Contracts for Differences, commonly known as CFDs, are a financial instrument that has caught the attention of many traders around the world. They’re known for being speculative, and come with a set of risks we'll dive into in this article.

At Pearler, we believe in the power of a diversified investment strategy . Though CFDs might not align with the long-term approach we usually talk about, they're a reminder of the market's diversity and complexity. By exploring them, we’re not suggesting you include them in your portfolio, but simply giving you information to understand the options out there.

So, let's approach CFDs with curiosity and a bit of caution. In this article, we'll explore what they are, how they work, the risks involved, and why they might not fit into a long-term investing strategy.

A breakdown of Contracts for Differences

Firstly, what exactly are CFDs, and how do they work? Let’s break it down in simple terms.

Definition: what are CFDs?

At its core, a CFD trade is an agreement between an investor and a CFD broker. They agree to exchange the difference in the price of an asset from when the contract is opened to when it’s closed. This means you're trading on the price movement of financial assets like stocks or commodities without owning the underlying asset. The concept might seem a bit complex at first. However, it boils down to betting on whether you think the price of an asset will go up or down.

How do CFDs compare to traditional investing?

The main difference between CFD trading and traditional investing is ownership. When you buy shares in a company , you own a part of that company. If the company does well (or suffers), your shares increase (or decrease) in value. With CFD trading, you don’t own the stock or commodity. You're only speculating on its price change, which means you can potentially profit whether the market is going up or down.

Another key difference is the use of leverage . CFD trading allows you to borrow money to increase the size of your trade, which can amplify both gains and losses. This makes CFDs much riskier than traditional investments, where the most you can lose is what you've invested.

While CFD trading can offer quick returns, it comes with high risk and isn't suited for everyone. This is especially true for people with a long-term investing horizon. Traditional investing in assets like ETFs and shares generally focuses on building wealth over time, an approach which focuses less on short-term market fluctuations.

In the investing space, CFD trading stands out as a distinctly different option compared to traditional methods. They offer an alternative for those interested in market dynamics and short-term price movements. However, it’s crucial to understand these differences to make informed decisions that align with your investment goals and risk tolerance .

How does CFD trading work?

To build on our basic understanding of CFDs, let’s walk through the mechanics of trading using a fictional case study.

Alex is an experienced investor who already holds traditional investments like bonds, shares, and ETFs in their portfolio. Alex is curious about diversifying their portfolio with CFDs. They decide to trade CFDs on a popular tech stock, believing its price will rise in the coming weeks. Here’s how Alex goes about it:

Opening a position

Alex opens a buy position on the tech stock CFD through their broker on the CFD market, with the stock currently priced at $100. Alex then decides to buy 10 CFDs. Since CFDs allow for leverage, Alex only needs to put down a fraction of the total value of the trade. Assuming a leverage of 10:1, Alex’s initial investment is $1,000 for a position worth $10,000.

Margin and leverage

The $1,000 is the margin, or the initial amount needed to open the position. Leverage amplifies the potential returns, but also increases the risk. This is because the full value of the position is much larger than the margin.

Fees and costs

Alex’s broker charges a small spread (the difference between the buy and sell price). The broker may also charge overnight holding costs if the position is kept open for more than a day. These costs are part of what Alex needs to consider in their potential profit calculations.

Closing the position

Two weeks later, the tech stock’s price has risen to $120. Alex decides it’s the right time to close the position and take profits. The value of the position is now $12,000. After closing the position, Alex’s profit is the difference between the opening and closing value of the trade, minus any fees.

Profit calculation

• Opening value: $10,000 (10 CFDs at $100 each)
• Closing value: $12,000 (10 CFDs at $120 each)
• Profit: $2,000 (before fees and costs)

Outcome

Alex’s decision to trade on margin amplified their profit. However, if the stock had moved in the opposite direction, it could have similarly amplified a loss. This example illustrates the high-risk, high-reward nature of CFD trading. While Alex made a profit, remember that prices can move quickly and in both directions, posing significant risks to the trader.

More on the risks of CFD trading

As mentioned above, CFD trading offers an alternative way to engage with the financial markets. It allows investors to speculate on price movements without owning the underlying asset. However, it carries significant risks that are important to be aware of and understand.

Market risk

Market risk – the risk of losing money due to unfavourable price movements – is a common factor in all forms of trading and investing. However, the impact can be more noticeable with CFD trading because of the speculative nature and the potential use of leverage. Price movements in the underlying asset can significantly affect your position. That sometimes results in losses that are greater than your initial investment.

Leverage risk

One of the key aspects of CFD trading is the ability to use leverage. This means you can open a large position with a relatively small amount of capital, like a deposit. While this can augment profits, it also increases the risk of substantial losses. Leverage magnifies the effects of market movements on your position. As such, a small decline in the market can lead to a rapid drop in the value of your investment.

Counterparty risk

When you trade CFDs, you're entering into an agreement with a broker rather than buying or selling the underlying asset on an exchange. This introduces counterparty risk – that’s the risk the broker may fail to meet the terms of the contract. If the broker encounters financial difficulties or fails, you might not receive the profits you're entitled to. Or, you could even lose your initial investment.

Liquidity risk

Liquidity risk arises when there isn’t enough trading activity in the market. Lack of trading makes it difficult to open or close positions at the desired price. While this can affect all types of investing, the risk can be higher with CFD trading. This is especially the case when trading less common assets or during periods of high market volatility. In such instances, you may face a lot of “slippage”, where the execution price of your trade is different from what you expected. Slippage can potentially lead to larger losses.

While CFD trading can seem like an attractive option due to the potential for high returns, it's important to be fully aware of the risks involved. Consider these risks and whether CFD trading aligns with your investment goals and risk tolerance. For most long-term investors, focusing on strategies that aim to build wealth steadily over time may be more appropriate.

Why CFD trading isn't aligned to long-term investing

In short, the speculative of CFDs nature and associated risks often place them at odds with long-term investing strategies.

Below is a table that compares the characteristics of CFD trading to those of a long-term investing approach, highlighting key differences in strategy, risk, and regulatory considerations in Australia.

Feature	CFD trading	Long-term investing
Nature of investment	Speculative, focusing on short-term price movements.	Focused on building up assets that grow over time, offering potential dividends (for shares and ETFs) or interest (for bonds) in addition to capital gains .
Risk profile	High risk due to leverage, which can amplify both profits and losses. High market risk and greater potential for losses that exceed the initial investment. Losses tend to be more common than gains.	Generally lower risk, with an emphasis on steady growth, capital preservation, and compounding returns over years or decades.
Investment strategy	Uses short-term market volatility to speculate on price movements without owning the underlying assets.	Involves incremental investing approaches such as Dollar-Cost Averaging (DCA) .
Due diligence	Often focused on short-term trends and market sentiment, with less emphasis on the analysis of underlying assets.	Based on comprehensive analysis of the investment's long-term potential, including financial performance, competitive advantage, and market conditions.
Suitability	Suitable for experienced traders who understand the risks and can manage potential rapid losses.	Suitable for investors seeking to build wealth over the long term.
Regulatory considerations in Australia	The CFD market is regulated by the Australian Securities Investment Commission (ASIC) . ASIC’s measures include leverage restrictions, margin close-out protections, and negative balance protection to manage risk. While these measures offer some level of protection, there are still inherent risks in trading CFDs.	Subject to standard investment regulations, with protections focused on transparency, fairness, and the integrity of financial markets.

Now that we know the speculative nature of CFD trading and the high risk for losses, it’s evident it generally doesn't align with the principles of long-term investing. Within the Pearler community, long-term investing is a popular and often preferred approach. While understanding different financial instruments, including CFDs, is valuable for well-rounded investment knowledge, it's important to stick to strategies that match your risk tolerance, investment goals, and time horizon.

Final words on CFD trading

In wrapping up our exploration of CFD trading, though an interesting option, they considerably depart from the principles of long-term investing that many of us follow. The high-risk nature of CFDs makes them a speculative venture that's not suited to investors looking to build wealth over the long term. However, every investment type, including CFDs, has its place in the financial world.

If you’re focused on long-term growth, the allure of quick profits is unlikely to distract from the fundamentals of investing. That is, thorough research, a deep understanding of investments, and a strategy aligned with your financial goals and risk appetite. Remember, investing is a marathon, not a sprint. The key to success lies in a well-considered, diversified strategy that stands the test of time.

Happy investing!