Introduction to CFDs: Learn what they are and whether they are right for you

If you are relatively new to the world of investing, you might feel a bit overwhelmed by the wide range of financial instruments available out there, some of which have strange-sounding acronyms.

One of those that you might have heard of is CFD. CFD actually stands for Contracts for Difference, and while at first it might sound complicated to you, it’s actually not that hard to understand once you break it down.

What does it do?

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A CFD is a contractual agreement between two parties (i.e. you and the CFD provider) to pay the difference in the value/price of an underlying asset, between the time the contract is first opened, to the time that the contract is eventually closed.

Essentially, a CFD allows you to speculate that the price of an asset will move up or down, without actually having to own the asset itself.

The ability to make money when the price moves in either direction can be useful if you think a particular asset is about to depreciate in value.

Contrast this against the normal scenario whereby (a) you have to buy the actual asset itself, which might be beyond your capital or budget, and (b) you realise a profit only when the price goes up in value.

How do you make a profit from this instrument?

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As mentioned earlier, you are able to make a profit when you correctly predict the future movement of an underlying asset’s value/price.

For instance, if you think the value/price of gold will increase in the future, then to make a profit, you would enter a CFD contract to buy gold.

Vice-versa, if you think gold prices will drop instead, you would open a CFD contract to sell gold.

What kind of (underlying) assets can you trade?

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The underlying asset can be in various forms such as stocks, currencies, commodities, indices, binaries, options and even special Exchange-Traded Products.

How does it work?

There are basically 2 parts to a CFD contract:-

• The first part is the opening of the contract, whereby you enter into an open position with a CFD provider on a certain underlying asset at a particular price. As mentioned earlier, you could choose to either buy (take a long position) or sell (take a short position).

• The second part is the closing of the contract, whereby you do the opposite of what you did earlier in the opening position. So if you started with a buy, then you will close with a sell trade. And if you started with a sell, then you close with a buy trade.

After the contract has been closed, the difference in value will ultimately determine whether you have realised a gain or a loss.

Basic scenario examples

To help illustrate what we’ve covered so far on the workings of a CFD, here are some examples.

Scenario #1: BUY a.k.a. ‘long position’ SIA stock

For example, let’s assume I choose to open a contract to buy a $100 CFD on SIA stock. If the underlying SIA stock price went up by 5%, on paper, I would enjoy a profit of $5 (5% x $100).

But the reverse is also true whereby if the underlying SIA stock falls in value. If the stock price fell 10%, technically I have made a loss and owe the CFD provider the difference in value of $10 (10% x $100).

Scenario #2: SELL a.k.a. ‘short position’ DBS stock

Now, let’s assume that I predict the DBS share price will drop in value in the future and I open a contract to sell a $200 CFD on DBS stock. If my prediction is true and the underlying DBS stock price went down by, for instance by 5%, then technically I have made a profit of $10 (5% x $200).

But if the underlying DBS stock increases in value instead, say by 10%, then technically I have made a loss of $20 (10% x $200).

Use of leverage

Another important difference about trading CFDs from other conventional instruments is that you can trade on margin and thus decrease your actual cash outlay.

What this means is that, for instance, if you were to normally buy 100 shares of a particular stock that has an ask price of S$10, you would have to come up with S$1,000 in cash.

But if you were to trade CFDs, the broker usually only requires you to pay an initial margin of 10-20% of the actual outlay to open the contract. So effectively, you can trade shares worth S$1,000 for only S$100 (assuming a 10% margin).

This ability to leverage enables you to magnify your profits, but at the same time, it can also cause you to make large losses. So be cautious to not overdo it.

Furthermore, do take note that you can still trade CFDs without using any leverage, in which case your risk would just be the same as if you were trading in the markets directly as normal.

Basic scenario examples with leverage (trading on margin)

To get an idea of how leveraging affects the outcome, let’s re-visit our earlier examples, but now with the use of margin for trading.

Scenario #1: BUY a.k.a. ‘long position’ SIA stock

For example, let’s assume I choose to open a contract with a 10% margin to buy a $100 CFD on SIA stock. So to begin the trade, I need to provide $10.

If the underlying SIA stock price went up by 5%, on paper, I would enjoy a profit of $5 (5% x $100). In terms of Return-on-Investment (ROI), this works out to 50% ($5/$10).

But if the underlying SIA stock falls in value by 10%, technically I have made a loss of $10 (10% x $100). In terms of ROI, this works out to -100% ($10/$10).

This compares to an ROI of 5% (when the share price goes up) and -10% (when the share price falls) if he had invested directly in the underlying shares.

Take note that whether I make a gain or loss from the trades, I will still need to pay any financing and transaction costs and commissions due to the CFD provider.

So this means that any profit in gross dollar terms for this potential scenario is actually less than $5 and any loss is actually more than $10.

Scenario #2: SELL a.k.a. ‘short position’ DBS stock

Now, let’s assume that I open a contract to sell a $200 CFD on DBS stock with a 20% margin. So to begin the trade, I need to provide $40.

If my prediction is true and the underlying DBS stock price went down by, for instance by 5%, then technically I have made a profit of $10 (5% x $200). In terms of ROI, this works out to 25% ($10/$40).

But if the underlying DBS stock increases in value instead, say by 10%, then technically I have made a loss of $20 (10% x $200). In terms of ROI, this works out to -50% ($20/$40).

Again, taking into consideration financing and transaction costs and commissions due to the CFD provider, any profit in gross dollar terms for this potential scenario is actually less than $10 and any loss is actually more than $20.

Be aware of the risks with CFDs

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Similar to most investments, there are risks in trading CFDs and it may result in losses that can exceed your deposits.

As mentioned earlier, CFDs are usually leveraged instruments and thus have magnified gains and losses.

That is why, as a trader, you will need to conduct your own due diligence and familiarise yourself with the product you will be trading.

In addition, always assess your capital and risk appetite and stick to your plan.

An important tip you may want to follow is to never risk more than 2% of your capital on a trade. This is the money that you can actually afford to lose. For example, if you have S$10,000 on hand, you should not exceed a loss of S$200 on a single trade.

There are also comprehensive platforms available out there that provide some risk-management aspects to help automate this; one example is IG’s unique guaranteed stops which can help you to set an absolute cap on your potential loss.

In the event that the market suddenly and quickly turns against your favour, you can specify a price beforehand to close out your position and thus limit your losses.

In return for this ‘safety feature’ that gives you more peace of mind, you only need to pay a small premium which, even then, is only payable if your stop is triggered.

Dos and don’ts for new CFD traders

You may be excited to start trading several CFDs. But a lot of discipline is required and we would recommend you to start slow.

DO work hard on building a single trading method that is effective and suitable before trying or incorporating a new one.

DO start very small with CFD positions, regardless of how experienced you think you are at trading other products, so as to avoid unpleasant surprises. It’s not the same!

DO keep your risk levels conservative and stop losses, as well as maintain sensibly-sized positions.

DON’T choose your provider based on which one offers the lowest margin requirement. Think about it, lower margins might tempt you to take more risks and being over-leveraged is not a situation you want to find yourself in when things are not going well.

DON’T over-stretch yourself and do too many trades to the point that it is hard for you to keep track. Remember to focus and pay attention to your existing trades.

DON’T put all your money into CFD trading. It should not make up the majority of your portfolio nor should you depend on it to earn a living.

So if you’re ready to get your feet wet in CFD trading, go ahead and open an investment account but always remember to do so with only reputable firms. One such company would be IG, the world’s No.1 CFD provider.

This article was sponsored by IG, the world’s No.1 CFD provider (by revenue excluding FX, 2016). All views expressed in the article are the independent opinion of ZUU.