Why You Should Not Buy CFDs If You Are A Long-Term Investor
If you are opening a brokerage account, you might also come across an option to open a CFD account. What exactly is a CFD? And should you be using it to buy stocks instead of the standard brokerage account?
You might feel that using CFDs to buy shares might be beneficial, as it allows you to buy shares with minimal cash due to the leverage of the instrument. Typically, many brokerages allow 10x leverage for CFD. This means that to buy S$1,000 worth of shares, all you need is S$100.00 to settle the trade.
However, CFD can be a dangerous instrument, if you do not fully understand what it is about. Let’s us run through the basics of CFDs and why you should never use it to hold long-term shares.
What is CFD?
CFD means “Contract For Difference”. It is actually a form of derivative, a contract between two parties and not an actual ownership of a share. So, when you buy a CFD, you are merely entering a contract with a counterparty to bet on the direction of a stock, either up or down.
Some CFD contracts are internally bought and sold within the brokerage’s internal system and not on the open market. Even if some CFD offers direct market access, meaning that your trade would trigger a similar trade on the actual stock market, you are not really buying any shares. You are simply buying a contract that is betting on the movement of the shares.
For a short-term trader, that might be fine, as they might sell the shares again within the next few days. However, if you are a long-term investor, it would mean you are not a shareholder of the company, even if you have bought the CFD. This exposes you to multiple risks such as:
- Counterparty risk that your profit from the CFD would not be fulfilled.
- Brokerage solvency risk, as you are only trading within the brokerage’s internal system.
- No shareholder rights
- Might not benefit from some corporate actions at the company
- The liquidity of the CFD might be different from the liquidity of the stock market.
Therefore, if you plan to buy and hold a stock for the long-term, it is better to just buy the stock directly. Everything else is just a distraction.