The Benefits of Using Contracts for Differences

Contracts for differences (CFDs) are financial instruments that track many assets including forex, individual equity shares, commodities, indices, and cryptocurrencies. CFDs allow you to trade the capital markets using leverage.

What is a Contract for Differences (CFD)?

A contract for differences (CFD) is a financial instrument that tracks the movements of an underlying asset such as a stock, currency pair, commodity, cryptocurrency or index. It differs from the underlying instrument in that you do not have to post the entire amount of capital to buy the underlying instrument. Instead, you only need enough to cover the change in the price from where you plan to enter the trade, and where you will exit the trade.

This compares to a stockbroker who might require that you need to have nearly all the capital in your account to buy equity shares. In some cases, when you purchase a CFD, you might be entitled to the dividend that is granted by the company on the underlying shares. CFDs can be used to trade directionally, or you can buy one CFD and simultaneously sell a different CFD and capture the relative value change.

Do CFDs Provide Leverage?

A CFD has an imbedded leverage feature which will differ from broker to broker and asset to asset. Leverage is a feature that enhances your trading returns, as it allows you to increase the capital you control with borrowed capital.

For example, some brokers will allow you to purchase $4,000 of EUR/USD while only posting collateral of $10. To use leverage, you need to open a margin account. Each broker will have different criteria for opening a margin account. They will generally ask you questions about your trading experience as well as your investing knowledge.

It’s important to understand how leverage can impact your trading returns. If you can purchase $4,000 of EUR/USD using 400-1 leverage, it will only take a 0.25% ($4,000 * 0.0025 = $10) move to either double your money or wipe out your capital. So, while leverage is an attractive tool, it can be a double-edged sword.

When you open a margin account, your broker will require that you always have a specific amount of capital in your account.  Each time your place a new trade your broker will require that you post a specific amount of fund which is referred to as initial margin.  The margin required is the amount of capital needed if the price of the CFD moved against you by a larger than the normal amount.

Your broker wants to make sure that you have enough capital allocated to a trade that if there was a larger than normal change in the price, that you have the funds to cover the losses. As the market moves, the amount of margin that you need to hold against each trade will change. If the price of the asset that you are trading moves against you, your broker will take maintenance margin to cover additional losses in addition to your initial margin. If the price of the security you are trading moves in your favor, the initial margin will remain unchanged, but any maintenance margin that was collected will decline.

The margin calculation is in real-time, and it tells your broker the minimum amount of capital you must have in your account to continue to hold your position.  If your trade moves against you and you are unable to increase the capital you have in your account, your broker will have the right to begin to liquidate your position.  Make sure you completely understand the margin agreement you sign and your broker’s rights to liquidate your position before you start to trade CFDs.

Trading CFDs relative to Stocks

CFDs can be very efficient for investors who are looking to trade stocks. This is because the leverage that is used in CFD trading, is much higher than the leverage you can receive with a stockbroker. For example, Amazon shares are trading near $1800 per share.

This means that you would need $1,800 just to purchase one share of Amazon stock. Many CFD brokers offer leverage of 20-1 which would allow you to purchase 1 CFD of Amazon for as little as $90 per CFD. A 5% rise in Amazon shares will allow you to double your money. Additionally, for the same $1,800 that would allow you to purchase 1-share of Amazon stock, you could buy 20 Amazon CFDs. Lastly, CFDs allow you to short the stock without having to borrow the shares.

Managing Your Risk

CFD trading can be risky, especially if you use leverage, so you must have a plan in place before you make each trade. To avoid the risk of ruin, you should limit the amount of capital you place on each trade to 5-10% of your portfolio. For example, if you plan to trade a portfolio of $5,000 the maximum you should post for each trade should be $500. This will provide you with a strategy that will provide some forgiveness if you start slowly.

Another concept you should follow is to cut your losses and let your profits run.  If the market moves against you and hits your stop loss, you should exit and live to see another day. If the market moves in your favor, move your stop-loss up and let your gains compound as the market moves in your favor.

Summary

Contracts for differences (CFDs) are financial instruments that allow you to trade the capital markets without purchasing the underlying instrument. CFDs track underlying instruments and provide leverage to help you enhance your returns. This would include equity shares, commodities, indices, forex, and cryptocurrencies. To trade CFDs with your broker you will need to open a margin account. While leverage can significantly enhance your trading returns, it is a double edge sword and can also lead to robust loses. You must have a well thought out risk management plan that you can employ on each trade, before risking any of your hard-earned capital.