CFD Investing: what is CFD investing and how does it work?
CFDs or contract for differences have become extremely popular among investors. But what are CFDs exactly and how to invest in them? In this article you will read everything you need to know about this popular derivative.
What are CFDs?
A CFD is a derivative. This means CFDs always relate to an underlying asset. This could, for example, be an Apple share. The different parties come to an agreement to exchange the price difference between the opening (purchase price) and the closing (sell price) trade price of the underlying asset. CFD trading of the Apple share has many similarities with trading an Apple share directly.
What to learn by reading our guide about CFD investing?
- How to invest in CFDs?
- Where to invest in CFDs?
- How to use a leverage?
- What’s the margin call?
- What’s the stop loss?
- How to invest in falling prices?
- What are the CFD costs?
- What are the advantages and disadvantages?
Applying to an online broker to invest in CFDs is a piece of cake! In general, investment software offers you two options:
- Buying: You earn money when the underlying value increases.
- Selling: You earn money when the underlying value decreases.
On its turn, the price evolution of the underlying asset determines your result. When buying a CFD on the Apple share, you will earn money when the Apple share price increases. The CFD background principle and process is therefore child’s play!
Special CFD brokers are the place to be to invest in CFDs. Let’s take a quick look at two well-known and reliable CFD brokers:
Plus500 has been fully optimized to guarantee smooth CFD trading. To go even one step further, investing in CFDs is the core and only business they offer. The Plus500 software is extremely user-friendly and you can start trading CFDs on all known shares, commodities, index funds and currency pairs. A nice additional feature about Plus500 is the fact they offer a free of charge and unlimited demo which allows you to try out all possibilities.
Looking for a broker which not only offers CFDs but also other products? DEGIRO is your place to be! Joining this party will allow you to invest in both CFDs and for example physical shares. DEGIRO is known as one of the cheapest brokers in the Netherlands. Registration for an account at this broker is completely free of charge and will be completed in the blink of an eye.
Another reliable party where you can invest in CFD’s is Markets.com. At Markets.com you can use advanced analysis tools. This makes Markets.com very suitable for the serious trader who wants to be active in daytrading. Use the button to open a free demo account with Markets.com:
An important CFD feature is the possibility to make use of a so-called leverage. A leverage is a process whereby you will only pay a fraction of the full value of the underlying asset while the broker is investing (loaning) the rest. The maximum leverage ratio which can be applied by a private person is 30:1. Leveraged trading has the advantage it can be used to achieve larger profits. A clear disadvantage is the bigger risk on losses.
But how does CFD leveraged trading work? When placing an order, you need to provide the trade amount. A leverage ratio of 5:1 is used if the balance on your account is €1000 and you decide to buy €5000 of CFD shares. But what does it mean in practice?
- A 10% price increase of the CFD share? Your profit is 50%.
- A 10% price fall of the CFD share? Your loss is 50%.
Therefore, a leverage allows you to do a bigger investment with a smaller amount of money. Nevertheless, it consequently needs to be taken into account the loss-profit ratio is much higher and you should be careful for a so-called margin call.
Brokers do not want to lose all their money and therefore they have implemented a built-in protection layer. After all, a broker doesn’t want to be accountable for your losses. Therefore, the use of a leverage goes hand in glove with a margin. When the asset price decreases with 20% all the money on your account will be removed when having a 5:1 ratio.
If the price would further decrease to 21%, the broker would have to invest extra money. To prevent a similar situation, brokers make use of a margin call. When your balance moves towards £/€/$ 0, the broker will request you to deposit money in order to avoid closure of the position. But what if you don’t act upon their request? In that case, the broker will close your positions in order to prevent them from making a loss themselves.
The margin call can be a very annoying feature. It’s therefore of crucial importance to carefully consider beforehand if you can compensate the expected price fall before the actual price increase when buying a CFD. Otherwise a potentially profitable position turns into a position whereby you lose your whole investment.
A proper way to prevent a margin call, is to make use of a stop loss. Installing a stop loss is pretty easy within the CFD trade domain. The stop loss indicates at which loss percentage your position will automatically close.
It’s very wise to always use a stop loss. That way, you can prevent one negative position from blowing up your entire account. Watch out though because you will have to pay extra for a guaranteed stop loss. In exceptional market situations (such as a market crash), a delayed stop loss can sometimes occur. In this case the additional costs are for the broker’s account when having set a guaranteed stop loss beforehand.
Besides using a stop loss when trading CFDs, you can also use orders. An order will allow you to set a value at which you will automatically open a certain position. A stop loss can ensure your loss does not increase too much. You can also set a take profit which indicates the level at which you automatically take your profit.
By combining all these features and functionalities you can automate CFD trading to a large extent. Logically, it all starts by executing an extended analysis. Nevertheless, when you know all the ins and outs and what to do at which moment, you won’t to have to sit in front of your computer 24/7 anymore. It saves you time and some blurry eyes!
Placing an order is fairly easy at a CFD broker.
Another clear CFD advantage is the fact you can also benefit from falling prices by going short. In many software packages this means going for the option “sell”. By going short with your CFD, you will directly profit from falling share or asset prices.
Buying classic shares, it is rather difficult to profit from falling prices. CFD trading nevertheless makes it possible to profit from a wide range of different market fluctuations and circumstances.
Of course, CFD investment also costs you money. In practice you do not pay a fixed CFD commission rate. A favorable situation because it also makes small investments interesting ones. You do pay a so-called spread when investing in CFDs.
The spread is the difference between the purchase and the sell price. Depending on the volume a spread on an asset can increase or decrease. Your transaction costs nevertheless will remain equal percentagewise regardless of the amount you invest.
When investing in CFDs you will also have to take into account a financing charge. After all the broker lends you money to hold your position. With a 5:1 leverage ratio 80% of the money belongs to the broker. To maintain this position, the broker charges a daily financing charge.
This financing fee will only be charged when you decide to hold a position overnight. The financing fee percentages can always be found looking at the derivative data. Logically, on a daily basis the transaction costs do not form a blocking factor. CFDs are nevertheless not really favorable as option when aiming for long-term investments. After all, the interest quickly rises to a few percent and this is at the expense of the profit.
Another major advantage of CFDs is the fact CFD investment is easy to understand. Its simplicity is achieved by for example the share and the CFD having the same value. Many other derivatives require quite some calculation effort to determine your profit. Determining your return on investment is a lot easier when talking about CFDs. Let’s exemplify this by considering the two below cases:
In the first example we are for example buying a CFD. Let’s suppose you are buying a CFD on the Apple share. The current price is £/€/$ 1000. Your account balance is also €1000. You nevertheless decide to buy 5 CFD shares by using a 5:1 ratio leverage. The share price then increases from £/€/$ 1000 to £/€/$ 1100. In this case, your profit is £/€/$ 100 per share. You have achieved a 50% profit instead of a 10% profit.
You can also invest in a CFD to speculate a price fall of the CFD Apple share. In the previous example the CFD Apple share price was €1000. Let’s suppose you also have a €1000 balance on your account. You buy again 5 shares and you use the 5:1 ratio leverage. The share price increases again from £/€/$ 1000 to £/€/$ 1100.In this particular case, you lose £/€/$ 100 per share. The leverage has caused a 50% loss instead of a 10% loss.
By investing in CFDs you are magnifying your profits and losses. A broker’s software will often show you in real-time how many euros you have gained or lost. We nevertheless do advise everyone to make this kind of calculations before opening a position in practice. This prior calculation will help you to determine whether the investment justifies the risk.
Furthermore it is important to remember that although it is easy to understand the underlying mechanism of CFD”s, CFD investing is far from easy. You have a high probability of losing your full deposit.
- CFD are easily accessible because you don’t pay fixed transaction costs.
- You can use a leverage to magnify your profits (and losses!).
- You can invest in falling prices by going short.
- By using a stop loss, you can limit your potential losses.
- All possibilities can be tested via a demo.
- You can invest in various known assets.
- CFD use is quite straightforward.
- CFD investment starts at only €/ £/$100.
- The margin call can make you lose your whole investment.
- You pay a financing charge for long-term positions.
- Your losses can quickly accumulate.
Investing in or speculating with CFDs can be really interesting. CFDs offer a lot of flexibility and possibilities, making them often more attractive than many other derivatives. But don’t be fooled by the simplicity at first sight. A CFD can be a negative gamechanger and when taking the wrong decision, your whole investment can be gone in the blink of an eye. Therefore, the first step should be to practice using a free demo.