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CFDs - What are CFDs and what are the opportunities and risks?

Annette de los Santos, April 30th, 2021

CFDs ("C.ontracts for D.ifference ”) are on everyone's lips: touted by banks and other financial institutions as the ultimate, vilified by well-known business magazines.

Therefore, this post deals in depth with how CFDs work. The advantages and disadvantages of CFDs are shown in order to make it easier for potential investors to decide whether they should dare to use these instruments - or not, based on objective criteria.

What are CFDs?

Legally speaking, CFDs are Issuer's bearer bonds, i.e. a bank or a financial institution.

From an economic point of view, CFDs are derivatives, which means that their price depends on one Underlying from. Instead of investing directly in the underlying asset, e.g. buying a share, some players trade with CFDs. You can rely on rising prices of the underlying asset (so-called Long position) as well as falling prices (Short position) put.

What is a margin?

As with stock market futures, a security deposit must be deposited for each individual trading position, the so-called Margin (Deposit amount). It is intended to cover the closing-out costs until the next trading day, i.e. overnight. With CFDs, for example Commerzbank, the margin is between 2% and 5% - depending on the base value.

Each issuer sets its own margin for each underlying. Particular care should be taken if the margin is very low (for example with some UK banks). These CFDs are “unclean” because the banks often execute the orders with a delay in order to earn more through the price and the spread. This makes the CFDs much more risky for the investor.

Margins below 2% are dubious and such products not recommendable - The low margins serve the sole purpose of the issuing financial institution to attract as many customers as possible.

Before the order is placed, the respective margin of the relevant underlying is displayed to the investor. This security deposit is immediately debited to the account and is thus cash effective.

Example I: Margin

  • Gold price € 1,337
  • Margin is 5%

The ratio is always 1: 1, which means there is no subscription ratio as is the case with various other derivatives such as warrants, knockouts or mini futures. As a result, € 1,337.00 would normally be debited from the account, i.e. it would be cash effective immediately. In fact, the investor is only charged 5%, i.e. € 66.85. In this example, the issuer pre-finances the investor 95% of the investment.

The margin is even lower on the DAX. At Commerzbank, for example, it is 2%. The investor's CFD account is initially only charged with the margin of x% of the invested money. The issuer “lends” him the remaining investment amount.

In the example above, the investor has used 5% equity for his investment, 95% is borrowed capital (of the issuer). This "leverage effect" can tempt you to buy more CFDs than the investor can actually "afford".

But Attention: If the position is closed, the entire investment amount of 100% becomes cash and therefore due. In the example above, the remaining 95% is debited from the investor's CFD account.

With a positive development of the CFD with corresponding profits, this is not a problem. However, if a loss is incurred, the investor will have to spend a large amount (in the above example 95%) to cover this loss to close out.

What is an obligation to make additional payments?

If the issuer provides for this, a Obligation to make additional payments enter. Obligation to make additional payments means that the investor must inject more money over and above the margin in order to compensate for any price losses that may have occurred.

This case occurs when the Maintenance margin of the issuer has been reached or fallen below. The maintenance margin denotes the minimum amount of security that must be kept in order to maintain the position on the CFD account.

It then finds a so-called Margin call instead, that is, the investor is asked to deposit further funds. If the investor does not follow this request, the position is automatically closed.

In the event of strongly negative price developments and high investment volumes, investors may be obliged to make additional contributions to Total loss of the capital employed and beyond. It has already happened that investors had to file for personal bankruptcy because they could no longer meet their obligations to make additional contributions.

Example II: Obligation to make additional payments

  • A buys a CFD on 100 shares in XY AG on Friday at a price of € 100
  • The investment volume is therefore € 10,000
  • The investor must deposit a margin of 10%, i.e. € 1,000
  • On the following Monday, the share price fell by 20% (so-called Opening gap)

In order to maintain the maintenance margin, A is asked to add 10% of the price loss of a total of € 2,000, i.e. € 200. If A does not do this, the position is closed and A realizes a loss of € 2,000 on this trade.

Tip: There are issuers who exclude this obligation to make additional contributions. If you are considering trading CFDs, make absolutely sure that there is no obligation to make additional payments. In this way you have already ruled out a significant risk.

CFDs as an instrument for day trading

CFDs are primarily for the so-called Day trading thought, that means they should not be kept overnight without good reason, because:

  1. It case interest on, usually 3.5% to 4% p.a.
  2. The risk of larger ones Course changes after 10:00 p.m. is high and investors can no longer take countermeasures. He has to wait until 8:00 a.m. the next morning. But by then it can be too late to avoid serious losses.

But also with Day trading the investor is not immune from the risk of total loss if the stock exchange prices suddenly plummet during important events. This was the case, for example, on the day after the referendum for Brexit, as well as in March 2011 when a nuclear disaster struck in Fukushima, Japan.

The risk of larger price fluctuations also exists with leverage products such as warrants, knockouts and mini futures and these also pay interest overnight, which is reflected daily in a slight change in the price of the leverage product to the detriment of the investor.

Why are CFDs traded?

CFDs are traded to increase money even with relatively small amounts. In day trading, the trader usually sits in front of the trading program all day and naturally wants to earn as much money as possible.

If he were to invest € 1,000 in a "normal" single share, for example, and this would increase by 1% on that day, the trader would have earned just € 10 at the end of the day. It goes without saying that this result is neither sufficient nor satisfactory.

CFDs offer the possibility of making considerable profits even with smaller amounts, as leverage is used here. Assuming the leverage has a factor of 10, the price increase increases tenfold.

In example II, the trader would then achieve a profit of € 100 from the aforementioned € 1,000 and the price increase of 1%.

Attention: Of course, the leverage also applies to price losses! You should therefore make sure that there is no obligation to make additional contributions to the CFD.

What are CFDs traded on?

Like other certificates, CFDs can be traded on commodities such as gold, stocks, indices and currencies.

For the raw material oil, CFDs are traded on a future and not on the so-called Spot, that is, the current daily rate. The CFD is not limited according to the term of the future, but expires six to eight weeks in advance.

At the DAX is both possible, Spot other Future. It is very important to differentiate between these two factors in order to decide which prices you should pay attention to as an investor and, if necessary, set them as buy, sell, limit or stop loss.

How does order placement work with CFDs?

In CFD trading, you always go either long or short based on a certain underlying asset. This means that it is not possible to bet on red or black at the same time - as in roulette.

With other certificates, both a put and a call product could be acquired on the same underlying asset. Whether this would make economic sense is another question. If you go long and short in CFD at the same time, the position is immediately closed by the system and settled at the currently relevant price. This can result in losses for the investor.

Components of a CFD

  • Underlying: Product on which the CFD is traded (commodities, stocks, indices, currencies).
  • Spread: It describes the difference between the buying and selling price, i.e. the ask and bid price. The spread is higher than, for example, with knockouts or mini futures. The spread also differs depending on the underlying. It is around € 0.40 per CFD.
  • Margin: Security deposit that must be deposited in% of the price of the underlying asset × number of CFDs traded by the investor. In other words, it is the investor's equity share when buying a CFD.
  • Interest rate: The interest is only calculated for open overnight positions; there is no interest charge during the day.

What you should definitely consider before investing in CFDs

If you have become curious and want to dare to try CFDs, there are three things you should definitely take to heart.

  1. Be sure to work with one for a long time Demo version or a model portfolio until you feel confident enough to trade CFDs for real.
  2. Choose an issuer with whom no obligation to make additional payments consists.
  3. Invest only so-called "play money" in CFDs, that is financial resources, the loss of which is economically manageable for you.

Image Copyright: Alexander Ishchenko / Shutterstock.com

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