If you’ve ever dabbled in the share market or have friends that do, you’ve probably heard of contracts-for-difference, or CFDs.
You may have also heard that these financial instruments are incredibly leveraged – meaning you can potentially make bigger gains proportional to the amount of money you put in (your margin). Of course the reverse is also true – you can potentially make a far greater loss as well.
For this reason, some people with a little money to invest, such as young people, are drawn to CFDs – enticed by the prospect of huge returns. The rise of smartphone-optimised trading platforms is also attracting more young people to them.
But whether money is actually “invested” in CFDs can be disputed. The extreme risks associated with CFD trading have led some to consider it as a method of gambling. The Australian Security and Investments Commission (ASIC) describes CFDs as “a way of betting on the change in value of a share, foreign exchange rate or a market index.”
So would you be better off only investing in stocks (shares)?
To know the answer to this question, you need to understand some of the key differences between CFDs and stocks. This will help you to decide if CFDs are suitable for you.
CFDs versus Stocks
When directly trading stocks, you are buying and selling a small ownership of a publicly-listed company at prices determined by the market. Generally, if you make a wise investment choice, you can hope to make money by selling these shares in the company at a higher price than you bought them for. Provided you sell at the right time of course! Depending on the shares purchased, you may also receive an income stream in the form of dividends.
But when trading CFDs, you’re not actually buying and selling shares in a company. You’re making an agreement with a CFD provider to exchange the difference in the value of a contract which is derived from the price of a share/commodity/currency/index. So you never own the assets – you merely trade a contract between you and a CFD provider to pay or receive a price difference.
In buying a stock (without a margin loan), the cash you put in is exactly what you get in shares. So if you invest $2000 in a stock with a share price of $2, you get 1000 shares – so $2000 worth of that stock.
But when buying a CFD, you only have to put up a fraction of this value – yet you can achieve gains and losses as if you had bought the whole value. Essentially you are buying a product with the gearing embedded into it. For example, you can place an order to buy 1000 CFDs at $2 each. The total value of this contract would be $2,000, but the CFD provider might only require you to put up 5% of this to execute the contract, so only $100. This amount is known as your margin. The CFD provider covers the rest of the contract’s value.
In this example, if the price of the CFD’s underlying asset rises 10%, say from $2 to $2.20, you make a gain of $200 (10% of $2000), so a return on your $100 margin of 200% (not including commissions, fees, charges or interest). But if it goes the other way, you can lose just as much – meaning you can lose a great deal more than your original deposit.
CFDs are not for the faint-hearted.
So in this scenario, by just buying the stock a 10% rise in the share price means a 10% gain, but in buying the CFD, a 10% rise in the underlying asset price means a 200% gain. This is how CFDs are leveraged.
The risks of trading in the share market are apparent to most people, with the media often reporting about stock crashes and financial crises. But with stocks, the maximum amount you can lose is only the total amount invested.
CFDs take this risk to another level, because you can lose much more than your initial margin. Because of this, there is a high chance of receiving the dreaded margin call. There are many stories (such as this one) of people losing hundreds of thousands after receiving multiple margin calls, despite only putting up small amounts in CFDs.
Other risks associated with CFDs include counterparty, execution and gapping risks, so be sure to fully educate yourself about these before you begin trading them. There are things you can use to mitigate the risks of CFD trading like a ‘stop-loss feature’, but these are not guaranteed to be executed by the CFD provider. You can take out a ‘guaranteed stop-loss’ but you have to pay a premium price for these to the CFD provider.
You can trade stocks from markets all over the world.
Similarly, CFDs can be traded on many different stocks, indices, currencies and commodities across the globe.
With stocks, most people invest over the long term and let their shares grow slowly over time. As such, they are more of a ‘set and forget’ investment than CFDs.
In trading CFDs, lots of money can be gained and lost very quickly, so they are usually traded over short time periods. They are not a set-and-forget investment!
Although investing in stocks should not be done without the right knowledge and advice, far more expertise is required to trade CFDs.
CFDs need lots of attention and management because of the leverage and the fact you’re always competing with someone. If you make money out of the trade, the other party loses. If you lose, they gain. Chances are the people you’re competing against may be risk managers for big financial institutions with years of experience and advanced knowledge of financial models.
With ownership of stocks, you can receive annual franked dividends.
CFD providers try to replicate dividends by crediting CFD holders (in a long position) with ‘dividend adjustments’. But they don’t receive franking credits.
While the share market is extremely regulated, the CFD industry is less so. So, you need to thoroughly investigate the credibility of which provider you trade CFDs with.