One of the most popular, but also highly risky, financial instruments, which thanks to its specificity attracts investors from all over the world. Find out how Contracts For Difference work.
Contracts For Difference (CFDs) are popular financial instruments that allow investors to earn profits on differences in the exchange rate of various types of assets, such as stocks, indices, currencies, commodities or cryptocurrencies (so-called underlying assets). CFDs allow investors to access markets and assets that would otherwise be difficult to access or available only to a selected group of investors, as they allow trading without actually owning a given asset, which reduces the costs of obtaining or exposure to a given asset, eg. related to the transport and storage of given assets – as is the case with, for example, commodities.
When investing in CFDs, an investor does not buy a real asset, but concludes an agreement (contract) with a broker for the difference between the purchase price and the sale price of a given underlying asset. If they believe that the price of an asset will increase, they may enter a “buy” position. If the price actually increases – the investor earns on the transaction. If an investor believes that the price will go down, they can enter a ‘sell’ position and profit from the price drop.
However, it should be remembered that CFDs are high-risk instruments and investing in them requires thorough market analysis and knowledge of the risk. That is why it is so important to understand exactly how CFDs work and what risks they carry.
Following the observation by the European Securities and Markets Authority (ESMA) of a sharp increase in the number of CFDs traded in the EU, as well as the level of losses when trading this contracts, it issued a decision in 2018 requiring all providers of CFDs in the EU to clearly communicate on the level of losses recorded on retail clients’ accounts, updated quarterly.
Some results of retail clients investing in CFDs in selected EU countries:
- Poland: Around 79% of investors reported a loss in 2016 and 2017, with an average per capita of 10 060 PLN in 2016 and 12 156 PLN in 2017
- France: Over 89% of investors lost money in total between 2009 and 2013, with an average loss of 10 887 EUR
- Portugal: Total investor losses amounted to 66.8 million EUR in 2016 and 47.7 million EUR in 2017
A significant aspect that distinguishes CFDs is the possibility of trading with financial leverage. This is a functionality that allows an investor to conclude transactions for amounts exceeding the actually held capital. This can potentially increase the return on a given investment, but also increase the loss if an investment does not perform as expected. It is important that investors carefully consider the potential risks and benefits of using leverage in their investment decisions.
An investor wants to invest in gold worth 20 000 EUR. The financial leverage on this asset is 1:20 (5%), which means that they only need to put up 5% of the trade value to open it, which is 1 000 EUR. This means that the investor entered into the transaction worth 20 000 EUR, having only the equivalent of 1 000 EUR.
If the gold CFD price increases, giving the investor a profit of 200 EUR, this will result in a rate of return of 20%, from the invested amount of 1000 EUR. Without the 1:20 leverage, the investor would need to have 20 000 EUR in the account and the same possible profit of 200 EUR would mean a return of 1%. Thanks to the use of leverage, the rates of return on investment can be higher with a smaller investor’s contribution. However, it is a double-edged sword. In the event of a decrease in the gold price and the result of the transaction -200 EUR, the investor loses 20% and out of 1000 EUR he only has 800 EUR left.
Security deposit, often described as margin, is the amount an investor needs to deposit to open a CFD investment. It is directly related to the use of leverage. It is a certain percentage of the value of a given contract that an investor must deposit to gain exposure to a larger transaction value, where the difference between the security deposit and the transaction value is covered by a broker. In case an investor loses on their trades, a broker can deduct the amount corresponding to the losses from the margin.
The size of the margin depends on the size of the position and the risk associated with a given asset. For example, for riskier assets, such as cryptocurrencies, the margin requirement may be higher than for less risky ones, such as stocks.
Closing orders (Stop Loss)
Closing orders, also known as Stop Loss, should be an important part of investing strategy. They are used to protect the investor’s capital and minimize the risk of losing a large amount of money.
Stop Loss orders automatically close an open position when the price of an asset reaches a predetermined level. It is set by the investors themselves and can be changed, depending on the market situation.
Thanks to closing orders, an investor can limit losses if the price of a given asset does not perform as expected. These orders are especially important in markets that are characterized by high volatility and uncertainty, such as the Forex and commodity markets.
It is worth noting that closing orders are not a guarantee of no losses, as they can only be executed at a lower price than the opening price of the transaction.
Orders similar to Stop Loss are Take Profit orders, which close an open position when the price reaches a profit level predetermined by the investor. Thanks to this, there is no need to constantly check the quotes, and it also helps in sticking to the previously adopted investment strategy and it prevents overholding positions caused by greed (you can read more about emotions accompanying investors and how to deal with them here).
To sum up, CFDs are financial instruments that allow investors to make a profit in the event of changes in the price of a given underlying asset, without actually owning it. An important element of investing in CFDs are closing orders, which allow investors to limit potential losses, as well as financial leverage, which can multiply potential profits or losses.
It should always be borne in mind that CFDs are more risky than other types of assets, so before investing funds in them, it is necessary to thoroughly understand their mechanics and the risks they carry.