In the rush of chasing that exponential rate of return for your investments, you will come across many opportunities. You might have been told to look into CFD as an avenue for you to gain from volatility in specific markets. In this article, let’s look at what and how to invest in it.
You may often hear people talking about CFDs — most probably because they know someone who has made a killing (or losses) through these. So what exactly is a CFD, and why should you care about investing in them?
Short for contract for difference, CFDs allow traders to benefit from price movements on underlying assets such as forex, stocks, and commodities without having to buy the asset itself. It works by agreeing with a broker to pay the difference in price between a particular contract’s opening and closing prices(read this article for more info).
It allows traders to take advantage of rising and falling markets — as long as they can forecast which way it will move correctly. CFDs provide exposure to markets without actually owning them – you can think of CFDs like future contracts. Still, instead of predicting stock prices, you predict whether or not the value of an asset will rise or fall within a predefined period.
CFDs are generally traded in the margin (meaning that you must pay only a percentage of the total value of the security), which enables you to amplify your returns if speculation is correct. However, market volatility may also cause losses even before your contract expires, known as ‘negative gearing’. Therefore, it’s essential for traders looking to invest in CFDs through brokers to understand precisely how they work and be aware of all associated risks before deciding whether or not it’s suitable for them.
If you are familiar with the traditional way of trading, you would probably know that your gains will be determined by how much prices have moved in your favor.
It’s known as ‘margin’, which refers to the initial outlay required for a trade. For example, if you wanted to buy one futures contract of crude oil at $70 per barrel today, it would cost you around US$500 (assuming each contract represents 1000 barrels of oil). If the spot price of crude oil goes up three weeks later, by, let’s say, $75 per barrel, your net profit would be:
(Price difference * number of contracts) – Initial Margin = Net Profit
Where Initial margin = Outlay on one contract x Number of contracts
So if you had six contracts with an initial margin of $500, your net profit would be:
($75 X 6) – ($500 X 6) = $1,250- $3,000 = A net profit of US$1,750.
Oddly enough, CFDs are used by both retail day traders and institutional investors.
While all CFDs allow traders to receive a position on their value without actually owning them. It also means that CFD brokers require traders to have a particular portion of funds in their account before allowing them to trade – this is known as Initial Margin or IM. The amount required varies from broker to broker – it can range from 1% up to 30%. These figures may seem small, but remember that CFDs are traded in the margin. If you’re trading with 20%, your available funds will be reduced by 80%!
Now, depending on the market conditions and how much volatility there is when you open your position (which also determines Initial Margin requirements), this may increase again as prices fluctuate. If there’s not enough equity in the account for the IM levels required at any point during trading hours, then traders will receive a call requesting additional funds. Traders should note that this is an automated process – brokers do not need to contact them before making these adjustments.