What Are CFD's?

EP 4

Picture this: You and a friend make a bet about the outcome of your local Cockroach Race down the Story Bridge. If your friend wins, you owe them $5, but if you win, they owe you $5. Now, imagine if instead of cockroach races, you were betting on whether the price of something like a stock or a currency would go up or down. That's essentially what a Contract for Difference (CFD) is - a bet on the financial market.

So, What Are CFDs Exactly?

At its core, a CFD is like a friendly wager between two people. Instead of betting on insects, though, you're betting on the price movements of various assets like stocks, currencies, commodities, indices, or even cryptocurrencies. It's a way to speculate on whether the value of these assets will rise or fall.

Let's break it down with a simple example. Say you want to buy a share of a company valued at $10. But you don't want to invest the full $10 upfront, so you opt for a CFD instead. You strike a deal with a broker - if the stock's price goes up by $1, they'll pay you $1, but if it drops by $1, you'll pay them $1.

Now, if the stock's price rises to $11, your broker will owe you $1. But if it falls to $9, you owe them $1. In essence, CFDs allow you to profit or lose money without owning the actual asset. Pretty cool, right?

The Magic of Leverage

One of the standout features of CFDs is leverage. This means you only need to put down a small amount of money, called margin, to control a much larger asset. For instance, if you want to buy $10,000 worth of a stock, you might only need $1,000 as margin to do so using a CFD.

Here's a more detailed example: Suppose you believe the price of gold will rise. Rather than buying actual gold, you use a CFD to speculate on this increase. You find a broker offering gold CFDs and purchase 10 CFDs at the current price of $1,500 per ounce, effectively buying 10 ounces of gold.

With just a 10% margin (in this case, $1,500), you control the full $15,000 worth of gold. This is leverage - a powerful tool in CFD trading that allows you to control larger assets with a smaller investment.

Risk and Reward: The CFD Rollercoaster

As exciting as leverage sounds, it's a bit like riding a rollercoaster - thrilling but not without its risks. There are A LOT of people who have completely blown up their trading accounts (including me) due to not understanding leverage and position sizing properly.

If the asset's price moves against your bet, you can suffer substantial losses. For instance, if the gold price dropped to $1,400 per ounce, you'd lose $1,000 (10 CFDs x ($1,400 - $1,500) = -$1,000).

Leverage is what makes CFDs intriguing for wealth building and trading effectively, but it's also why they've received their fair share of criticism.

Regulations for Safer Trading

To protect retail traders, regulators like ASIC have introduced new rules. Margin rates have increased, ensuring that traders have more funds in their accounts to cover potential losses. Limits have been set to prevent total losses on CFD positions from exceeding the funds in the trading account. Certain benefits to traders have been prohibited, and margin close out ratios are now more conservative.

While the leveraged nature of CFD trading has its risks, it also offers tremendous advantages over traditional trading instruments. In the upcoming weeks, we'll delve deeper into these and some of the opportunities and benefits that CFDs / Index trading in general, brings to the table.

Cheers

Marto