If you have read about contracts for difference on other websites, you may be wondering about whether CFDs are a wise choice for long term trading positions i.e. buy and hold. After all, as many critics point out, you are trading ‘on margin’, which means you are effectively borrowing most of the cost of the shares or other underlying security, and consequently paying interest. Even worse, the interest is charged every day to your account, so you need to pay attention to the interest costs and make sure that the larger moves balance out these costs. Financing costs may mean that in the end you might have to put more funds in even if the underlying has not lost value.
A number of investors tend to utilise CFDs for holding long positions to gear up their positive returns on different asset classes. Most people are intrinsically optimistic. CFDs mean investors can gain greater leverage to the market. If you deposit 6% on the CFD you want to buy and the stock price goes up 2.5% or thereabouts, you will make more than 40% on the CFD.
But just as you must know what you are doing to take part in any type of trading or you should expect to lose, this simply gives you another factor to add to the profit/loss equation when you calculate the risk/reward of the trade. The interest charged is perhaps a couple of percentage points over a standard bank rate, and if your stock picking is any good, you are probably expecting a better return than that. So long term trading with contracts for difference should not be ruled out on the basis of generalities, but considered carefully to see if it fit your trading objectives.
Where CFDs really score is in the gearing or leverage that is available for your money. Many investors still use CFDs for directional trading and like the fact that their initial outlay is so small. If Tesco (TSCO) is currently trading at 370p to buy and you purchase 1,000 shares using a normal brokerage account, you would normally need £3,700 to buy 1,000 shares. With a CFD, because of the margin required, you might only need to put up 5%, so you would only tie up £185.
You can profit from maybe ten times as many shares as you could afford to buy because of the leverage that you get, so provided your choice is profitable, this can more than make up for the interest charged. The spread between the bid and ask prices is usually reasonable, and the commission for each transaction is not very expensive, being a fraction of a percent. Where it applies, you can save half-a-percent in stamp duty by not buying the actual shares.
The timeframe for long term trading can be several weeks to months and sometimes even years and as such fundamental triggers play a more important role than technical factors. One thing to keep in mind is that utilising CFDs to take advantage of longer term trends requires a different trading methodology. In particular, when taking long-term positions you need to be able to ride the larger market movements so will need to set wider stops because otherwise you risk your trade being stopped out early on due to the normal up and down day-to-day market fluctuations. You can do this by taking a smaller position size, since here you are expecting to capitalise on the bigger market movements which should still make for a highly lucrative trade.
But there are also other ways that don’t involve paying interest that you can use contracts for difference in long term trading strategies. Going short can often be more profitable than buying or going long, as prices tend to fall faster than they rise. For example, if you foresee a decline, then you can easily take a short position using CFDs and actually get paid a minimal amount of interest for the duration of the trade. While the amount paid may not be very significant, that situation counters the argument of others that CFDs cannot be used long term because of the charges.
If you own shares and you expect that there will be a downtrend, you can keep your shareholding and take a short position in CFDs to avoid loss. If the shares go down, the CFDs will increase in value by the same amount, hedging your position. Hedging like this can also be done with options, but they are not as flexible, as you must take a set size of shares. Certainly if the shares instead increase in value, you neutralize the potential gains by losing on the CFDs, but that is not what you anticipate will happen. Taking the CFD position is protection from loss.
