Contract for Differences (CFD), basically allows you to trade in leveraged products without forking out huge capitals upfront. This approach essentially manifests both your potential profits and losses, but with proper risk management, you can ensure asymmetric returns as a trader. To be an all-rounded wealth builder, it is important to have knowledge in different investment instruments and their associated risks. So let’s delve into the 5 most important things that investors must know about CFDs.
(1) What are CFDs?
CFDs are derivatives because they derive their values from underlying assets like gold, shares or currency. This means that investors are not trading the assets. Instead they are actually trading the contracts with the service providers. This is important because investors are not owning or taking physical delivery of the underlying assets. Money is made or lost when the value of the asset moves either in your direction or against you. Thus, with CFDs, investors have the full option of going “long” or “short” the asset.
Another attractive feature of CFDs is that it allows you to put down a small investment capital for a much larger market exposure. As leveraged financial products, they are traded on margin. So instead of paying the full value of the underlying asset, you pay an initial margin to open the position. You may be required to maintain some minimum margin or top up margin, especially during volatile market conditions when the prices of these assets move against you.
Thus, there are ample opportunities to make big money with small investment. On the other hand, while CFDs can be very flexible, investors must also exercise risk management because the risk of losing more than your deposit is very real, especially when market forces turn against you.
(3) Why trade CFDs?
If you have been observing the market trends of an asset for a long time and are confident of spotting its future movements, then trading of CFDs could potentially be for you.
Firstly, you need to open an account with a reputable CFD service provider like IG. Understand the transaction charges and fees involved. Typical transaction charges would include commission fees, daily financing costs or bid-offer spreads involved.
You need to factor these costs in before trading CFDs because they may affect your returns. For every trade, there will be an “open” and “close” position. If you are long and the closing out price is higher than the opening price, the CFD provider pays you the difference. If the price is lower than the opening price, you pay the difference. The situation is reversed if you are shorting an asset.
(4) Do you have the time?
CFDs are ideal for traders who wish to exploit future price movements of assets.
However, if you have limited time to monitor the performance of your trades, brokers have tools in place such as price alerts and risk management tools like stops that are designed to safeguard you against the risk of leveraged trading. This is an important issue especially if your day job does not allow you to have access to the market movements or the underlying assets are traded at a different time zone as opposed to your waking hours. Under such circumstances without risk management tools, you may not be able to react quickly to limit any losses that you may suffer.
(5) Managing the risks
When you enter into a CFD position, you are likely to have a strong view on the future direction of the price of the underlying asset. But like all things in life, things can always go wrong. Your predictions may not be accurate and your views may turn out to be wrong. Thus, to mitigate potential losses which can destroy your wealth, you need to set stop loss to limit your losses. For example, IG offers a unique guaranteed stop function that ensures that your losses will be capped. This is important given that CFD is a leveraged product that may manifest your losses significantly.
Besides market risk, another risk that you need to note is counter-party risk. The last thing you would want is to be earning good profits only to realize that your CFD provider is not able to hold up their end of the bargain. This is once again the reason to deal with a reputable CFD provider. Do check the Financial Institutions Directory on the MAS website whether the firm has the requisite authorisation or licence.
If you are looking for a CFD provider, IG is celebrating its 10 year in Singapore. There is also an online community that you can join if you want to bounce off ideas with other traders as well.
All views expressed in the article are the independent opinion of SGWealthBuilder. Sponsored by IG Asia Pte Ltd