CFDs are leveraged financial derivatives that can yield high returns, but of course, this comes with higher risk. Usually traded on margin means that your losses can exceed your initial investment! It is estimated that 74-89% of retail investors lose money when trading CFDs and other leveraged instruments such as forex.
The risk is so high that the European Securities and Markets Authority (ESMA) has made it mandatory for CFD brokers to give a risk warning on their web pages, stating the percentage of retail investors who lose money when trading CFDs with them.
A Contract for Difference (CFD) is an arrangement between a buyer and a seller where the payout is dependent on the difference between the opening and closing times of a contract (typically within a day, as a holding cost may be charged by your broker if it is held after market closing hours). The buyer will earn when the closing market prices are higher, i.e. the price has increased. On the other hand, the seller will earn when the closing market prices are lower, i.e. the price has decreased.
Jack buys a CFD from a broker, in which the underlying asset is 100 shares of CapitaLand Investment. The current price of a CapitaLand share is $4, so Jack will pay $400 (assuming no margin or other charged fees). Say this rises to $5 at the end of the day. In this case, as the closing market price is higher, the buyer will receive a payout equaling the difference from the seller. Hence, Jack will receive ($5-$4) x 100 = $100 from the broker.
Same as above, except instead of rising to $5, the price falls to $2.50 at the end of the day. As the closing market price is lower, the buyer will have to pay the difference to the seller. So, this time, Jack has to pay $1.50 x 100 = $150 to the broker.
CFDs for foreign exchanges are likely the most popular of the bunch. In foreign exchange CFDs, you are looking at the rise or fall in the exchange rate between a pair of currencies, such as the US Dollar and Japanese Yen pair. CFDs come in many forms, so it’s best to do your due diligence before jumping into trading them.
Long Position: you act as the buyer. Take this position if you expect the underlying asset’s price to rise.
Short Position: you act as the seller. Take this position if you expect the underlying asset’s price to fall.
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Underlying asset prices may not move drastically most of the time. Hence, brokers will offer trading on margin for CFDs. This means that you’ll be borrowing money from the broker to increase the size of your initial investment. If the leverage is 20:1 (may also be stated as a margin requirement of 5%), this means that for every $1 you put in, you’re borrowing $19 to buy $20 worth of CFDs. This is a way of maximising returns, but also losses, in your investment!
The margin account is where your initial investment goes. It acts as collateral for your open position and ensures that you never owe any money to the broker, so both you and the broker can rest easy. If your CFD position makes a loss, your losses will be taken out of this margin account immediately.
When your margin account hits a minimum threshold, referred to as the Maintenance Margin Requirement (MMR), a margin call will take place to request that you top up your margin account. If you do not top it up, you will have your position forcibly closed by the broker (to prevent further losses and hence an owing of money).
Some brokers do not perform Margin Calls and will instead close your account immediately once the Maintenance Margin Requirement is hit. In this case, the requirement level may be called the Margin Closeout instead.
CFDs typically have lower trading fees than shares and options.
Commission charges usually range from 0.1% to 0.25% of the CFD value amount (not your initial investment) when you buy or sell CFDs. Sometimes, this is subjected to a minimum amount. Also, this does mean that you will be charged twice for a simple buy-and-sell transaction; once when you buy and once when you sell.
For some brokers, they may not even charge commission fees, and the only extra amount you’re paying will be the bid-ask spread! Note that the bid-ask spread is internally formed by the brokerage and is one of the main ways they profit from your trades.
Bid-Ask Spread
When it comes to any type of financial instrument, you may be presented with two different prices. One is the bid price, and one is the ask price. The bid price is the price at which you sell the financial asset to the broker, while the ask price is when you buy the broker's financial asset. The bid price is typically lower than the ask price, which is how the brokerages profit!
The difference between the bid price and the ask price is known as the bid-ask spread, and you can think of this as the price the brokerage is charging you per financial asset.
In the context of CFDs, you will buy CFDs at the ask price and close your position at the bid price.
CFDs are generally opened using leverage. Hence, you only need to pay a fraction of the position value upfront. You will borrow the rest from the brokerage. Hence, leverage will amplify your gains on the initial amount due to having a much larger position opened for you. Be warned, though, that this also heightens your losses!
If you’re expecting the price of a share to plummet, shorting CFDs is one of the various ways to profit from the fall of a share price. Using derivatives such as options and CFDs are a good way to take an indirect short position in shares.
Like any other financial derivatives, you can use CFDs to hedge your portfolios against possible losses. This can be a complicated process, so seek out professional advice if needed!
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With higher returns come higher risks. While trading on margin magnifies your earnings, it also magnifies your losses if the market swings the other way. You may lose your entire original investment and more!
Like options, CFDs are not available for every share, bond, or index you come across.
CFDs are usually not traded on exchanges; they’re traded over-the-counter (OTC) with your brokerages. This means that the other party is actually your CFD broker, who could fail to fulfil their end of the contract (e.g. if you close your CFD position but your brokerage fails to pay you the difference that’s due). This inability to fulfil their financial obligation will void the value of your CFD. Hence, you must choose an appropriate brokerage with a strong financial standing and stellar reputation.
Note that you cannot transfer your CFD over to another CFD brokerage! They are contracts between you and the brokerage you bought it from.
As mentioned, there are two different prices: the bid and the ask. On exchanges, the bid and ask price are settled through demand and supply, i.e. the transactions taking place on the exchange. However, because over-the-counter transactions operate in a closed system, the brokerage firm decides the bid and ask prices for their CFDs, with reference to the market price of the underlying assets. As such, there may be a difference.
Typically, brokerage firms will try to remain competitive and follow the market price as closely as possible. Still, when the market faces high volatility and prices constantly fluctuate, the bid-ask spread may widen and deviate from the market prices. As we know, the bid-ask spread acts as a brokerage fee, so a widening spread is not favourable to investors.
While CFDs are banned in the US, the MAS allows CFDs to be traded in Singapore, as long as there is a fact sheet of risks that goes alongside it. However, only selected brokers registered with the MAS are allowed to broker CFD trades.
Here is a non-exhaustive list of CFD brokers in Singapore:
Before you’re allowed to trade CFDs in Singapore, you must pass a Customer Knowledge Assessment (CKA). As part of MAS regulation, you will have to complete the CKA before opening an account with a broker. The brokers themselves will typically give this assessment. However, do perform your own self-assessment to make sure that you’re ready to tackle CFDs in the market!
CFDs are advanced financial products that require a good understanding of risk and return. If you are new to investing, we advise you to give our articles on basic investing a read first and get some experience on the basic markets before moving on. If you’re already ready to tackle CFDs, do your due diligence and research the products that you’re eyeing. Financial derivatives can open a world of wonders for your portfolio. Still, it is important to always keep the risks in mind, which, especially in the case of CFDs, may be very substantial.
CFDs 101. COMPLETED. ✅
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