A CFD stands for a “Contract For Difference”, which is a tool used to trade derivatives. Just as in regular option trading, ownership of a CFD reflects the movement of its underlying asset (but offered only by specific, regulated, CFD brokerages). Though you aren’t actually purchasing that asset, you can profit from a move in price per 100 shares without putting as much cash as you normally would. Although all you own is a contract, it is similar to betting on a spread on a race or football game. While you can bet on the performance of a horse or team without owning it, you can do the same with a stock. Every bit of research I did on these investments mention their rise in popularity throughout the last few years.
Contrary to options contracts, they are not fixed contract size nor do they have expiration dates. While a loss in CFD land is tied to the size of the stock's movement, a loss in an options contract equates to total loss in principle. They seem similar on the surface but the mechanics are actually quite different.
Why Are They Risky?
One reason they are risky is because CFD’s are not as regulated as other more popular instruments. That means you won’t be able to trust the financial safety nets we are so accustomed to. Do your research on what you are buying and who you are buying from, as your broker likely doesn’t have a fiduciary responsibility to you. Basically, you are trusting that your broker will provide their obligation to you.
CFD’s are not available for American traders, therefore they aren’t covered by American laws. The Securities and Exchange Commission is leery of those selling short, especially since the beginning of the Great Recession (2008). That being said, you may be able to find a broker abroad if you don’t reside in the US yet retain citizenship.
Fiduciary Responsibility: Legal duty to act in your best interest
Another reason they are risky is because of the leverage normally involved in the trade. Smaller margin requirements and lower upfront money is needed, but know that losses can be magnified. Though a fraction of the money is needed to enter into a contract, you will be responsible for 100% of the gain or loss. The aforementioned fraction will vary per broker, they sometimes can be as little as 1%. Using margin allows the possibility to use such leverage. Unlike other investments, doing so will risk losing more than the initial deposit of your trade. Not fun, if you are on the losing end of things.
Depending on your approach, CFD’s may not make sense when based on small moves as you’ll have to pay the spread on each entry and exit of the trade. Though fees may be small, they can add up per trade.
How To Include Them in Your Investment Portfolio
While these instruments would be risky if it were the only investment strategy you were implementing, there are a couple scenarios they can be best utilized. Many times it can be used while trading foreign stocks, as a means to protect against currency volatility. Another way to use CFD’s is to protect against events you think may affect your investments.
For instance, we all knew that the stock market would be affected by the 18 month Trump-Clinton boxing match that just took place. On the night of the election, the DOW Industrials Average was down almost 700 points. This would be a time where CFD’s could be used to hedge against economic and political events. Some thought Wall Street would be kind to a Hillary victory, as they know what they can expect from her. Others thought electing a businessman like Trump would we beneficial to the markets in anticipation of friendly business policies. Depending on what camp you related with or what you thought would happen, you may have bet on a certain outcome using CFD’s that contradict your other investments. This is the classical example of hedging through Contract For Difference.
As an expat, CFD’s offer a unique opportunity to you. Don’t let its appealing flexibility steer you away from acknowledging its downside. Anytime you hear the word leverage, assume you should do more research than you normally do. Though we all seem to think we can predict that next big move, make sure you aren’t betting dinner with CFD’s. It’s best used in practice using discretionary income, as part of a well-diversified portfolio. Any other approach may be putting your money at undue risk. I wish you the best and happy trading!