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What are CFD's?

CFDs are contracts for difference, which is a derivative product. Their value is derived from another asset such as a stock, an index, a commodity or a currency pair. CFDs make it easy for an investor to speculate on rising or falling prices of an underlying asset.

When you open a new CFD position, you are essentially buying a contract that permits you to have 100% exposure in an underlying asset while you only have to invest a small amount of cash (the so called margin).

Consider the following trade on the Plus500 platform:

Tesla Plus500

You want to buy 10 shares of Tesla Motors, which is trading at $220.49. This would normally be a $2,212.90 investment (including bid/ask spread), but the margin for these shares is only 10%, so you only have to pay $221.29.

You can immediately choose a profit target and a stop loss and you can see how much money you would make or lose on this particular trade.

What is margin?

The margin is a payment to your broker to guarantee that you can afford this position. The broker buys the shares for you and you essentially get a loan from your broker, so you also have to pay interest on a daily basis (the premium). If the central banks are keeping the interest rates very low, the premium will also be very low. When rates are low, CFDs are very interesting due to the low financing costs.

If the margin is 10%, you will have a gearing or leverage of 10. Movements in the shares will be 10 times greater for your position. In the example above you would be able to lock in a profit of $250 with an investment of only $221.29, a return of 113%.

CFDs are risky

Trading CFDs involves risk and you should always use a stop-loss order to limit the risk and the losses. Don't be tempted to open very large positions for your account. Don't forget that you can lose more than what you have invested or that you can even lose more money than what you have put in your account (only Plus500 guarantees that your account cannot go below zero).

In the example above: say you have put $300 on an account and that you have opened the long trade on Tesla. If Tesla opens 15% lower because of bad news, the new value of your position would be $1,880.96, a loss of $331,93. Your initial deposit would be totally gone and you would suddenly have a debt of $31,93 to your broker.

Markets can and do move very quickly from time to time, so you should always protect your position with a stop loss or even a guaranteed stop loss. Keep your positions small and don't be tempted to use the maximum amount of leverage that the broker offers. For example, if you have a $3,000 dollar account you could risk $100 on a new trade, like in the Tesla example above. And maybe you would only have a maximum of 4 open positions like this, risking $400 in total. The Tesla position would be an exposure of about $2,200 dollars, so 4 positions like that would be an exposure of $8,800. Remember: since the leverage is 10, you could create an exposure of $30,000 with a $3,000 account.

Position sizing

You can calculate the size of your position when you have chosen a place to put your stop. In the Tesla example above, the stop has been placed at $210. You can then choose the amount of shares to trade in order to keep the total risk on this trade around $100. You are willing to take a $100 risk, so in this case you would trade 10 shares. Should the stop be at $200, you would only trade 5 shares.

Counterparty risk

A CFD is an agreement where you can profit from the change of price from an underlying asset, without having to invest the full amount. You don't invest directly, but you give your money to your broker and they will open the position for you. When you want to close the position, you will get or lose the difference between the opening and closing price.

The broker is your counterparty, so the counterparty risk is that your broker can't live up to its obligations. A recent example will make this clear. In 2015 the Swiss National Bank surprisingly intervened on the currency markets, creating a surge in the Swiss franc. The giant move happened so fast that everyone who was short on the Swiss franc ended up with huge losses, even when they had put up a stop loss. A lot of Alpari clients lost a lot of money and saw their accounts go below zero. When clients could not cover up their losses, these losses were passed on to Alpari and the company went bankrupt. Other clients ended up with worthless CFD contracts and they had to wait for months before they could get their money back from their accounts.

See the 1 hour chart of the huge CHF move:

CHF

How can you reduce the counterparty risk? First and foremost, work with a reliable broker. Take a look at their balance sheet: what's the amount of capital they have, how much profit did they make the last few years, do they use segregate accounts for your funds and so on.

It's also not a bad idea to work with a few different CFD brokers in order to spread the risks.

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