The Understanding of CFDs as Complex Instruments

CFDs are complex instruments and you risk losing money quickly with leverage. About 74% to 89% of retail investors lose money by trading in CFDs. You must consider whether you yourself want to run this high risk of losing your capital.

A CFD is an instrument with which you can speculate with the lever on the movements of a stock, index, commodity or coin pair. In the example below, we assume that you want to speculate on Twitter shares.

A CFD is a 'contract for difference' and gives the investor the opportunity to take advantage of a rise or fall in shares, currencies or indexes without actually becoming the owner of it. With this instrument you earn money through the difference in underlying value between the opening (buying) of the CFD and the closing (selling) of the CFD. A CFD is a contract between the broker and the investor and is not traded on the stock exchange, but only on the own broker's platform. CFDs provide the opportunity to earn money from increases (going long) and decreases (going short).

There are many CFD brokers. You can compare CFD brokers to find the best one. If you live in South Africa, you should choose among CFD trading brokers in South Africa.

Why trade in CFDs?

CFDs trading is a form of active trading with which you can quickly respond to important events. This makes it a much more active form of investing than simply buying shares, bonds or investing in investment funds. This is really something for the active investor or trader.

Thanks to the leverage effect, you can achieve very high returns with a small investment. Note: if you make a mistake, you can also make big losses.

Trading CFDs is not dependent on trading times. The trade can go through day and night for many instruments. This is certainly the case for the indices. You can therefore trade CFDs on the AEX at 8 pm in the evening.

Via CFDs Trading you can speculate on the markets in two ways: on price rises, but also on price falls. If you go 'long';, you will earn money if the price of the share or the underlying asset rises. If you go short, you speculate on a fall in prices and you will earn money if the underlying asset falls. With CFDs you can therefore also earn money if the stock markets are in a bear market (sharply falling trend).

Margin & Lever Effect

When trading CFDs, you do not have to pay the entire underlying value of the financial instrument. Depending on your broker and the traded product, this is 2% to 20% of this underlying value. Despite this margin, you have the same profit or loss as if you actually owned the financial product.

The lower the margin, the higher the leverage effect. This leverage effect allows you to increase the potential profit. But it is important to remember that the loss due to this leverage effect is also reinforced. In 2018, ESMA limited the margin for leveraged products in Europe.

Practical example: speculating on shares with CFDs

In this example we will show how you can trade in shares via CFDs. We show a general image because the way to open CFDs on almost all platforms is very similar. Via the fxtrading demo you can also practice for free and unlimited. It is an accessible CFD platform that is also very user-friendly for newcomers. Not as many bells and whistles as many other brokers, but the simplicity of this platform makes it very interesting for people who want to start trading CFDs.

First you have to look for the share in which you wish to trade. On the platform you can choose from various underlying values ​​such as coin pairs (forex), commodities, indexes and shares.

You will see that the leverage for equities for European traders has been limited to 5. If you are willing to use $ 1,000 of your assets, the leverage ensures that you are actually trading with $ 5,000.

A premium is also specified: this is the interest that you will receive or have to pay if you leave the position open for more than 1 day. The leverage is made because you are speculating with borrowed money and you have to pay a very small interest on this. An investor who focuses on the longer term and, for example, wants to hold shares or currencies for a few months, will see financing costs rise over time. With a long-term vision, it is therefore not wise to opt for CFDs.

You can click on buy / long (speculate on a price rise) or sell / short (speculate on a price fall and still make money with it).

If you want to buy shares from XYZ for 5,000 euros, then you should keep € 1,000 euros as a margin.

If you want to buy the share and go long, you pay € 10.00 per share. However, if you want to sell or go short, you will receive € 9.95 per share. The difference between the posted bid and ask prices is called the spread. In this case the spread is € 0.05. This spread is of course preferably as low as possible.

Immediately upon opening the order you also enter a stop loss rate and possibly a target for profit. In this case, a stop is chosen that is 1 euro away from the entry price: € 9.00 for a long position and € 10.95 for a short trade.

A profit target of € 2 is also set. In the case of the long position, the CFD would close at a rate of € 12.00. In the case of a short position, the trade is closed at a rate of € 7.95.

You also immediately see how leverage works: although you only put in € 1,000, a 20% increase would mean a 100% profit for you. The share then rises from € 10 to € 12, but you have earned € 1,000.

Conversely, the leverage also works: a 10% loss results in a 50% loss on your stake. The shares rise or fall in value: the entire difference of this position is entirely for your account (hence the name CFD: Contract For Difference).

We hope this information can help you.