A contract for difference (CFD) is a popular form of derivative trading. A CFD involves two parties agreeing to exchange the difference in the value of a financial product between when the contract is opened and when it is closed.
During the CFD’s life, gains and losses are realised as cash flows between the trader and broker. Unlike other investments where you own an asset outright, with a CFD, you never actually own the underlying security – you are simply speculating on the price movement.
CFDs were introduced in the early 1990s in London as a way for professional investors to trade bonds without having to go through the hassle of opening a new broker account. The CFD market has since grown exponentially, with traders now able to speculate on a vast range of underlying markets, including indices, shares, FX, commodities and even cryptocurrencies.
The popularity of CFD trading in Singapore has been on the rise in recent years. According to data from the MAS, the value of contracts traded on Singapore’s three leading exchanges – SGX, CME and ICE – increased from SGD1.4 trillion in 2016 to SGD2.8 trillion in 2018.
The high degree of leverage
A primary attraction of CFD trading is the high degree of leverage on offer. It would be best to remember that it can magnify your profits and losses.
For example, if you buy 10,000 shares in Company A at SGD5 per share. The total value of your investment will be SGD50,000. If the share price rose to SGD6, you would make a profit of SGD10,000 (20% return on investment). However, if the share price fell to SGD4, you would lose SGD10,000 (20% loss on investment).
The costs of CFD trading
Another downside of CFD trading is the costs associated with it. Unlike other forms of trading, such as share dealing, the broker usually charges additional fees through spreads and commissions.
Spreads are the balance between the buy and sell prices of a market, and they can vary depending on the instrument you trade, the time of day and overall market conditions. For example, the spread on gold might be SGD10 per ounce, while the spread on EUR/USD might be just 0.5 pips (0.00005).
The commission is a fee that brokers charge for each trade that is placed. It is generally a minor percentage of the total value of the trade. For instance, if your trade is worth SGD10,000, the commission might be SGD25.
The risks of counterparty default
When you trade CFDs, you effectively enter into a broker’s contract. If the broker goes bust, you could lose all of your money. To protect yourself from this risk, it is important to only trade with a well-regulated broker.
The risks of volatile markets
CFDs are traded on margin, meaning you only need to put down a small deposit (usually 5-10%) of the total value of the trade. It can be advantageous in volatile markets as it allows you to take more prominent positions than if you were to trade with your capital.
However, it can also magnify your losses if the market moves against you. For example, let’s say you buy SGD10,000 worth of Company A shares on margin. If the share price then falls by 10%, your loss would be SGD1,000. However, if the share price fell by 20%, your loss would be SGD2,000.
The risks of stop-loss hunting
When trading CFDs, it is vital to use stop-loss orders to protect yourself from significant losses, an order you place with your broker to sell a security when it reaches a specific price.
For example, you buy 10,000 shares in Company A at SGD5 per share. You might place a stop-loss order at SGD4.50, which would automatically sell your shares if the price falls to that level.
One of the risks of using stop-loss orders is that some brokers may “hunt” for them, meaning they deliberately move the price of a security lower to trigger stop-loss orders so that they can repurchase the security at a lower price.
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