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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

What are CFD's and how do they work?

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. With CFDs you can 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).

It is a contract between you and your broker since you will never physically own the product you bought or sold.

Cfd trading example

Consider the following trade on the stock Tesla:

Tesla

You want to buy 10 shares of Tesla Motors, which is trading at $220.49. This would normally be a $2,204.90 investment (including bid/ask spread), but the margin for these shares is only 20%, so you only have to pay $440.98.

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.

A CFD is a "contract for difference". This means that if Tesla increases to 250.49 dollars and your take profit is hit, you make a 30 dollars x 10 shares = 300 dollar profit. So the Tesla stock saw a price rise of about 14%, but compared to your margin, you make a profit of about 300 dollars or almost 70%. In this case the leverage is 5 and this is what magnifies your profit.

On the contrary, if the price falls and your stop loss is hit, you lose 10 x 10 = 100 dollars. The Tesla stock lost about 4.5%, but compared to your margin you lost about 22.5%. Again, the leverage in this example is 5 and magnifies your loss.

Long and short

With CFDs, you can go long and speculate on rising prices, but it's also possible to open short positions, so you'll win money when prices are falling.

With CFDs it really doesn't matter if the market is rising or falling, you can profit from both these moves, up or down. You only need to make sure that you're betting in the right direction. If your trade goes in the other direction, you will end up losing money.

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). It's also possible that the broker is opening this trade virtually, so it doesn't end up on the real market. In this case the broker is betting against you. If you win, the broker pays you the difference, if your trade loses then your loss becomes profit for the broker.

If the central banks are keeping the interest rates very low, the premium will also be very low. When rates are low, CFDs are interesting for short term speculation due to the low financing costs.

If the margin is 20%, you will have a gearing or leverage of 5. Movements in the shares will be 5 times greater for your position. In the example above you would be able to lock in a profit of $300 with an investment of only $440.98, a return of 68%.

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. European regulated brokers now have to guarantee that your account cannot go below zero, they all offer negative balance protection since 2018. Other regions have followed these regulations and most brokers now offer negative balance protection for retail clients.

In the example above: say you have put $500 on an account and that you have opened the long trade on Tesla. If Tesla opens 25% lower because of bad news, the new value of your position would be $1,653.67, a loss of $551,22. Your initial deposit would be totally gone and you would suddenly have a debt of $51,22 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 for stocks is 5, you could create an exposure of $15,000 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 $210.49. 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.

Trade commodities

Commodities are all around us, they are the raw materials we need and use in our daily lives. Oil, gold, gas, sugar, coffee, soy, beans, corn, wheat etc.

Commodities markets matter, not only because they trade essential components of our society. They have an important impact on the economies of the world and present attractive investment opportunities.

There are different types of commodities.

  • Metals or "hard" commodities (lead, copper, nickel, alluminium, gold, silver, platinum, palladium, etc.).
  • Agricultural commodities or "soft" commodities (cocoa, sugar, coffee, soy, etc.).
  • Energies (crude oil and natural gas).

Trading commodities is a little bit different than trading stocks.

The price of a stock depends on the supply or demand and the current performance of the company it represents.

Although commodities markets are moved by the forces of supply and demand as well, some of them are perishable and current weather conditions influence on draughts or floods.

Storage plays a fundamental role on hard commodities, soft commodities and energies, which require a specialized type of storage conditions.

CFDs (Contracts for Difference) allow you to trade raw materials with a limited investment. The leverage effect will magnify your profit or loss.

For example: you want to buy 10 ounces of gold at 1,239.60 dollars per ounce.

When trading with CFDs the initial margin is very low, only 10% or $1,239.60. With an investment of only $1,239.60 dollars you take a position of 12,396 dollars. But you still take advantage of the full increase of your investment, should the market rise. If the price falls, the loss is also magnified.

gold

A CFD is a "contract for difference". If gold rises to 1,339.60 dollars and you sell this CFD, you collect the profit of $1,000. This means that you can get a large exposure with a very limited investment on any raw material. In the case the market falls, your loss would be $300 with the selected stop loss. Without a stop loss, you can lose all the margin you invested when the market moves against you.

Open an account

Compare the CFD platforms and try the free demos or open an account right away.

With an account, you can trade CFDs on shares, indices, commodities (oil, gold, silver, platinum, etc.) and on the Forex market (currencies).

With the free demo, you can practice with a fictitious capital so that you learn how to trade with CFDs and familiarize yourself with the platform from the brokers we selected.

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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