CFDs and protecting your portfolio in a bear market
Contract for Difference, or CFD, provides a way for traders to speculate on the movement of a stock price without buying the stock itself.
They are approved instruments listed on the ASX, and because of growing popularity, CFDs can also be traded on a wide range of other markets including indices, energies and commodities.
So how does it work?
Firstly, much like typical shares, there are two CFD prices – the buy and the sell price – allowing you to speculate in either direction.
By initially trading at the buy price, you will profit if the underlying asset’s value increases. By initially trading at the sell price, you will profit if the asset’s value decreases (Note, this second characteristic sets CFDs apart from the shares you’re trading with your typical share broker. It is called “short selling” or “shorting” and is generally not offered to retail share investors on standard share broking platforms. Shorting is used by investors aiming to profit from a fall in the price of an asset.)
Unlike a futures contract, CFDs do not expire. So once you open your position, it remains in place until you close it out.
The major point of buying and selling CFDs is that they’re traded on margin. This means you only pay a small fraction of the value of the underlying shares instead of paying the full value.
A position on a CFD therefore effectively gives you a leveraged exposure, and as many of you know, leverage is a double edged sword as it can amplify your returns and losses. But we’ll get to that later.
CFDs can also be traded through a licensed broker like one of the leading CFD providers, ThinkMarkets.
On opening a CFD position (whether long or short) you pay a deposit known as the Initial Margin.
The initial margin is the minimum amount that you need to deposit with your CFD broker to ensure that you can meet your obligations if the market doesn’t go your way.
For share CFDs, the initial margin is expressed as a percentage, and is set by the broker because your responsibility on margin trades is to the broker.
Typically it’s around 10% to 20% of the value of the underlying asset.
As an example, if the share price of Stock A is currently at $10, and the initial margin is set at 20%, to buy (or sell) 100 CFD contracts you would have to put up an initial margin with the broker of $200.
This is the minimum balance that you must hold with the broker at the close of each trading day to ensure your CFD position remains open.
Margin is a ‘good faith’ deposit, i.e.,collateral that is held by the broker to hold open a position. This is not a transaction cost, nor is it charged as a profit or loss amount to your account balance, rather, it serves to ensure you have sufficient capital in your account relative to the size of your position.
As an example, suppose that after buying a CFD contract, Stock A’s share price moved from $10 to $9, a 10% fall for the day.
Your position has moved against you $100 (-$1 x 100 shares). This would also mean your equity has fallen from $200 to $100 and you would need to add another $100 to maintain your initial margin requirement of $200.
If the floating value of your account falls below your margin requirement, your broker may close the position, so it is important to maintain a sufficient balance in your CFD account relative to the size of your position.
The initial margin plus any profits, or less any losses will be returned when you close your CFD position.
It’s worth noting that each day that your long CFD position is open, you must pay contract interest (CI) to cover the borrowing cost of the value of the shares.
In other words, if you’re long (bought) a CFD, you will get charged incremental daily interest to your account.
Depending on the prevailing interest rates, you might earn contract interest when you enter a short position.
It’s easy to see how a leveraged derivative product like a CFD could magnify both your profits and losses.
In the simple example above, if you had bought Stock A directly with cash, a 10% move up or down in the share price would leave you with a 10%, or $100 profit or loss respectively.
If you had used a CFD to do the trade instead, the 10% uptick in Stock A’s price has also yielded a $100 profit. However, if we consider the return as a percentage of your initial outlay (i.e., the $200 initial margin), your return is 50%. In other words, you’ve magnified your percentage return 5X.
By the same token, a 10% downtick in Stock A’s price means you’ve lost 50% of your initial outlay.
We can see that if we trade the same quantity of CFDs as shares in the underlying asset, the gross P & L in dollar terms is the same, it’s just the percentage returns which are magnified.
According to ThinkMarkets, one of the most popular ways to use CFDs is for hedging positions.
Let’s suppose that you have bought a share, and the price is pushing lower and your profit and loss is in red territory.
In this scenario, opening a short CFD position on the share allows you to limit your losses, as the short position will be gaining value should the market continue moving lower.
Structuring the size of your position according to your risk profile is also key for long-term profitability in trading.
For that reason, when starting with CFDs it is important to choose a broker like ThinkMarkets who offers variable contract sizes as well as a number of other client protections aimed at limiting your risk, even in volatile markets.
This article was developed in collaboration with ThinkMarkets, a Stockhead advertiser at the time of publishing.
This article does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.