If you are familiar with trading stocks, here are some reasons to consider CFDs
But while stocks may be a fairly straightforward way to start your investing journey, for investors who already have a fair amount of experience, there are opportunities to explore other types of instruments that are available in the market.
One of those interesting alternatives to conventional stock trading is Contracts-For-Difference on Shares, or otherwise known as CFDs.
A CFD is a contractual agreement between two counterparties (i.e. you and the CFD provider) to pay the difference in the value of an underlying asset that takes place over the lifetime of that contract.
CFDs have become increasingly familiar amongst the trading community, and here are some reasons why traders find them more attractive than traditional stocks.
Use of leverage
Usually, when you buy a particular stock, the amount of cash you invest corresponds to the equivalent worth in units of shares.
So for example, if you invest S$5,000 in ‘SATS Ltd’ stock that has a share price of S$5 on SGX, you will end up with 1,000 units of shares; i.e. S$5,000 worth of ‘SATS Ltd’ stock.
With CFDs however, you are able to use leverage and therefore only need to provide a fraction of the capital.
So if you are looking at buying 1,000 units of ‘SATS Ltd’ share CFD at S$5, the CFD provider only requires you to provide 10% of the initial capital. This means that for the same value of shares, you only need to fork out $500.
That 10% amount is what’s called the margin, and as long as you’re able to fulfill that continual capital requirement, you will still be able to enjoy the gains when the share price appreciates in value as if you actually owned S$5,000 worth of that underlying ‘SATS Ltd’ stock.
For instance, if the ‘SATS Ltd’ stock price went up by 5%, on paper, you would enjoy a profit of S$250 (5% x S$5,000) (excluding the commissions and funding costs). This would also mean that by using CFDs, you made a 50% return on investment with your initial $500 capital, versus 5% with traditional shares.
However, the reverse is also true if the stock falls in value. If it happens that the ‘SATS Ltd’ price fell 5%, technically you would have made a loss of $250 (5% x S$5000) or 50% loss on your initial $500 capital.
As you can see, leverage when using CFDs is a double-edged sword: it can enhance your profits, but it could also magnify your losses.
In the case of stocks, the maximum amount of money you could possibly lose is capped at the total amount that was invested. But with CFDs, you could lose more than what you invested if you’re not careful with the amount of leverage.
That being said, with the right approach, which usually consists of implementing risk-management measures, leverage can enable you to get more bang for your buck; or for those with a limited investment budget, the ability to trade on more products.
Ways that share CFDs can differentiate your trading strategy.
Short-term Opportunistic Returns versus Long Term Value Appreciation
When it comes to stocks, as mentioned at the beginning of this article, most people tend to invest in them with a long-term outlook for either capital gains or dividends.
CFDs, on the other hand, are usually traded over shorter periods of time, in order to glean returns at opportunistic moments. When done correctly, you can get impressive returns relatively quickly. But of course, there’s also the chance that you will end up with huge losses if you’re not careful.
Trade in either direction
Since a CFD enables you to realise gains from the difference in value of the underlying asset, regardless of whether it goes up or down, this versatility is useful when you have a view that a particular asset is about to depreciate in value.
Normally in stock trading, investors are aiming to buy low and sell high, and they are only able to make a profit when the stock price increases in value. The short selling of traditional shares is more complicated for retail investors.
Hence, when markets are falling during a down-cycle, existing stockholders either have to sell in order to avoid a sustained loss or hold on to the stock and hopefully ride out the storm. As for those who are holding cash on the sidelines, they are also unable to participate until they feel that the markets have reached the turning point.
But when CFDs come into the picture, you would still be able to make a profit via short-selling.
Again using the example of the ‘SATS Ltd’ stock, if I expect its share price to drop in value in the future, I might open a contract to sell S$2,500 worth of CFD on its underlying stock.
If my prediction turns out to be true and the ‘SATS Ltd’ stock price went down by, for instance, 5%, then I would have made a gain of $125 (5% x S$2,500). Note that if instead the ‘SATS Ltd’ stock price went up, then the same amount of losses will apply.
Not necessarily mutually exclusive
The versatility of CFDs bring us back to the topic of choosing between stocks and CFDs, and it actually turns out that it does not necessarily have to be mutually-exclusive.
CFDs can also be used in tandem with traditional stocks: If an investor plans to hold the actual shares of a company in the long term, but believes that the share price will fall in the short term, he can take a short position using CFDs of the underlying stock. This way, the investor can hedge his overall portfolio and offset his short term losses.
So now that you’ve seen how CFDs can be a useful option to widen an investor’s trading approach, why not sign up for a demo account and find out for yourself if it’s really suitable for you.
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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.