InTheKnow: Contracts for differences

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on April 23, 2018 - April 29, 2018.
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There are numerous instruments that investors can use to profit from rising and falling asset prices. One such instrument is a contract for difference. A CFD is an agreement between an investor and a provider to exchange the difference in value of a financial product between when the contract opens and closes.   

If investors believe the price of an asset will rise, they can buy long and profit from every increase in price. Conversely, if they believe it will fall, they can short-sell and profit from every decrease in price. However, investors will incur a loss if the markets do not move in the direction that they are expecting.

 

 

Leverage

A CFD is a financial derivative that allows investors to participate in the price movements of an underlying stock at a fraction of the cost of buying a full share. This means investors can trade a full portfolio of shares, indices or commodities without requiring a large amount of capital.

Investors may only need to come up with as little as 2% of the share price, depending on the CFD broker and type of shares traded. However, investors should be aware that increased leverage can also mean magnified losses.

 

 

Example of CFDs

Company X has an ask price of US$30. An investor believes the company’s share price will increase, so he goes to a CFD broker and buys 1,000 of Company X’s CFD shares. The broker informs the investor that the margin factor of Company X is 5%, so the investor only needs to pay US$1,500 (compared with the full price of US$30,000 to own the actual shares).

The investor predicted correctly — Company X’s share price rose to US$35. He can now calculate the profit by multiplying the difference between the closing price and the opening price of his position ([US$35 - US$30] 1,000). So, he has a profit of US$5,000 from his investment in the CFDs. This excludes any additional fees and charges (such as commission and spread) that may be imposed for the transaction.

If the investor predicts wrongly, he has to sell his CFDs at a loss. For example, if Company X’s bid price falls to US$28, the investor will make a loss of US$2,000, excluding additional fees and charges.

 

 

Hedging tool

If investors have already invested in an existing portfolio of stocks and think they may lose some of their value over the short term, they can hedge the stocks with CFDs. Investors can try to make a profit from the short-term downtrend by short-selling CFDs to offset any losses in their portfolio.

 

 

Portfolio diversification

CFDs are commonly traded over the counter, where a broker or CFD specialist provides the bid and ask prices. As most CFD brokers offer products in major markets worldwide, investors have access to any market that is open from the broker’s platform, allowing greater portfolio diversification. How much investors need to deposit depends on the size of their position and the margin factor for their chosen market.