Why trade CFDs instead of Stocks?

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But aren't CFDs more risky than Shares Trading?

Q.: What are the Risks?

A: Like any leveraged derivative investment, there is always an element of risk when trading contracts for difference. The gearing nature of CFDs may help to boost your profits if you correctly predict movements in share prices. However, the risk of loss also increases disproportionately if the stock’s price moves against you, losses can exceed the funds you deposit into your account (although in practice you can cap losses through the use of stop loss orders).

Q.: But aren't they more risky than shares trading?

A: Taking out a CFD on 10% margin for 1000 Next (LON: NXT) shares is equivalent to buying 1000 Next shares from a traditional broker. In other words the risk is identical whether you buy 1000 Next shares or take out a contract for difference controlling 1000 Next shares. And this is where CFDs are unique in that you do not actually own the shares. Rather, you make a profit - or a loss for that matter - on the difference between the price at which you bought and the price at which you sold at the close of contract.

Gearing is widely used in trading and stock investing: futures, options, warrants, contracts for difference, and the mother of all - FOREX. Many newbies are attracted to the possibility of putting a small deposit and acquiring big exposure. For instance in forex trading normal leverage is 1:100, but you could find one with 1:200 and even 1:500 (albeit I would say that gearing yourself x500 is suicide). This is one of the reasons CFDs are so powerful - with the same amount of money that you can go and buy 1000 Next shares you can gear yourself up and maximise profits.

That’s where it comes down to how the instruments are used - if they’re used responsibly it is identical to buying shares. The big difference here is that you can also short them i.e. basically profit if Next shares decline in value. These are the circumstances in which contracts for difference can be such powerful instruments - because you can make money on a falling market. Even better you can use CFDs to hedge your portfolio of shares so in a falling market your losses are mitigated - people who had short index positions as hedging instruments have actually done quite well out of this market, better than those people who only had a long only portfolio.

It is however important to recognise that margin trading carries inherent risks and you need to manage this risk by taking volatility into account and using sensible risk management. CFDs aren't suitable for laid back investors who want to buy and forget; they require hands-on attention and being prepared to make a sharp decision quickly. I wouldn't recommend anyone who is starting out to gear himself/herself beyond 1:3 for the first year or two of trading. Gear yourself too aggressively and it is like pointing a gun to your head as the higher the leverage, the faster money disappears in front of your eyes if a position moves against you. On the other hand use gearing responsibly and you stand to reap the benefits.

A lot of people suffer with CFDs because margin is used. If you take on too much margin (risk) then even small moves in the underlying can cause serious problems.

Q.: But do I have the control?

A: You are in control of the leverage used in your trading account and don't need to use the full leverage that brokers make available to you. In fact, if you so wanted you could treat your CFD trading account like a conventional share dealing account and only limit your exposure to what you would invest in a normal trading account. So for instance, if you have $20,000 cash in your CFD account you could always take positions equaling no more than $20,000 in market exposure. This would equal zero leverage and represents no more risk than a standard share dealing account. This, coupled with sensible stop losses is a good way to gain some experience while minimizing risks.

Q.: But how can you lose more than is in your account?

A: It is easy to lose more than your CFD trading account in theory. This is how it works -:

If you only have to put up 5% margin upfront and you use up all the funds in your account, then if the share moves more than 5% overnight then you will be wiped out. Anything past that and you are in the red. Imagine a situation where it moves 15% or more you are now in the red for twice what you had in the account yesterday .

Using leverage sensibly is imperative. You do want to control positions that are larger than your capital base but you have to do this with prudence. The key is how much is at risk.

Q.: Aren't the odds against you? The house always wins in the end...

A: With Direct Market Access trading you can't say that the house wins because you are not betting or trading against the house. You are participating in a real market with real buyers and sellers. The odds are not really against you as they are with a spread betting company or any other over-the-counter outfit who can artificially manipulate spreads and execution. But then again, in the end, it is essentially a skill game. And in case of Direct Market Access, the house wants you to trade more because they don't earn by doing tricks to get your capital. Instead they earn from commissions.

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