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The recent spotlight on growing your money and trying to beat the ever-increasing cost of living in Singapore has brought about several notable changes in the investing landscape. The Singapore Exchange (SGX) moved last year to reduce the size of lots for trading of stocks and bonds, and there has been a lot more exposure of different trading instruments with the increased interest from the general public.
However, when it comes to the area of trading Forex and Contract for Difference (CFD) products, the sentiment tends to be polarized. While there is a significant community of people who trade these products, there is also a strong sentiment against trading these products, largely founded on certain stigmas as well as a lack of knowledge about the products and how to trade them.
We take a look here at some misconceptions about CFDs and how you can actually use them in your favour. But first, here’s a look at how CFDs work:
What is a CFD and How is it Traded?
Essentially, a CFD is basically the difference in price between when a trade was entered and when it was exited. The CFD follows the movement of the asset underlying it, e.g. a stock so you don’t actually own the asset, but you realise either or a profit or a loss when the underlying asset moves either upwards or downwards in relation to the initial purchase price. It is called a contract because this is essentially a contract between yourself and the broker to trade the stock without actually owning it.
One of the key differences between trading CFDs and normal stocks is that CFDs allow you to trade on margin, which means that your initial capital required to make the trade is a lot less than the same purchase of the actual stock itself. This allows people access to leverage where they are able to buy a much higher position for much less. Let’s say a CFD broker provides you with a leverage of 50:1, you could essentially trade a CFD by starting a position of $50,000 with only an initial investment of $1,000.
We’ll go a bit further into the actual trading of CFDs later on in this content series, but for now, let’s address some key misconceptions that stop people from actually starting their investment journey:
1. Trading CFDs is Dangerous and Can Lose You a Lot of Money
This is a rhetoric that you will hear very often when it comes to products like Forex and CFDs. The reason for this, when it comes to CFDs, is that with the ability to have a higher leverage and take a higher position than your initial investment (as illustrated above) also comes the risk that you lose more than the amount you invested. It is important to note that this shouldn’t so much be an indictment on the product itself, but rather a cautionary tale in human behaviour and greed. And this certainly doesn’t just apply to CFDs alone, with many other investment products having the ability to either make or lose you money.
The point here is that the product can be used to make some wise and timely investments without having to actually put in too much money, but as a wise man once said, “With great power comes great responsibility”. Ok fine, you might not exactly be Spiderman, but the truth still remains that this product does give you the ability to make some big moves. Understanding the downsides of being overleveraged or overtrading is key to not contributing to the misconception that CFDs are just giant black holes that suck your money in.
We will explore the matter further in a later article, but one point to note is that it’s also important to choose a trading platform that gives you the ability to mitigate this risk with processes and tools in place to help you manage your investments, especially for people like me who don’t have the time to be staring at a screen to track movements every minute of the day.
2. CFDs are Complicated
Ok I’ll have to admit, the first time I heard the name “CFD” I immediately assumed it was some complex product that required hours of study and understanding. You know, the kind of product that if you actually bothered reading up on, you might as well trade it as a full time job. Well thankfully, CFDs aren’t like that.
With CFDs, you are well within your ability to construct a contract with assets you are familiar with. That being said, as we always nag preach, it’s important to make sure you’re well educated with the workings of any investment product with jumping right in. There is a plethora of training resources that you can get access to that will give you a bit more confidence to trade CFDs whilst understanding the underlying risks so that you are more aware of what you are doing. As always, knowledge is power.
3. I Need a lot of Money to Start Trading CFDs
This is another misconception that is lumped together with Forex trading, but for slightly different reasons. As we mentioned earlier, the ability to leverage your position means that you can enter a position with a much lower cash outlay than you normally would if you were to buy the asset directly.
What is key to understand here is the margin rate, which, simply put, is the percentage of the total price that you have to pay initially. CFDs tend to involve much lower margins than dealing with a normal stock broker. So let’s say, for example, that you wanted to buy 1,000 DBS shares at $15 per share. Normally, you would have to pay $15,000 (excluding other fees), but with a CFD, at a 10% margin rate, you would only have had to set aside 1,000 x $15 x 10% = $1500 as margin.
The situation where you would need more money is if the total loss is greater than your initial paid up margin, and this is where people can often lose a lot more than they initially invested when they either make decisions emotionally or get too greedy.
It’s important to realise that we tend to hear and remember the “horror stories” of trading more than we do the small wins and successes that many people have enjoyed when it comes to investing. There are 3 critical things to take note of here:
- Understanding your risk appetite and investment goals
- Understanding how the product works and the inherent risks involved
- Understanding how the platform tools can enable you to make better decisions
We will go into the last point in further detail in subsequent articles, so stay tuned and follow us on Facebook as we explore how you can utilise these tools to grow your money.
What are your thoughts on trading CFDs? Share your thoughts with us here.
This is the first article in an investment series sponsored by IG. For access to more of their educational resources, you can check out their education track here.
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