As opposed to stocks or currencies, trading and investing into contracts for difference (“CFD”) started relatively recently – in 1990s. They initially served the financial institutions for hedging against value movements of stocks and other assets. And just along the way they became a product used in markets by small investors and traders.
The essence of CFD
When using CFD instruments, the trader does not become an owner of a physical stock. He can make no profit claims and also has no deciding rights. On the other hand, he does not pay any stock exchange commissions and CFD trading is faster and easier in comparison to traditional assets.
How does CFD work?
CFD are financial derivatives that are used for speculation on price movements. Put simply, CFD is created by opening a position and ends with the position close. One may speculate on decrease or increase of prices. When closing a position, the trader’s speculation is compared to the real price movement, which then means a profit or a loss. This is then multiplied by using leverage, that enables increasing own capital by using often significantly higher volume of foreign capital. Trading with bigger “money” may then lead to profit increase, as well as to potential loss increase.
An example of leverage trade with CFD
To give you a better idea how leverage works, we present you a simplified case. We will use Apple stocks movements between 2 January and 3 January 2019. At the beginning, Apple stocks were traded at the value of 157.92 USD (2 Jan 19, 4pm). On the following day at 9.30am, its value was 144.04 USD, which meant a decrease of 8.79 %. In the table of trading examples below, the leverage height is between 1:1 to 1:5. We can see three different results according to the leverage height. The profits or losses happen depending on our decision, whether we speculate on increase or decrease. Let’s see an example when a trader expected Apple stocks decrease and speculated on it.
A model of how the leverage works when trading stocks by CFD
|Laverage||Opening price||Closing price||Change (%)||Investment (EUR)||Profit/loss (EUR)||Spread* (EUR)|
Let’s assume that the trader opened his position on 2 January at 4pm with 10,000 EUR, speculated on decrease and then closed the position at 9.30am. Without using leverage, he would make a decent profit of 879 EUR. When using leverage 1:5 this profit becomes 4,395 EUR. As you can see in the example, financial leverage may help to bigger profits, but could also make losses in the same height. That’s why it is necessary for the trader to realize, how much willingness to risk he has. If the investors demand low risk rate, then CFD trading should not be the way. This type of trading could be an interesting and welcomed part of portfolio for investors with positive attitude to risk.