Business: Explaining CFDs

The problem I have with this sort of advertising is that most people who sign up for these products have no idea how they work.

The “fine print” on most of the products always warns of the risk of “significant loss of capital” or that “losses could exceed capital”, meaning you could lose more than you started with.

I trade and invest across a broad spectrum of securities and instruments, from long term investing to ultra-short term trading.

In fact, I trade CFDs just about every minute of the day.

We like to call that “scalping”. This is the “art” of taking many small profits from the intra-day moves of shares or securities.

So what are CFDs?

Simply put, A CFD is a “Contract for the Difference”.

It is a product offered by institutions for you to trade and the profit or loss is the difference between the opening price of the trade and the closing price of the trade.

CFD categories are mainly shares, commodities, indices (like the Dow Jones) and forex.

CFDs track the exact price and movement of the underlying instruments.

They offer traders the ability to generate superior returns in both rising (going long) and declining (going short) markets.

We call that “speculating”.

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Ironically, what makes them attractive to traders like me is the “risk” they offer.

Think high risk high reward.

CFDs provide leverage or gearing, depending on the investor’s risk tolerance and capital.

So what exactly is leverage?

“Gearing” or leverage is another way of saying “use the bank’s money to trade”.

It’s like buying a house.

When you apply for a bond, the bank usually requires a deposit.

CFDs work exactly the same way.

Let’s say the house you are buying costs R2-million and the bank requires a 10 per cent deposit.

What have you just achieved?

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Based on your ability to pay off the debt over time (with interest), you have literally just bought a R2-m asset for R200 000, a fraction of what it’s worth.

With CFDs the word “deposit” is replaced with the word “margin”. It’s the same thing.

Now let’s assume you sell that house next year for R2.5-million. What have you achieved? Well you just made R500 000, less the interest for one year.

CFDs work exactly the same way and your initial “margin” is returned to you.

This is what makes CFDs attractive to traders.

You put down a little to own a lot and you scoop the profits (or losses) in the short term. In this case “short term” could be minutes, days or weeks.

Trading forex, for example, many brokers offer massive gearing, up to 500 times your money.

So with $100 you could trade (risk) $50 000 from which to try to profit.

Different securities have different levels of gearing but I’m sure you get the picture.

CFD trading is exciting and can be very lucrative.

Understanding how they work and managing your risk is the difference between making money and wiping out your account.

Send your suggestions for Robby P’s next topic to benonicitytimes@caxton.co.za.