You may be familiar with common investment options like exchange-traded funds (ETFs) or mutual funds. Today, we’ll look at an instrument some money movers are increasingly drawn towards: trading contracts for difference (CFDs).
A CFD is an agreement between two parties to exchange the difference between the entry price and closing price of an underlying asset. Traders can speculate on prices moving up (long positions) or prices moving down (short positions). If the value of an underlying asset increases between the open (buy) and close (sell) of a contract, the seller will pay the buyer the difference in price. If the value of the asset decreases, the buyer pays the seller. This ability to short sell — to profit from a falling market — makes CFDs more versatile than a lot of other investment options.
Underlying assets in a CFD could include anything from global indexes (S&P 500, DAX 30) to stocks, industry sectors, currencies, and commodities, and eventually, crypto assets. CFDs can be traded even when the underlying market is closed (which is also possible with tokenized underlying assets), and traders like being able to access a host of markets all in one platform.
While that sounds straightforward enough, one particular aspect of CFDs make them exceptionally risky: they’re traded on margin. This means a buyer is able to purchase the entire value of a contract by investing just a fraction of the amount (leveraged trading). Say you wanted to buy 100 shares of a stock worth $20 — a $2000 investment. With a CFD you might only have to put up 10% of the total value for the right to exchange the difference of the full position. You can see the appeal: commit $200 to gamble $2000.
The problem, of course, is that leveraged trading magnifies losses just as it does gains. Say that stock price drops 10%. You’re not losing $20 on your $200 investment, you’re losing 10% of $2000 ($200). It’s entirely possible to be stuck with a loss that exceeds your initial deposit without the possibility to hold out for a recovery (more on that a few sentences below).
The example below illustrates the leveraged nature of a CFD for 500 shares of Apple stock:
An even simpler example of leverage: You want to bet your friend $100 that Barcelona will win the Champions League, but you only have $10 right now. Your friend accepts the $10 as a “placeholder” for the real value of the bet ($100). If Barcelona doesn’t win, you’ll be on the hook for the full $100. Of course, you could have also turned those $10 into $100 had Barcelona won without technically committing $100.
There is also the element of counterparty risk — that the person or entity on the other end of the transaction defaults and fails to meet the contractual obligations of the CFD. That means you will have to re-supply the CFD (your counterparty cannot do so) and you will not be able to realize your gains.
While CFDs may be an exciting short-term ‘trading’ instrument, usually held for a just few days or weeks, they are not suitable as a long-term investment. On top of being volatile on account of their potential to significantly magnify losses, buyers have a minimum margin to maintain, and are given X days to top up your margin should you not meet the margin requirements (this is called a margin call). If you do not meet the margin requirements, you will be forced to sell and accept your loss.
A more sound investment strategy is based on the ability to hold onto the underlying assets — to actually own them — through the dips until you feel the time has come to sell (you never have ownership of the underlying assets of a CFD). An alternative to gambling with CFDs may be to buy and hold a selection of low-cost index tracker funds like ETFs or real estate funds (REFs) for buy-and-forget results over the long term.