Contract for differences are commonly called CFDs. In the financial world, CFDs are essentially contracts that promise that the buyer will pay the difference between an asset’s current assessed value and the asset’s contract value (the price of the asset at the time of the contract’s execution). If there is a positive difference, the buyer pays the difference and the seller makes a profit. However, if there is a negative difference between the contract price and the current market value price, then the seller pays the difference and a loss is assumed. One of the most alluring benefits to investing with CFDs is the ability to trade on margin. However, the generous margin terms also make contracts for difference quite risky. To better understand the concept of margin trading and CFDs as a whole, I will go into what exactly a margin is.
Margin is a common financial mechanism usually found in stock market transactions. You can think of a margin as a type of short-term loan. Let us say you want to buy five shares of stock valued at $100 per share. The only problem is that you only have a total of $250 to spend towards this purchase. What you can do is buy all five shares buying using your own money as well as money that you can borrow on margin. When trading equities (stocks), financial institutions will often “match” your contribution and allow a margin equal to your investment. However, in CFD trading, margin requirements are often much less. Sometimes as low as 5% for stocks and even lower when trading contracts on some commodities, indices or currencies. Of course, they will only grant you a certain amount depending on things like credit-worthiness, trading experience and even the type of stock you plan on purchasing. What it sounds like is that trading on margin is a great way to multiply your investment power using money that is not yours. While this claim is not necessarily false, it is also not necessarily true and many people have gotten into a lot of financial trouble because they chose to trade on margin.
In general, when you trade investments on margin, the lending institution charges you interest. This interest rate and the way interest accrues can vary from place to place. Usually when trading a CFD, the margin is applied each night, at which time a margin adjustment is made. This means you must settle up your account. For instance, if your original margin amount was 10%, but the investment has not gone your way and now you only have 5% in cash behind the investment, the CFD broker will inform you that you must fund your account so that it is once again at 10%. Failure to do so gives the broker the right to liquidate the investment without your permission.
One thing you must remember about trading on margin is that if you make a bad investment, you are still responsible for paying the loan back. As a basic example, say you put up $1000 to control a CFD worth $10,000. Right now you have only put up $1000, but if the value of the investment were to fall to $5000 and you decided to sell, you would then be out your $1000 plus you would owe the CFD broker $4000 to cover your loss. This is why investing on margin can be so risky. It is easy to lose more than your initial investment.
However, let’s say that on the other hand you invested $1000 to control a $10,000 CFD. Instead, your investment went up to $15,000 and you decide to sell. Now you have made $5000 – a 500% return on your investment. Had you invested the entire $10,000 yourself (instead of utilizing margin to leverage your investment) then you would have still made $5000, but it would only be a 50% return on your investment. Therein lies the power of trading on margin.
