Is contract for differences a right investment?

Yap Ming Hui: One particular type of investment has been gaining traction lately because of its popularity in investment apps, which is the contract for differences (CFD). At first glance, CFDs do seem like a great way to multiply assets and grow wealth. However, there is more to know about CFDs before selecting this as a means of investment.

IN today’s financial landscape, there are many options for the public to invest in.

One particular type of investment has been gaining traction lately because of its popularity in investment apps, which is the contract for differences (CFD).

In fact, a good friend of mine has approached me for counsel about this subject. His son had recently started trading on CFDs via the eTORO app, and found that he could make a lot of money with very little time and effort invested.

In the excitement of experiencing significant gains, he has informed his father that he is considering quitting his full time job as an engineer, despite receiving a salary that is well above his peers in the industry.

In his opinion, the gains from CFD investments can be potentially higher than what he is earning as a full-time employee and requires relatively low capital.

Being unsure of the decision his son is making, naturally my friend approached me to find out my take on this.

At first glance, CFDs do seem like a great way to multiply assets and grow wealth. However, there is more to know about CFDs before selecting this as a means of investment.

In this article, we’ll be covering what I have shared with my friend and hopefully it will be useful to your investment planning and management.

What is a CFD and why is it popular?

A CFD is an arrangement made in underlying investment trading where the differences in the settlement between the open and closing trade prices are made through cash payments.

CFDs are popular because you only need to invest a fraction of the stock price, instead of the full stock price. This mechanic allows traders to place short-term bets on a particular stock, without needing the capital to purchase the stock. It is an advanced strategy that is used by experienced traders to grow their wealth.

How does a CFD work?

Before we dive into how the CFD works, let’s briefly outline a traditional means of trading. Let’s say you’d like to buy stocks of XYZ which is priced at US$5 (RM21) per share. To buy 1,000 of these shares in normal case, you’ll need to fork out US$5,000 capital. In time, if the share price increases to US$7 per share, you would have made US$2,000 in profits from US$5,000 in capital.

Because CFD trading is a leveraged product, you don’t need to put up the full value of these shares. Instead, you only need to cover the margin, which is calculated by multiplying your exposure with the margin factor for the market you are trading.

So, if XYZ stock has a margin factor of 10%, then your margin would be 0% of the total exposure of your trade (1,000 share CFDs times US$5 = US$5,000), which is US$500. Instead of forking out US$5,000 to purchase the full share, you put in just 10% of that to contract the share from a broker, which is equivalent to US$500 for 1,000 shares. By the time you sell the shares when it has reached US$7 per share, you would have made US$2,000 with a capital of US$500.

Price bets

Essentially, CFDs are used by investors to make price bets as to whether the price of the underlying asset or security will rise or fall.

CFD can be used this way to trade many investments, including exchange-traded funds (ETFs), stocks, stock indices, cryptocurrencies, and regular currencies. But as with everything else in trading, there are advantages and disadvantages to trading with CFDs.

The advantages

One of the reasons why CFDs are attractive is that investors can profit in both the rising and falling of the market. If you predict a market is on an upward trend, you can open a CFD position that will profit as the underlying market increases in price.

If you predict the market is on a downward trend, you can also open a CFD position that will profit as the underlying market decreases in price. This is referred to as selling or “going short”, as opposed to buying or “going long”.

CFDs are also traded on the margin, meaning the broker allows investors to borrow money to increase leverage or the size of the position to amplify gains. The leverage in the CFD market can be as low as a 2% margin requirement.

Because of the margins, investors don’t need a huge capital to start trading, and have more freedom to diversify their strategies. Often, traders can open an account for as little as RM1,000 with a broker and multiply their wealth quicker than traditional trading.

Also, on investment platforms such as eTORO, investors have the option of copying the CFD trading strategies of popular and experienced investors, thus reducing the time to research and monitor the investments.

The disadvantages

While a CFD sounds like a good option for multiplying your income with less capital than usual, never take anything at face value. Everything has its pros and cons.

When it comes to CFDs, be careful about the investment platform that you choose to buy it from. Some platforms like eTORO are not licensed in Malaysia and are in fact on the Securities Commission investor alert list.

You may think that you are safe because plenty of other people are using the app. However, what this means is that you are exposed to risks such as fraud and money laundering, and should that occur, you may not have the protection of the law.

Also, just like how leverage can amplify gains with CFDs, it can also magnify your losses when your prediction is wrong.

Double-edged sword

It works just like a double-edged sword. Hence it can be fairly easy to lose your capital if you are not a seasoned CFD trader. On eTORO, a disclaimer clearly states that “You should not invest money that you cannot afford to lose”.

You may ask: “But how about if I choose a popular investor to follow? Will I still be at risk then?”

Of course. Just like how you may put your money in the hands of a wrong fund manager, you also run the risk of choosing the wrong investor to follow, especially if it is based on popularity.

In fact, your risk to follow a popular investor is rather high considering that they are not required to hold any professional qualifications and investment management licences from the regulators like unit trust fund managers and robo advisors.

So, should I invest in CFD?

At the end of the day, while CFDs may have attractive opportunities, it is not an investment alternative that suits everyone.

Investing in CFD could be suitable for you if you have the following profiles:

> You are a high-risk investor with excess capital that you can afford to lose

> You are looking for short-term investment opportunities,

> You are an experienced investor with advanced knowledge and skill in trading.

In Malaysia, the CFD is not available to retail investors. CFD can only be offered to “sophisticated investors” who have more than RM3mil in net personal assets and fulfill other necessary requirements.Even if you do fulfil the criteria above, make sure that you invest only a small portion of your assets into CFDs.

For the clients who explicitly expressed their interest in CFDs, I recommend to allocate less than 1% of their total investment assets into CFD trading.

On the other hand, CFDs are not the investment for you if you are investing to accumulate and preserve your wealth, have a low or moderate risk appetite, and have little to no trading experience.

In short, if you have limited time and money to grow your wealth, it is best to stay away from CFDs and focus more on solid investment opportunities instead.

After listening to my sharing, my friend agreed that trading in CFD is a risky activity that comes with a lot of uncertainties.

He decided to advise his son not to quit his full time job and spend less time and money on CFD trading. Just like any investments, the risk of losing money is real.

When you are unsure if an investment alternative is a good and safe bet for you and your family members, it is always wise to consult the advice of a licensed independent financial adviser.

Yap Ming Hui is a licensed financial planner. Any reliance you place on the information shared is therefore strictly at your own risk. The views expressed here are the author’s own.

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