Assume, you are a 100% sure that your favorite stock will increase in price over the next day but you only have $1,000 to invest. Wouldn’t it be nice if you could lever your capital to invest, let’s say, $5,000? As CFDs (Contracts For Difference) offer high leverage, they are a great way to do that!… but is it really that easy to become rich?
Short-term stock movements are not predictable
Let me first straighten out: You could never be a 100% sure to know whether the price of your favorite stock is increasing (unless you have insider knowledge). Moreover, the shorter the considered holding period of your investment, the more the probabilities of an increase or decrease converge to 50-50. Thus, extending the holding period increases the probability of earning money (see visualcapitalist.com for a great visualization). However, when investing in CFDs, you would have to pay a compensation for overnight positions. But before bringing in a verdict, we should first learn more about them:
Definition of CFDs
CFDs are speculative derivatives whose quotation depends on the price of an underlying. Feasible underlyings are stocks, indices, (commodity) futures or currency pairs. As with forwards and many other derivatives, CFDs are traded over-the-counter, i.e. they are not exchange-traded. Except for futures, there are no maturity caps and you can bet on both increasing (long) and decreasing (short) prices. Thus, CFDs can be used for almost anything.
Risks of CFD investments
To achieve leverage, you have to deposit a margin that is used to compensate adverse price movements. If more than 80-90% of your capital is consumed, you will likely be asked to increase your deposit (so called margin call). If you don’t fullfil the margin call and 100% of your capital is depleted, your positions will be closed.
In constrast to other derivatives (e.g. short positions in put options), losses from CFDs are limited to the amount of deposits in your account. However, you have to consider that leverage works in both directions (i.e. the probability of a total loss increases in leverage) and most retail investors (70-80%) lose money when investing in CFDs.
See the following example to get an idea of actual numbers. We will compare a simple stock investment to a CFD (on the same stock).
- Stock Price: $1,000
- Stock investment: 1
- CFD: 5
- Stock investment: 100% (i.e. you have to invest the whole $1,000)
- CFD: 20%
- Invested Capital:
- Stock investment: 100% * $1,000 = $1,000
- CFD: 20% * $1,000 = $200
- Leveraged Capital for a $1,000 investment:
- Stock investment: 1 * $1,000 = $1,000
- CFD: 5 * $1,000 = $5,000
- Price change of the underlying: -5%
- Stock investment: -5% * $1,000 = -$50
- CFD: -5% * $5,000 = -$250
In summary, an investment in CFDs most likely depends on your individual risk aversion. If you are risk seeking and have no fear to lose your invested capital, CFDs might be appropriate. However, you should take into account that price changes work in both directions and short-term probabilites for price increases and decreases are equiprobable. Most importantly, three out of four CFD investors lose money, which is why I would not buy them.