CFDs Suitability in an Investment Portfolio


Q.: Are CFDs suitable to use in an investment portfolio?

A: Are CFDs right for you? Decide if trading CFDs is likely to meet your investment needs and objectives. Granted, CFDs may not be the best tool for long term buy and hold investing but it still has a place in any investor's portfolio. Even if you're a long term buy and hold investor you can use contracts for difference to take advantage of short-term market swings in the market without affecting your long-term equity portfolio. Not only that but some investors are using CFDs as a means to hedge and protect their share/equity investments - for instance say you have bought 5000 BP [LON: BP] shares at 460.5p [pence] expecting that BP will rally following a recovery in the oil price. You plan to keep your BP equity as a long term investment. However, after a few days it appears that BP is heading down and is now trading 440p; you still believe that BP shares are good value in the long run but expect some further short-term price weakness as a key support level has been breached. So to hedge your share holding to cover against further weakness in the share price in the short term you could short-sell 5000 BP shares - this way your losses in the physical shares will be offset by your gains in your short CFD trade (excluding brokerage fees). At the end of the day, however, many investors who venture from shares trading to margin trading utilise CFDs as either a way to make faster money or have a more diversified investment portfolio (as CFDs also provide access to indices, commodities, forex..etc).

 

Q.: Is CFD trading day trading? What do I need to start?

A: To start you will need to open an account with a CFD broker. When opening an account you will be required to include details of your trading experience and a basic statement of your financial position - this is because CFDs are leveraged products and your broker is obliged to ensure that you fully understand the risks of trading on margin.

When trading contracts for difference you do not necessarily need to day trade - in fact you can hold on to a trade indefinitely although it wouldn't make sense to hold a CFD trade for months on end. You don't need to spend all day starting at a computer monitor - in fact all you need is to spend around 15 minutes researching your market everyday gathering routine information, with the online brokers it will only take you minutes to place trades.

However, you do need to have a basic understanding of the market workings and have a grasp of technical analysis - i.e. interpreting a share's price chart to reveal current investor sentiment, as well as an understanding of volume, moving averages and candlesticks which can all be incredibly useful.

And you will also need a link to a news service like Bloomberg to remain on the loop on the main world markets each morning as well as some share analysis software application like eSignal or Sharescope to provide the graphs for particular shares' past records (although brokers also provide you with their in-house charting software most of the times).

But that's it once you are familiar with the software and the broker's CFD trading platform you're basically ready to go.

Complaining about CFDs because of their leverage or complexity is missing the point. There is nothing wrong with the CFD product. The problem is with the people who use them.

Q.: But is trading contracts for differences gambling!?

A: CFD Trading becomes gambling when you stop sticking to a set of rules. There are loads. If you're day trading (and by this I mean entering a position and exiting at the end of a trading day) with your CFD trading account you are more likely to be gambling and have a greater probability to lose in the long run. Why? Because fees will get you! My advice is to START SMALL and build confidence. Set stop losses on EVERY POSITION. NEVER lower your stop loss when a trade isn't going your way. When it is going your way, trail the stop loss. Lock in your profits. CFD TRADING IS NOT A GET RICH QUICK SCHEME. If you are getting rich quick, chances are you'll equally get poor quick too at some point. I try to look at CFD trading as an alternative method to share dealing (plus you can go short). You pay less in commissions and the platform is usually better. You can leverage but gearing yourself to the tilt is not recommended. Imagine holding a leveraged position in Barclays when their share price plummeted. You'd have lost your whole account, probably owed the spread betting company some more too.

Q.: What is 'Shorting' or 'Going Long'?

A: Trading with contracts for differences allows you to hold both 'long' [buy] and 'short' [sell] positions. All CFD broker will allow you to trade both 'long' and 'short'. The great benefit of this is of course that profits can be made both on the way up and on the way down giving you the opportunity to profit both a rising and falling market. 'Going long' is when you buy a trade and profit from it moving upwards and 'shorting' is when you profit from an asset falling in price.

'Going long' means buying a CFD in the expectation that the underlying asset will increase in value.

'Going short' means selling a CFD with the expectation that the underlying asset will decrease in value.

In both instances, when you close the contract, you hope to gain the difference between the closing value and the opening value.

For instance, you might buy a CFD ('go long') over Company XYZ's shares. If the price of Company XYZ's shares rises and you close out your CFD, the seller of the CFD (the counterparty) will pay you the difference between the current price of the shares and the price when you took out the contract.

However, if the price of Company XYZ's shares falls, then you would have to pay the difference in price to the seller of the contract. This could exceed the amount of money you originally put in, because of leveraging.


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