What Are The Advantages & Disadvantage Of Trading Using CFDs
This article was written in collaboration with IG, the world’s No.1 CFD provider (by revenue excluding FX, June 2020). All views expressed in this article are the independent opinion of DollarsAndSense.sg based on our research. DollarsAndSense.sg is not liable for any financial losses that may arise from any transactions and readers are encouraged to do their own due diligence. You can view our full editorial policy here.
In a previous article, we wrote on how you can open a Contract For Difference (CFD) account in Singapore online using Myinfo.
A quick recap if you are not familiar with CFDs. They are a type of derivatives that derive their value from the performance of an underlying asset, such as equities, forex, indices, commodities and more.
When we buy a CFD, we enter a contract with our CFD providers, where we mutually agree to exchange the difference between the opening and closing price of an asset.
Whether we are long-term investors or short-term traders, CFDs are tools that can be used to gain market exposure to various types of assets. In this article, we will highlight some of the key advantages and disadvantages of trading using CFDs, compared to investing directly in the asset classes.
#1 With CFDs, We Can Take Both Long & Short Positions
When buying a CFD, we can take both long & short positions in the market. For the uninitiated, having a ‘long’ position means that we believe the prices of the assets will rise. Conversely, having a ‘short’ position means that we believe the prices will fall.
In other words, CFDs allow us to take a position in either direction of the market, whether we think the prices will move up or down. In contrast, when purchasing stocks, we usually only take long positions, unless we borrow shares from our broker to short-sell.
As long-term investors, we can consider using CFDs for hedging purposes. By taking a short position in a CFD, we can hedge against near-term price correction in our long-term investment portfolio. If share prices drop, the loss in our investment portfolio will be offset by a similar gain in our CFD. If we are confident that the price decline is no more than a short-term fall, we can even use the profits from our CFD to invest in more shares for long-term investment.
Unlike futures and options, CFDs do not have any fixed expiry, so we can hold on to our CFD for as long as we want. However, there are finance charges that we may also incur when we buy and hold CFDs.
#2 CFDs Allow Us To Trade A Wide Range Of Assets
When trading through a CFD provider such as IG, we gain access to a wide range of asset classes that we can trade. For example, IG allows us to access more than 17,000 markets across shares, forex, indices, commodities, and more.
This makes it very convenient for investors and traders who want to take on positions in multiple asset classes, without having to manage a dedicated account for each asset type. For example, through CFDs, we can take on positions in commodities such as gold, silver, copper, lead and iron. This makes sense, especially if we want to start having more market exposure to these asset classes in small amount, without necessarily wanting to hold them over a long time.
#3 You Can Utilise Leverage With CFDs
Through leverage, CFD traders can gain a larger exposure in the financial market than the capital they put up. Say, if we are trading indices through IG, we need a margin of 5%, which gives us the equivalent of a 1:20 leverage. The more volatile an asset is deemed to be, the higher the margin requirement will be. For example, IG generally requires a 10% margin for shares, 20% for commodities and 5% for indices.
By taking on a bigger exposure through leveraging, we potentially earn a higher return on our capital in exchange for higher risk. This could be attractive for some traders seeking higher returns in the financial markets, particularly for the short term.
#4 The Use Of Leverage Is A Double-Edged Sword
While leverage can increase our investment size – thus, higher potential return – the opposite is also true. If prices move against the position that we take, our losses are magnified. Not only can losses be significant, it’s also possible that we lose more than the initial capital we put in if prices move quickly against us.
Hence, if we are trading CFDs, it is important that we must adopt the right risk management habits. For example, we may wish to put a stop-loss on every trade we make, such that it triggers an automatic sell-off if prices hit a certain pre-determined loss level that we have set. This would help ensure that our trading account doesn’t blow up because of one bad trade.
The fact that we don’t own the underlying asset also means that CFDs may not be ideal if we wish to own an asset over a long period. Furthermore, we will incur financing charges if we use leverage for our CFD, making it more expensive to own the CFD in the long term.
We Don’t Own The Underlying Asset
When we trade CFDs, it’s important to remember that we don’t own the underlying assets that we buy. For example, if we trade DBS shares through a CFD offered by IG, we enter a CFD contract with IG instead of buying DBS shares directly from the stock exchange. We own the profits and losses from the CFD, rather than the assets itself. So if we are taking a long position, IG will pay us the price difference between the opening and closing position if the value of the shares we trade goes up.
What this also means is that the creditability of the broker that we use is extremely important. Ideally, we should only trade with a broker that is regulated by the Monetary Authority of Singapore (MAS) – such as IG – rather than unregulated overseas brokers that lack an established reputation.
Gain Access To CFDs Via IG
If we are keen to explore trading via CFDs, we can consider opening an account with IG – the world’s No.1 CFD provider (by revenue excluding FX, June 2020). We can open an IG account online via Myinfo, or head to their Singapore office located at 9 Battery Road to do it in person.
Besides giving us access to more than 17,000 different markets, IG also provides its clients with valuable educational content on IG Academy, such as online courses, webinars and live sessions that will allow us to better understand and stay up-to-date with the financial markets. We can also join the IG Community to share and discuss trading ideas with like-minded traders.
For those who are new to trading, or to specific asset classes that we have never traded before, it’s advisable to start with a demo trading account that allows you to practise CFD trading with $200,000 virtual credits. This gives us a chance to try out various trading strategies, familiarise with the assets and platforms that we are using, and allow us to learn from mistakes without committing any money beforehand.
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