CFDs, or Contracts for Difference, can be seen as an agreement between two parties to exchange the difference in the price of an underlying asset. This is made possible using derivative instruments, which act as middlemen. The resulting transaction is cashless (in other words, no real assets change hands), and thus you do not need to own or borrow any assets for this form of trading to work.
If you think the share price will go up, you can trade CFD’s on that stock; if your prediction were correct, your account balance would have increased by the value of the rising price at the end of the contract period. If you were wrong, your losses would be the opposite of the rise.
What are the risks?
Let’s look at the risks associated with CFD trading.
Leverage and Margin Calls
One of the biggest dangers with CFD trading is that many brokers allow you to trade on a margin, using borrowed funds to increase your ability to profit from price movements. To give an idea of how this might work out for you as a trader, imagine that an asset has increased in value by 10 per cent. Your broker then offers you leverage at 2:1, meaning that they’ll let you borrow double the amount of cash that exists in your account (so $4000 instead of $2000).
If you choose to take advantage and trade CFDs worth $4000 (i.e. 4 lots) on this stock, and you’re correct and the price rises by a further 10 per cent, then you will have made $4000 on your initial investment of $2000 – an overall profit of $6000.
So how does this work out for the broker? Well, they hope that you don’t cash out before expiry as if you do so before contract-end, they’ll be obliged to return the original amount borrowed (in this case, $4000). If, however, you were wrong, and it decreases in value by 10 per cent instead, then at least the broker has reduced their risk somewhat because now only half as much money would be lost ($2000 rather than $4000). The point is that up until expiry, the brokers are exposed to unlimited risk, so it’s important to remember that when choosing a broker, you should always read the small print!
Diversification
Another key risk to be aware of is that CFDs are highly correlated to the stock market as a whole. This means that if the market falls, then the price of most CFD assets are likely to do so also. For this reason, it’s important to think carefully about how much exposure you want to have to anyone particular underlying asset. Consider, for example, investing in different sectors such as technology, commodities and healthcare, as this will help you spread your risk somewhat.
High Spreads
Unlike buying stocks outright, you’re also paying the broker a commission for each transaction when trading CFDs. This commission, otherwise known as the spread, is built into the asset’s price and can vary from broker to broker. Always make sure you’re aware of the spreads being offered before opening an account.
No Voting Rights
Finally, it’s important to remember that owning shares in a company gives you specific rights, such as the right to vote on issues affecting that company. You do not have any such rights with CFDs, so if you’re interested in a company, then be sure to research what’s going on behind the scenes.
In conclusion
While CFD trading can offer opportunities for high profits, there are also several risks to be aware of. By understanding these risks and taking appropriate measures to mitigate them, you can give yourself the best chance of success in this type of trading. Beginner traders are advised to use a reputable online broker like Saxo Bank. For more information, see it here