How to trade CFDs

Many people have heard about CFDs, not aware of what they are, what opportunities they offer, but also what risks they contain. In this article, I will outline the basics in a nutshell.

What are CFDs?

• CFDs are contracts for difference, a derivative with a strong leverage and thus suitable only for well experienced traders being aware that higher chances come along with higher risks.

Why trade CFDs?

• Trade CFDs to speculate on whether an asset’s price will move up or down – without having to own the asset.
• CFDs are a derivative product available on shares, forex, indices and commodities, covering both the long and short side of an investment.

Difference to put and call options (warrants)

• A warrant is being issued by an investment bank typically with a fixed maturity and a predefined strike.
  
  
• If you want to trade a call option on an underlying currently trading at 150$, but call options are available with a strike of either 140$ or 170$ only, you will have to make an unsuitable choice in any case.
  
  
• A CFD position can be opened at any price level and thus offering a significant advantage over warrants.
  
  
• CFDs require a margin. As long as your margin balance is ok, you can hold your CFD position without having a predefined maturity date. Due to the intrinsic finance cost, CFDs are preferred for rather short-term investments.

Functionality – basic

Your broker will charge you a commission for dealing CFDs – in this example I want to keep it simple and explain you the function of the leverage and the position size only. Once you will understand how this works, you can further read in to commissions etc., which have a further (small) impact on your performance too.

In the example below, the shares of Virgin Galactic (SPCE) were in a steady uptrend. Let’s assume you bought 1 share at USD 19.50 and sold it at USD 26.00 – your capital gain was therefore 6.50 USD or 33.33%.

 

How does the investment into a CFD calculate?

Note: The P/L% of the initial margin remains the same for 1 or 100 contracts (share CFDs)
Information about the P/L calculation and more examples can be found here.

With 100 CFDs bought long on SPCE at 19.50 USD, you will have to pay an initial margin of 97.50 USD, the P/L resulting from the difference to the exit price of USD 26 is 650 USD.

While the overall P/L of your entire account balance has grown “only” 6.50%, remember you did not invest the entire 10’000 USD available, but only 97.50 USD of it. Therefore, the P/L of the absolute amount compared to the initial margin is a whopping 666.67%! Or factor 20!

Let’s have a look at another theoretical example to outline the chances and risk involved.

In this example, we opened up a long position on SPCE on December 7th, just at the outbreak above the green trendline. Fast forward 2 month, SPCE rallied up and reached a target price of USD 55.

A direct investment into the share would have yielded a nice 85.87%.

So if you had a leveraged CFD position instead – your profit then was (85.87% x 20) 1717.4%?

Yes and No.

You only looked at the upside and ignored the downside! And this is where most investors will lose money! To explain you what happens, let’s take a look at two different investors:

• investor A has an account worth USD 10’000
• investor B has an account worth USD 100’000
• Both decide to invest 1500 CFDs long on SPCE at USD 29.59

 Their individual outcomes will be totally different!

Unfortunately, soon after the position was opened, SPCE took a dip of 6.63 USD. A direct investment into the share would have resulted in an unrealized loss of 22.41%.

For leveraged CFD positions, you pay an initial margin and when your investment is developing against the planned direction, you face a margin call. The situation for investor A and investor B is completely different though.

Hypothetical calculation of investor A:

You only invested 2219 USD of your account, but the theoretical P/L (-10350 USD) is so big, you would not only have received margin warnings, but very soon a margin call, thus resulting in a realized loss with no chance of profiting from the later upside rally in SPCE!

Hypothetical calculation of investor B:
Investor B would have suffered the (temporary) same loss of 10350 USD, but since he holds enough cash, his margin balance was never at risk and thus remains invested (unrealized loss).

Now that the rally started in mid-January, investor B looks at a wonderful profit of USD 38’115:

And yes, compared to the initial margin of 2219 USD, the absolute profit of 38’115 USD represents a whopping 1717.47% profit!

Opportunities / risk

• Get familiar with the use and calculations of CFDs before you place your first trade
• Trade only into the direction of a trend
• Analyze your chart well and incorporate a certain safety-cushion
• Set a stop to protect your position against unexpected market moves
• Do not risk most of your account in a single trade. The odds and the volatility of the market will play against you

Most investors lose money not because they are wrong about the general direction of their investment, but because they ignore the impact of the downside volatility on their position. Therefore start investing only a small amount / small portion of your account.

 

*SAMT as the marketing partner may be compensated by IG as a result of this promotional activity.