Flexibility and ease of use make CFDs a natural choice for those looking to profit from rises or falls in the value of a given asset. At the same time, CFDs can also be used to hedge risk from other investment positions.
The rise of instruments such as CFDs means that derivatives trading is no longer just for institutional investors or the elite.
CFDs as derivatives
CFDs are a type of derivative. But what are derivatives anyway?
Think of derivatives as a way of gaining exposure to a particular asset but without having to actually buy or sell that asset.
Derivatives are essentially contracts on a given financial asset. For instance, this could be a company’s shares, a stock market as a whole or a commodity such as oil.
These days, derivatives such as CFDs allow investors to open and close positions on such underlying assets at the touch of a button.
CFD stands for Contract For Difference. While CFDs readily provide investors of all types with a straightforward way to profit from upward or downward movements in a given financial asset, they were originally used by institutional investors as a means of controlling risk.
Hedge funds and certain other institutions first began using CFDs in the 1990s as a means of hedging the risk of their long equities positions. By entering into CFD positions that profit from falls in companies shares, they could mitigate the impact from any share price declines.
It wasn’t long though before CFDs began to be developed for a wider group of investors, who quickly appreciated the opportunity presented by CFD trading to maximise profit potential from gains or falls in asset prices.
Perhaps the biggest reason for the rise in popularity of CFDs among investors in general is that it is only necessary to put down a small percentage of the actual trade size.
For instance, using what’s known as margin you could only have to pay as little as 5% of the transaction value to open a position in the CFDs of a company’s shares.
Margin tends to be critical in understanding the profits or losses associated with CFD positions. It has the potential to greatly amplify both.
CFD trading example
Suppose we enter into a long CFD position in ABC shares as we expect the shares to rise. ABC is trading at 980/1000p. This denotes the bid/ask spread, where 980 pence is the sell price and 1000 pence is the buy price. We decide to buy 1000 CFDs.
In this example, the margin will be £500 (5% x (1000 units x 1000p buy price)).
Your expectation was right and the ABC share price moves up over the next hour and you decide to sell your shares for 1030. This means the bid price has increased by 50 pence.
1000p buy price minus the 1030p sell price = 30 pence
Your profit is 1000 units x 30 pence = £300.
You have made a 60% profit on the funds you invested in the space of just one hour.
Suppose, however, that you had been wrong. ABC shares begin to fall over the next hour and you decide to cut your losses when the bid price has reached 970p.
1000p buy price minus the 970p sell price = 30p
Your loss is 1000 units x 30 pence = £300.
The above was a simple example to demonstrate how CFD trading can result in both profits and losses.
However, a straightforward way of keeping losses to a minimum on each trade is by implementing a simple stop loss. In the example above, the position would be automatically closed as soon as the ABC share price fell to a certain level.
For instance, you could elect to close the trade if the bid price falls by only 5 pence. The good news is that you still retain the same upside potential as before.
Gains in all weathers
One of the great things about CFDs is that they can be used to profit from falls as well as rises in stocks or other assets.
The current bull market in global equities is now rather long in the tooth. This flexibility could be increasingly useful for when we eventually see a bear market again and we get more down days than up days across global stock markets.
The recent increase in tensions between the US and North Korea has provided another reminder of how global geopolitical events can put pressure on risk markets such as equities.
We can use CFDs on stock markets, such as the UK’s FTSE 100 or the US large cap S&P 500, to potentially profit from both the up days and down days across global equity markets.
Then there’s also the big moves in key commodities, such as oil, that investors can look to take advantage of through CFDs.
Over the space of around three years we’ve seen oil plunge from $100 to $30 per barrel, and then rise to the $50 per barrel mark.
CFDs on individual shares
CFDs offer a convenient, cost-effective way of trading on individual company shares. Shares in some of even the biggest names in the world can be sensitive to financial results announcements and other news flow.
Investors may also be able to exploit technical trading patterns by taking CFD positions on a company’s shares when stock prices move in and out of certain ranges.
Some investors may use CFDs to take advantage of both fundamental signals, such as results or news flow, as well as the technical indicators.
Hedging is not just for institutions. It can also be used in a straightforward way by individuals as well.
As an example, suppose you hold £10,000 worth of conventional ordinary shares in ABC company. ABC is due to report its financial results but you’re worried there could be an adverse reaction in the market. However, you don’t want to sell the shares as you are holding them for the long term.
Through CFDs you could short sell the equivalent amount of ABC shares on the day the company reports its financial results. If the shares do fall, you could potentially offset the negative share price movement from your conventional shareholding with the gain from your CFD position.
Assuming you have long-term conviction in the ABC shares, you could even decide to reinvest the proceeds of your CFD trade by buying the ABC shares at the lower share price, thereby increasing your conventional shareholding further.
With some research and risk control to mitigate the downside from positions, CFDs can be an extremely useful tool for any investor. Whether you seek to benefit from rises or falls in asset prices, or if you just want to hedge existing investments, CFDs can be a highly effective and efficient tool.
These days you can open and close positions at the touch of a button on your laptop. By using trading apps such as the one offered by Capital.com, you can even transact CFD trading through your smartphone.
Trade smart. Recognise the risks.