk that you face would still be in the underlying product that the CFDs is based on, be it shares, indices or commodities.
Personally, we think that only people who already have prior experience dealing with the underlying asset and should consider using CFDs.
Aside from the contract spread or commission that you pay, there may also be finance charges for certain types of CFDs such as those dealing in shares. Be sure to know the transaction cost so that you can include it in to your investment decisions.
Last, the creditability of the broker that you use is extremely important, since any contract that you make is ultimately with them. As such, you should only choose companies that are established and whom you are familiar with.