WHAT ARE CFDS - HOW DO THEY WORK?
Differences Between Buying CFDs and Various Underlying Assets
Foreign Exchange CFDs
So Should I, Or Shouldn’t I Invest In CFDs?
Basics Of CFD Trading
Chapter 1 – Key Points To Remember
We’ll take it from the top, in case you’re new to the world of investing and aren’t sure what the acronym means. CFD stands for Contract For Difference.
As the name implies, it’s a contract between you and a broker who sells CFDs, with your profit or loss being the difference in price between the time when a trade is entered into, and then time when you exit the trade. You’re literally exchanging the difference between those two values with your broker.
There are all sorts of CFDs including:
- Commodity CFDs (contracts that track specific commodities like soybeans, wheat, oil, etc.)
- Foreign Exchange CFDs (contracts that track currency pairs)
- Index CFDs (contracts that track a specific index, like the S&P500, the XJO, etc.)
- And Share CFDs (contracts that track the stock of a specific company)
As a contract, this is not the same thing as simply buying a share of stock in a particular company, although the CFD’s price mirrors the actual stock price, moving in the same direction, because the CFD's value is based on the underlying asset.
The first question you might ask then, is why bother to buy a CFD if you can just buy the asset itself?
It’s an excellent question. The main reason is that CFD margins are smaller, which means you have to spend less money to control the asset in question.
The best way to see this is to look at a conjectural example.
Let’s say you’re buying 100 shares of stock at $25. The total value of that investment is $2500. A traditional broker usually uses a 50% margin, which means that you need 50% of the value of the asset to make the purchase, or $1250.
Now let’s look at the numbers if you buy a CFD, rather than the stock itself. Most CFD brokers only use a 5% margin, which means that you could buy the same investment with an outlay of just $125. Big difference, right? Which means that you can buy a lot more investments with whatever amount of money you’ve got.
Let’s start the clock and move through time, beginning from the point when you finalize your purchase.
Your broker gets a commission called the spread. Let’s say the spread is 5 cents, so if the underlying stock appreciates by 5 cents after you enter into the contract, congratulations! You just broke even. If the underlying stock continues to appreciate, everything after that is pure profit when you close out the contract (sell). So let’s say the stock appreciates to $26. You’d see a profit of $0.95 per share, 100 shares, or $95 ($1.00, minus the 5 cent spread).
What we’re really talking about here then is leverage. That’s the biggest advantage that CFDs offer over more traditional investments. The smaller the margin, the more leverage you’ve got, which allows you to control more assets with less money, and that’s huge.
Here are some of the other key advantages to CFD trading in general:
- Global Reach – Most CFD brokers offer products from all over the world. That means one-stop shopping for you. You can take advantage of any opportunity from most of the world’s major markets, without ever leaving your broker’s platform.
- Fewer Rules and Regulations – Sometimes, depending on what, exactly, you are buying, you’ll face a dizzying array of rules about what you can and can’t do. Many instruments, for instance, prohibit short selling at certain times, or have different margin requirements.
While you’ll find a few rules in the world of CFDs, they are generally very few in number, and won’t cramp your style. This is especially true when selling short, because since you don’t actually own the underlying asset, you can short CFDs at any time.
- Full Service – Most CFD brokers offer the same types of trades as traditional brokers, including, but not limited to: Stops, limits, and congruent orders, and possibly (but not always) guaranteed stops.
- Extremely Low Fees – The fees charged by CFD brokers tend to be significantly lower than the fees charged by traditional brokers. An important rule of business is “keep your fixed costs low,” and low fees = low overhead costs for you!
- No Day Trading Requirement – This is huge. Some markets require a minimum amount of capital if you want to day trade, and the dollar value is usually pretty high, which shuts many novice investors out of the game entirely.
That’s not the case with CFDs. Accounts can be opened for as little as $1000 in some cases, although this will vary from one broker to the next, with some brokers requiring up to $5000 to set up an account. Even so, this is a fairly modest sum by comparison.
- Lots of Different Trading Options – See above, re: the different types of CFDs you can invest in. You have a full menu of choices available, and aren’t restricted to just trading in stock CFDs (although stock CFDs are a great way to get your feet wet!)
It all sounds almost too good to be true, and it’s true that CFDs represent a tremendous investment opportunity, but…and you knew there’d be a “but,” didn’t you? There are downsides, and before you jump into the world of CFD trading, you need to be aware of them.
The first downside is the spread. Because you have to pay the spread, it means that CFDs aren’t very good if you’re after micro-profits…that is to say, tiny movements in price from one hour to the next. The spread will invariably eat those kinds of profits up, and if you try to take advantage of small moves like that, you’ll consistently lose money.
The other big disadvantage is something we’ve talked about before: Leverage.
Leverage is a two-edged sword. When you trade at a profit, leverage will magnify the return on your investment, but don’t get cocky! The same leverage that helps you when you’re winning can burn you badly on losing trades, where they magnify your losses, which means you’ve got to be very careful to manage your risk if you want to be successful.
Later on, we’ll talk at some length about things you can do and strategies you can employ to help minimize your risks. For now, it’s enough to be aware that they exist. When used correctly, leverage can be a powerful tool that will help you achieve your goals much more quickly than would otherwise be possible.
BACK TO CONTENTS
Differences Between Buying CFDs And Various Underlying Assets
Earlier, we listed various types of CFDs you can purchase, and now that you’ve got a better understanding of what they are in general, we need to spend some time talking about how each of those types differ from simply buying the underlying asset.
We’ll talk about share CFDs first, because they’re the easiest to understand and are where most people start out when beginning to invest in CFDs.
If you’ve purchased stocks, then you already know just about everything you need to know about buying share CFDs. The process is functionally similar, but there are some important differences to be mindful of. These include:
- No ownership – when you buy a share of a company’s stock you physically own a tiny portion of the company in question. That’s not the case when you buy a share CFD. You simply own a contract that is in no way connected to the company’s stock (the underlying asset), even though the price of the CFD mirrors the company’s stock price.
- Much lower commissions – Buying stock carries much higher commission rates than buying share CFDs. Expect to pay about half commission rate. That’s huge, because lower commissions equal higher potential profits for you.
- Lower margins – We mentioned this above. Many stock brokers require as much as a 50% margin. CFD brokers require something closer to five (and sometimes less!).
- Financing – A small fee your broker may charge you to hold a position overnight
As we mentioned earlier, for any commodity you can buy outright on the market, you can buy a CFD. We mentioned a few earlier, but here’s a more comprehensive list, in case you’ve never traded in commodities before:
Cattle | Cocoa | Coffee | Copper | Corn | Cotton | Gasoline | Gold | Hogs | Lumber | Oats | Oil | Palladium | Platinum | Pork Bellies | Silver | Soy Beans | Sugar | Wheat
And so on. As you can see, there’s no shortage of options here, and this is only a partial list!
So the next logical question is, “What exactly is a commodity?” You already know that Commodity CFDs are contacts that track the underlying asset, but if you’re considering trading in Commodity CFDs then you need to understand the underlying product as well!
To that end, here’s the shortest, simplest definition of a commodity.
It’s a hard asset. A physical product people purchase on futures markets. They’re bought, sold, and traded in large quantity with uniform quality. What that means is that anything on this list can be made, grown, mined or generated anywhere in the world, but the uniform quality ensures that no matter where the good is produced, an apples-to-apples comparison can be made.
Here are the key differences to keep in mind when purchasing a Commodity CFD versus purchasing the underlying commodity itself:
- When you buy a commodity outright, it will come with an expiry date, something you don’t have to worry about when you buy a Commodity CFD
- If you want to break into the commodities market directly, be prepared to spend a ton of money. $20,000 is considered a pretty small contract, and they can run to about ten times that value. For most investors who are just starting out, that’s a lot of money! Again, Commodity CFDs can be purchased with a much smaller outlay
- Charting – If you don’t have a lot of exposure to commodities trading, then you’re probably going to want to read this twice. Commodities are priced on the futures market, but all the contracts traded on the futures market have a different expiry date. This can be seen on comprehensive pricing charts that track commodity prices. The charts used for commodity pricing display two months’ worth of information, but Commodity CFD pricing is based only on the current month. If you want to base your buying and selling decisions on more complete information, then in most cases, you’ll need to get that information from a source other than your CFD Broker.
Note: Commodity CFDs are NOT recommended for people who are new to CFDs in general. You need to have a deep understanding of the general commodities market and what you’re indirectly trading in before wading into these waters!
BACK TO CONTENTS
Foreign Exchange CFDs
You’ve probably heard the term “Forex.” That’s the shorthand used when referencing currency exchanges, and in particular, simultaneously buying one currency, then selling another currency to profit from the movement between a given currency pair.
In many ways, currency trading is a lot like a drug. Its fast paced and always on. Since currency trading isn’t done through a central exchange, you can do it 24/7. There is no “closing bell” here, and fortunes can be made and lost in the blink of an eye. It’s seldom that someone buys a currency position and holds it for more than a day. Often, they’re closed back out within hours, minutes, or even seconds.
It’s explosively volatile, and is the single largest over the counter market on the planet. To give you an idea of just how much money flows through the market on a daily basis, in 2010, the Bank for International Settlements reported that the average daily forex turnover was just shy of $4 Trillion dollars. Yes, that’s “Trillion,” with a “T.” That’s huge. Nothing else even comes close.
The foundation of currency exchanges are currency pairs, and these come in two flavors: Pairs and Crosses.
Here are the major currency pairs:
- EUR | USD
- GPB | USD
- USD | CHF
- USD | JPY
- USD | CAD
- AUD | USD
- NZD | USD
And here are the crosses.
Crosses are different from major pairings in that the US Dollar is entirely absent from the pairing:
- EUR | CHF
- EUR | GBP
- GBP | AUD
- AUD | JPY
The position of the currency in each pairing matters. The first currency listed in the pairing is called the Base Currency (also known as the Primary Currency), and the second is called the Quote Currency. Currency pairs are quoted out to four decimal places, and each point of movement is referred to as a “Pip.”
Here’s how the terminology is used. Let’s say that for the pairing AUD à USD, the price is .9400. If the price moves to .9401, then it has moved one pip. This lies at the bedrock of forex trading.
When trading currency, the prices you see listed on your broker’s information screen come from the biggest banks and corporations on the planet who are moving hundreds of millions, if not billions of dollars at a time. This is literally the grease that keeps the wheels of international trade and investment turning, and either directly or indirectly, you can be a part of it, if you want to.
There are some seriously compelling reasons to want to, even though it is a highly speculative market.
Its major advantages are:
- It’s an “always on” market, with no closing bell
- Has extremely low margins, paired with flexible position sizes
- Is entirely commission free
- And it’s the most liquid market on the planet
All of those are good things, and compelling reasons to consider jumping in, but of course there’s a downside.
All that volatility carries with it extraordinary risk. It takes a steady hand and nerves of steel (and preferably a huge supply of Red Bull, strong coffee, or other highly caffeinated drink) if you want to do well here, and for these reasons, it’s not a good fit for the novice investor.
Our advice would be to get your feet wet via Share or Index CFDs, learn how to make money consistently there, then perhaps move into strategic Commodity CFD trading, and only once you’ve mastered that should you consider jumping into the wild and wooly world of Foreign Exchange CFDs.
BACK TO CONTENTS
Index CFDs are functionally quite similar to Share CFDs, but where the latter track against shares of a particular company, the former track against an index, so what is an index, exactly?
Simply put, it’s a group of shares in companies that have a common element. That commonality could be that they’re all tech companies, or all pharmaceutical companies, or something else.
The Dow Jones Index is comprised of the 30 biggest companies in America, and the price of the index is weighted according to the size of each of the companies that make up the index. Put another way, if the majority of the shares in the companies that make up the index rise, then the value of the index will rise in tandem. If a majority of those shares fall, then the value of the index will fall by a corresponding amount.
If you’ve had at least some exposure to the world of investing, then you’ve probably heard of Index Funds. These are funds that buy stocks in the companies of a particular index, and see their performance mirror the performance of the index as a whole.
They’re great investment opportunities, because by buying into an index fund, you automatically gain a certain amount of diversity in your portfolio that you simply don’t get if you buy stocks in one specific company.
Index CFDs offer the same basic advantages, which makes them a compelling choice to consider, and not markedly different from Share CFDs, which means that they’re newbie friendly. Another huge plus.
Here are some of the bigger indexes from around the world that you may have heard of:
- Australia’s XJO
- China’s Shanghai Composite
- France’s CAC 40
- Germany’s DAX
- Hong Kong’s Hang Seng
- Japan’s Nikkei Index
- Singapore’s Straits Times
- The UK’s FTSE
- The US’ NASDAQ
- The US’ Russell 2000
- The US’ S&P 500
Not only are Index CFDs a great way to help diversify your investment portfolio, they’re also ideal if you think that the economy of a given country is going to generally do well, but you’re short on company-specific research. This way, you don’t need it and can still reap the benefits.
BACK TO CONTENTS
So, should I or shouldn't I invest in CFDs?
Now that you know what CFDs are and what basic flavors they come in, the next question is about you. You may or may not be well suited to investing in CFDs, and it’s important to be honest with and about yourself when making the decision.
Personally, we love CFDs, so please don’t think we’re trying to dissuade you from taking the plunge, but as much as we love them, we also want to make sure they’re a good fit for you, so as to maximize your chances of making consistent profits.
With that in mind, here are some reasons you SHOULDN’T invest in CFDs:
- If you don’t understand basic market mechanics, hold off on adding CFDs to your portfolio. It doesn’t require a ton of experience to invest in them successfully, but you absolutely need a firm grasp of the basics of buying and selling on the market. If you don’t have that, get your feet wet with stock purchases and master that before moving on to CFDs.
- Ignorance of the hidden dangers of leverage. One of the most common mistakes that novice investors make is underestimating their exposure. This happens because they fail to take into account how leveraged their positions are. As we said earlier, if you make a profitable trade, leverage will magnify your gains, but if you come out on the losing end, it will also magnify your losses. More novice investors than we can count have seen the value of their accounts wiped out because they didn’t properly account for the impact of leverage on their positions and failed to manage their risk accordingly. Until you’re sure you’ve got a firm handle on that, it’s best to steer clear of CFDs
- If you’re driven by your emotions. This is where so many investors, novices and veterans alike can sometimes go astray. If you don’t take anything else from this guide, then take this lesson to heart: Emotions have no place in investing.
If you’re not investing dispassionately, then CFDs are not for you. You need to create a cogent, comprehensive strategy and have the discipline to stick with it, regardless of what you’re feeling emotionally. You need to be able to say goodbye to an investment that’s losing money, rather than try to ride it out because you have some kind of emotional attachment to the investment, or the company the investment relates to.
Sometimes, companies we love and care about make bad calls. When that happens, the market punishes them for it. If you’re too close to the issue, emotionally, then you’ll take a drubbing, right along with the company in question.
Don’t allow that to happen to you. Build your strategy around your risk-tolerance, then stick with it, no matter what. Until and unless you can do that, then sadly, you’re not ready to invest in CFDs, and if you do, you’ll likely lose more money than you make.
For the purposes of the rest of this guide, we’re going to make the assumption that you’ve done some soul searching and self-analysis, and have reached the conclusion that CFDs are a good fit for you.
If that’s the case, congratulations, and we hope you’ll find what comes next to be of value.
BACK TO CONTENTS
Basics of CFD Trading
There are two ways you can trade CFDs, and you need to be fluent in both. They are trading long and trading short.
The difference is as follows:
A long trade is just like when you buy a share of stock. The key idea behind it is to buy low and sell high. That is to say, you buy when your data tells you that the value of the CFD in question is set to rise.
A short trade is the flip side of that equation. In that case, you’re selling high, then buying low. Essentially, you’re selling something you don’t own with the expectation that the price will drop, then buy it back at the lower price and pocketing the difference.
Obviously, there’s a lot more to successful trading than just this (and we’ll be going into a lot more depth in later sections), but this is the foundation of your entire investing enterprise.
These two things allow you to make profits, no matter which way the market is moving. If you only focus on one, then you’re limiting yourself to only being able to generate consistent profits when the market is moving in a single direction, and that’s not good because it will limit your success.
You don’t want your success to be limited by anything, so take the time to master both types of buying and selling, and while we’re on the subject of your success, here’s something else to keep in mind, especially if you’re a novice investor:
Don’t get into the game thinking that you’re going to make money on every single trade.
No one does.
The reality is that even the best, most successful investors in the world only succeed in turning a profit on about sixty percent of their trades.
Think about that for a second, then phrase it another way: The best guys in the world fail four times out of ten.
That’s true not just in the world of investing, but in just about everything.
Take baseball, for example. The best guys in the league bat around .300. That means that they successfully hit the ball about three times in ten, or put another way, they fail about 70% of the time. Keep in mind that these are the best players in the world, and on top of the game.
The point of all this is simply to outline that failure happens, even to the best of the best, and honestly, it happens a lot.
The difference between a successful investor and a failed investor isn’t that one is flawless and the other isn’t, it’s that the successful investor takes steps to minimize his exposure to loss and keeps playing, while the failed investor lets his emotions take over until he loses everything, and then, simply can’t afford to play anymore.
The biggest secret to your early success is simply this:
Keep your positions small until you really get a feel for the market.
The second biggest secret is that from day one, you should be
treating your investment portfolio like a business.
All businesses exist in order to make a profit. If they don’t do that, then they soon cease to exist, just as you will cease to be an investor unless you consistently make a profit.
By viewing your portfolio as a business, you’ll go a long way toward putting yourself in a constructive frame of mind. One that will help install the discipline you’ll need to find long term success.
We’ll be building on both of these ideas in later sections, as we walk you through developing your own trading strategy, but to give you a sneak peek, and using the first “secret” we mentioned, if you’re not sure or not as confident about a given position, go small. If you’re very sure, then go bigger (but still not too big).
By varying the sizes of your positions based on your confidence level, you can help minimize your risk, and when you do suffer losses, they’ll be both minimal and manageable.
In the sections that follow, we’re going to outline the ins and outs of investing in CFDs, but then, we’re going to move beyond just that and show you how to build the investment strategy we referenced just above.
Once you’re armed with that information, you’ll be primed for success, and should consistently make profits with your CFD positions.
Before we do that though, let’s summarize.
BACK TO CONTENTS
Chapter 1: Key Points to Remember
- CFDs are a type of derivative, because their value is determined by something else (in this case, the underlying asset, whose price movement it mirrors)
- The basics of CFD trading involve long trades (buy low, sell high) and short trading (sell high, buy low)
- If you opt to trade in CFDs, then you’ll face fewer rules, regulations and restrictions than with most other types of investments
- CFD Brokers also charge smaller fees, and allow you to use more leverage
- Leverage is a two-edged sword, and one you should be extremely careful of. When you’re successful, leverage will make you even more so. When you fail, it will also magnify your losses.
- When first starting out, it’s best to keep your positions small, until you have a good feel for the market. In fact, varying the sizes of your positions based on your confidence level is a key component to a successful investment strategy, but we’ll cover the particulars of that in a later section
- From the very beginning, you should view your investment portfolio as a business. This will help train your brain to approach investing with discipline, and it will plant the seeds for your long-term success.
- CFDs aren’t for everyone. You should have some basic familiarity with the way markets, buying and selling work before jumping in. You should also fully understand the implications of leverage and be disciplined enough to stick to your investment strategy and not allow your emotions to rule your decision making.
BACK TO CONTENTS