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Contract For Difference (CFD) is one of the most popular types of derivatives used in the financial markets. CFD trading allows investors and traders to gain exposure to a wide range of financial products in the market including equities, forex, indices, commodities and even alternative asset classes such as cryptocurrencies.
How Does Contract For Difference (CFD) Work?
A CFD is a contract between two parties (the buyer and the seller) to exchange the difference between the opening price of an asset and its closing price. Unlike listed companies, CFDs are not traded on an exchange. As a retail investor or trader, we can only buy a CFD from a CFD provider.
For example, using an illustration from IG, let’s assume DBS has a sell price of $26.29, and a buy price of $26.30.
If DBS’ next earnings announcement is approaching and we expect it to be good news and that the company’s share price will go up, we can take a long position on DBS for 2,000 share CFDs at $26.30. This is simply the equivalent of buying 2,000 DBS shares. It will also give us a market exposure of $52,600 (2,000 shares X $26.30). Alternatively, if we don’t expect DBS performance to be good, we also take a short position on DBS. In this instance, the converse apply. We make money if prices of DBS goes down and we lose money if prices goes up.
CFDs are leveraged products. This means we can choose to take up a bigger position than the cash we put up. So, if DBS has a margin factor of 10%, then our minimum required cash outlay would be $5,260 (10% of the total exposure of our trade). We have to maintain this margin in our account to hold our position.
Unlike buying the underlying shares, with CFDs, we can choose to go long or short for any position. If we think the price of a particular asset will drop in the future, we can choose to take on a short position. This way, we can trade both directions on any asset classes depending on our views on the market.
Who Should Use CFDs?
Due to leverage, CFDs are primarily used for short-term trading, rather than long-term investing. The idea here is to make profits off the short-term price movement in assets that we are trading, while simultaneously utilising leverage to increase our returns. Conversely, if prices move against us, our losses will be magnified.
As such, it’s usually traders who will actively use CFDs as their aim to profit off short-term price movements in the market. With CFD providers such as IG, you can trade over 17,000 markets across asset classes like equities, forex, indices, commodities and cryptocurrencies.
However, even as long-term investors, we can still use CFDs for hedging purposes. Supposed there is heightened volatility in the market (like what we have observed in 2020) and we do not want our portfolio value to fluctuate significantly. In that case, we can take on a short CFD position on the assets that we are already investing in for the long-term.
This way, if the assets that we invest in decline in value, the CFD short position that we take will increase in value and offset the investment losses we incur. When we are more confident about the companies’ future, we can close our CFD position and enjoy the future gain that the stock makes.
Unlike options or future contracts, CFDs do not have an expiry date.
When Trading Via CFDs, We Don’t Own The Underlying Assets
Whether you intend to hold a CFD position for just a short while or on a longer-term basis, it’s vital to note that CFD trades do not require you to own the underlying assets that you are trading.
For example, if you trade DBS shares through a CFD offered by IG, you are entering into a CFD contract with IG, rather than buying DBS shares directly from them. So if you are taking a long position, IG will pay you the difference in price between the opening and closing position if the value of the shares you trade goes up.
This is great, especially for traders, because it means they can make profits from their trades without the complication of having to own the underlying assets.
The risk here is that your CFD provider ends up not honouring the contractual obligations. While rare, if a CFD provider fails, then the positions that it has with its clients will be in doubt.
This is why as a trader or investor in Singapore, you should use a CFD provider that is regulated by the Monetary Authority of Singapore (MAS), such as IG, rather than providers that are not based and regulated in Singapore.
Opening a CFD Account With IG
If you wish to open a CFD account to seek opportunities in various financial markets, you can consider creating an account with IG.
For Singaporeans and PR, you can create an account using MyInfo, where the process will be even more seamless. Details required will automatically be taken from MyInfo so you only need to fill in some financial information and how much trading experience and background you have.
Once you complete the form, and upon passing the customer knowledge assessment, your IG account will be opened where you can fund and start trading online.
CFD Trading Can Be Risky: Build Up Your Knowledge And Start With A Demo Account First
As CFD utilises leverage, it’s possible that you could lose more money than your original capital if you are not careful. This is why it’s critical that you understand the products that you intend to trade and have risk management tools in place to reduce the risk that you face when trading. Remember, your CFD providers provide an execution-only service so ultimately, it’s your decisions on the type of trades you make. You can read up more about the various risks that you encounter when trading.
If you are new to the IG platform and are unsure how to use the platform, there is a series of videos and FAQs that you can rely on for any questions you may have.
Alternatively, consider opening a demo account first if you are new to trading. With IG demo account, you can practise trading with $200,000 in virtual funds, allowing you to get familiar with the IG platform and the trading strategies that you intend to deploy. Once you feel comfortable trading using actual money, you can proceed to open a live account with IG.
IG provides an execution-only service. The information in this article is for informational and educational purposes only and does not constitute (and should not be construed as containing) any form of financial or investment advice or an investment recommendation or an offer of or solicitation to invest or transact in any financial instrument. Nor does the information take into account the investment objective, financial situation, or particular need of any person. Where in doubt, you should seek advice from an independent financial adviser regarding the suitability of your investment, under a separate arrangement, as you deem fit.
No responsibility is accepted by IG for any loss or damage arising in any way (including due to negligence) from anyone acting or refraining from acting as a result of the information. All forms of investment carry risks. Trading in leveraged products, such as CFDs, carries risks and may not be suitable for everyone. Losses can exceed deposits.
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