If you’re the type of person who would love to own some blue-chip stocks, but whose trading account can only run to penny stock type investments, then you may need to look at contracts for difference (CFDs) for your trading. With the margin available on CFDs, you can enjoy the profits from a much bigger investment in stocks than you can afford to make.
Margin is the amount that the broker will lend you to make your trade. Typically, with a stock broker, they will allow you a 50% margin, which means you can buy stocks worth twice as much as your account size. If you instead hold your account with a CFD dealer, then you can control stocks worth about 20 times the amount of money you hold, as you’ll only need about 5%.
Certainly, there are a couple of points to bear in mind. With a margined product such as CFDs or futures, you can lose more than the money you have in your account. Just as the margin means your money is leveraged for profits, so it is also leveraged for losses. What this means in practice is that you have to keep a good eye on the underlying financial securities, and cut your losses quickly if they are going in the wrong direction, and before you get into trouble. This is the price you pay for being able to make large profits.
The other point with CFDs is that you will be charged interest by the dealer for every day that you are borrowing the money. The interest rate may be two or three points above a published bank rate. If you’re trading on a short-term basis, rather than investing for years to come, then your profits should easily take care of this additional expense.
But having said that, if you’re careful with the amount of leverage that you use, and understand risk management, then CFDs give you a great advantage over traditional stock traders. Another key to limiting possible loss is to ensure that you always use stop losses, and put them in place whenever you open a trade.
CFDs allow you to profit directly from the performance of the blue-chip stock underlying the contract, you can benefit from corporate actions and stock splits, and you’ll even get dividends if you’re in a long position. Of course, if you think the blue-chip stock is not going to do well, you can equally well take a short position using CFDs. In fact, when you take a short position you are paid a minimal amount of interest, rather than being charged it.
The great advantage of using your precious trading capital to trade CFDs in blue-chip stocks instead of trading small-cap stocks is that small caps can be very variable and illiquid, and are difficult to research properly. Blue chip stocks like the stocks making up the FTSE 100 for instance, aren’t as volatile and have smaller daily ranges compared to smaller caps – needless to say a £20 share has to do much more to move 15% than a 15 penny share. For the same amount of money, you can take an interest in the largest companies in their industries, with proven track records. This also means that your trading plan should be slightly different as you are able to take larger trade sizes for smaller daily to weekly movements.