Do you own the underlying asset of a CFD?
Newcomers to the financial markets need to decide not only what assets to focus on, but whether to be longer-term investors or shorter-term traders – or a mix of both. Understanding the difference between CFDs and investing will assist undecided market participants in making the right choice. Both asset types cater to different objectives and personalities in financial markets.
What is a CFD?
In finance, a contract for difference is a contract between two parties, typically described as "buyer" and "seller", stipulating that the buyer will pay to the seller the difference between the current value of an asset and its value at contract time. When you trade a CFD, you enter into a financial contract with a broker to exchange the difference in price of an underlying security (such as a stock) from the moment you enter the trade to the moment you exit it. Investing through CFDs offers many advantages, mainly access to foreign markets, investing with leverage, and selling in (short position) for assets that traditionally do not offer that option.
What happens when you buy CFDs?
The market exposure that CFD contracts provide with leverage is one of the major aspects that makes CFD trading so appealing to investors. With an investment of $1,000 and leverage 1:30, you can buy or sell an asset that is worth $1,000 x 30 = $30,000. But on the other hand it’s also important to understand the risk a CFD trading account has associated with it.
If you’re looking to invest into CFDs, you would ideally already have shares as a financial foundation. A long term trading strategy is where you hold onto the stock through the bad times of the company and keep it long enough to see the good times. This means even in the bad times, when the market is falling, your shares are still worth something. However, with CFD, you may be forced to sell before you see the good times. This is because, with CFDs, your profits and losses can far outweigh your initial outlay. In addition, you incur additional lending charges (e.g. 4%-6%) for the ability to leverage.
Do you own shares with CFD?
CFD trading is very similar to shares trading except that when you trade a contract for difference you don't own the underlying share. Unlike investing in stocks, when you trade CFDs, you are not buying or trading the underlying asset.
This could be likened to a race horse – if you win, or if you don’t win, you still own the horse. But if you’re at the track betting on the horse winning, you only get your money back if what you’re betting on comes to fruition. If the horse loses, you lose your bet.
So, why would you want to take such big risks betting on one particular outcome, when you could possibly own the horse and keep it for another day, maybe another win? The answer is leverage.
How long can you hold a CFD position?
The key difference between trading a CFD long and buying a security is due to the leverage that is employed. This means that you contribute a portion of the funds required, and the broker will lend you the remaining funds with which you will pay interest for each day. Therefore, you need to consider this before holding a long market position carefully.
CFDs do not expire so a trader can hold both short and long position, so long as you have funds for your position. If you're intending to go long, the stop-loss should be placed below the market price, or it should be placed above the market price if going short.
It is true that the cost of financing to hold positions long term cuts into profits but so do the spreads and commissions when you trade frequently. Provided you can generate a return on your investment that exceeds the financing cost and can manage drawdowns without a margin call, there's no reason this can't work for you.
The average yearly return for the Nasdaq-100 for the last 20 years is 15%!! If you subtract the financing cost for the CFD (my broker is 4%) it gives you about 11%.
Final say
In a summative tone, it is advisable that one holds a CFD position to speculate and foretell what will happen before buying the actual share. CFD trading can also work as a way to prevent potential losses when owning the real assets. As an example, if you own shares in a company that you bought a long time ago and you’re worried that the shares might drop but don’t want to sell for tax reasons (since you think they are still a good long-term investment), you could enter into a CFD contract where you’ll benefit from a fall in the share price. Should your hypothesis come true, you’ll profit from the CFD when the share price falls, which covers your losses on the actual shares.
