Markets can remain irrational longer than you can remain solvent.
—John Maynard Keynes (1883–1946)
British economist
The World of CFDs
Definition: Contract for differences (CFDs) are contracts between two parties to exchange the difference in value of a listed security (called, the underlying market) between the time the contract was opened and when it was closed. In addition, there are no closeouts in CFD, and these can be, among other, shares, forex, or commodities.
Example
• Equities: You buy 1,000 shares in Company X—you won the shares and pay the full price.
• CFD: A contract would give you the same exposure, but you would only pay a deposit, called a margin deposit.
• Trading advice: Use short CFD positions to hedge your long-term portfolio.
Advantages for Traders
These securities are powerful, in that they are generally cheaper than buying shares and work on margin, which means that you increase your risk exposure, and thus potential profits. Do not forget that the opposite is also true; possible losses are heightened.
Advantage 1: Hedging and Trading Swings
CFD trading enables traders to hedge their portfolio by opening positions in different types of securities and to do this in various countries and to choose whether they want to go long or short.
Advantage 2: Contract Sizes
I have always advised traders to trade within their level of comfort. In addition, trade within your level of knowledge. I have been told that these two are the same. The more knowledge you have about how to trade the various forms of securities, the better informed you are, and thus your level of comfort increases.
Except that even when you have knowledge, it does not mean that you will be comfortable with increasing your risk profile. CFDs enable you to choose your trade size, so start off small and build your comfort and knowledge as your experience improves.
Advantage 3: Margin Trading
Margin trading is defined as only being required to deposit a portion of the actual trade size in each transaction, that is, a CFD enables you to buy the underlying security at a fraction of the price. For instance, if Company ABC is trading at 100 dollars and the margin is 5 percent, then you would need to deposit five dollars to open and trade the CFD.
Risks involved with CFD Trading
Throughout the world of trading, CFDs are considered higher-risk securities, as set out in Volume 1. As stated before, a well-defined trading plan, a properly diversified portfolio, and a mix of fundamental and technical analysis reduce the associated risk of trading CFDs.
However, the following highlights some pertinent facts regarding CFD risk.
Risk 1: Leveraging and Stupidity
Some years ago, a client said this to me: “Why trade shares when you can get so much more if you trade CFDs on the same share?” While this statement may be true, he went on to make the fatal mistake many novice traders make.
He said: “And, if you believe that the underlying stock will rise by 3%, why not go for the highest leverage you can? Whether the leverage is 5% or 50%, you are trading the same underlying asset.” This statement is also true, but it assumes that your analysis will be correct and that the security will rise. What if is falls?
Every trading decision must accompany logic. If you are placing your entire portfolio at risk with every trade, then you are headed for a failure at some point. In this case, a total portfolio wipe-out is likely.
Effectively, always use proper risk and money management strategies, including trailing stop losses, risk only 2 percent of your capital with every trade, and always diversify your portfolio.
Risk 2: No Voting Rights
The answer is simple. This is not a risk, as traders generally are not in the market for the long term. As you have no intention of keeping the stock, you do not have to attend AGMs or other presentations. If you have no reason to vote, then trade CFDs, but if you wish to be a part owner of the company, you would be better suited to buying that company’s stock.
Chapter 14 pinpoints the essential skills needed to trade in foreign exchange markets.