Contract for Differences (CFDs) are a hot topic in the marketplace, but they are often misunderstood.
A quick search of the net will dig up plenty of horror stories concerning CFDs and how they've cost investors hundreds of thousands of dollars.
This is why ASIC has issued many warnings over investors thinking of getting into CFDs and why they've published an in depth guide which looks at possible risks you face.
So what is a CFD?
A contract for difference is an agreement based on an underlying asset such as a share, commodity or foreign exchange. At no stage do you own the underlying asset itself.
You go into the agreement with a CFD provider and essentially trade based on the belief that the short term value of the underlying asset will increase or decrease.
A CFD usually only requires you to invest a small margin of as little as 1% or as great as 15%. This means you could bet on a contract of 5,000 shares at $10 each, equalling $50,000, but if the margin was 5%, you'd only need $2500 to invest (5% of $50,000 is $2500).
Let's say you did this and believed the share price would increase so you decided to go 'long' (a term meaning betting that the share value will increase. The opposite is going 'short' and refers to betting that the value of the share will decrease.)
In this example the value of the share increases by 10%, bringing the total cost of the shares to $11. This means a total profit of $5,000 minus broker fees and other charges.
The ability to reap huge profits using little of your own money is also the biggest pitfall of CFDs because you also have the potential to lose a huge amount.
If you made the same bet as above but the share value dropped instead of rising by 10% you'd suddenly lose $5,000.
If the same happened but the value dropped by 20% you'd have lost $10,000. A CFD works in much the same way as a bet. For every person betting the value of the share will decrease or increase there are others betting on the opposite.
This is only one risk of investing in CFDs. In reality there are many other risks stemming from how they operate in the market and also how the CFD provider themselves are governed.
Related: The risks involved with CFDs
Like other financial instruments, you can use a stop-loss order on CFDs to minimise losses. This still presents risks as the order may not be executed at the price you set, meaning you could lose more money than you're prepared to. Some CFDs may allow a guaranteed stop loss but this will come with an additional price.
What types of CFDs are there?
There are two types of CFDs in Australia.
Over The Counter (OTC) CFDs
These are CFDs where you purchase them directly from the CFD provider and enter into an agreement with them. Each CFD provider will have their own terms and conditions which can present additional risks. These CFDs aren't as regulated as ASX Exchange-Traded CFDs and the price with an OTC CFD can be set by the provider themselves, or set by the market.
ASX Exchange-traded CFDs
These CFDs require you to visit a broker before buying and are listed on the ASX. They all operate using standardised terms and conditions so their risks in this area can be lower. Finally, the prices of these CFDs are determined by trade activity in the market.
CFDs: A word of caution
A CFD is in essence a bet which can be highly leveraged. For this reason you can make large profits and also lose a large amount of money which you might not have. Before thinking of investing in CFDs, it's crucial you seek professional financial advice.