Should you invest in a CFD?by Alexander Zane Financial Analyst
Are you considering whether to invest in a CFD? You may understand what CFDs are and how they may be of advantage to you, but knowledge of the alternative contracts on offer is essential to know if you are making the correct choice. In the following article, we will discuss all the options available for you.
This is the most basic and longest existing derivative available to you. A forward contract ensures that the buyer of the contract promises to sell the asset at a late date. The price at which you sell this asset, however, shall remain fixed on the signing of the contract.
These types of contracts rarely involve any intermediary, meaning the two parties engage with each other directly. This can be advantageous. No extra expenses will have to be paid and the deal can be completed without informing outside parties. You should know what you are doing in these kinds of deals, however. Should the deal go sour, you will have to engage with the other party directly.
The principles of this contract resemble that of a forward contract, in that it involves selling an asset at a later date. The key difference here is that they do have to involve an intermediary party, namely the stock exchange. Since the contracts are monitored, no modifications can be made to the contract after it is set. Modifications cannot really be made before the contract is set either, as the contracts are highly standardized by the exchange.
The contracts are subject to daily settlement procedure, meaning all profits and losses are calculated daily, to determine any additional prices needed to be paid by an involved party.
The forwards contracts are a far more regulated form of derivative. The reasons for all of these regulations seem to be justified, though, as they allow for minimization of risk.
These are regulated contracts, which the stock exchange monitors. They allow one side of the contract to make a decision on how they want to proceed once the contract expires.
Options contracts come in several different forms. The first option for the contract is to either call or put. A call option allows you to buy at a future date, although there is no obligation to do so. A put option allows you to sell at a later date, although there again is no obligation to do so. Although you have no obligation to go through with their option at the end of the contract, you do have to pay a premium price.
These can be further specified into either a long or a short option. A long option means an investor already owns the shares of a stock and plans to sell them at a price rise. A short position means that the investor does not actually own the stocks yet and plans to buy them once the prices drop. So, if we were to give an overview, we could have a:
- Long Call Option
- Short Call Option
- Long Put Option
- Short Put Option
This last derivative is probably the most involved option available. These are over-the-counter custom contracts that allow two parties to exchange the cash flows (expected net change in liquidity) of different financial instruments. Investors usually refer to the cash flows exchanged within the contract as legs. One of these legs remains fixed while the other is variable, determined on an interest rate, commodity or index price. There is no restriction on what asset the parties can use for a swap, although the most common option is to use them on loans and bonds.
They are most commonly used to when worries arise about the interest rate of an investment. A second company is then found to exchange their respective interest rates with. The first company may have a highly variable interest rate, where the second has a set rate.
As we said these exchanges are a tad complicated. They are used to amend already existing investments, so they are not recommended for first time traders.
The greatest advantage of CFDs over all these other derivatives is that they do not rely on real assets, but solely on making predictions on the behavior of this asset. The trader, therefore, does not have to pay large sums to be able to invest in one of these trades. They are highly flexible, allowing you to trade in a wide variety of assets, not solely relying on stocks. Additionally, a trader does not need to use a great amount of their own liquidity, as these contracts allow for trades to be carried out on margin.
The downside is that they are subject to a large range of charges, including the payment for spread, and holding costs. This also a highly unregulated market, where investors must rely on brokers more than anyone else.
Making a decision on a CFD
So, the CFD market seems like a great option for someone who wants to enter trading for the first time. These individuals would be suited for a market that is not tightly controlled without too much risk. It could have the potential to make good profits but would need an intermediary to deal with the details.
If you are better acquainted with trading, you may want a contract where you have even more options. If you want to make very large profits from your investment, the extra payments used for CFDs will hold you back. For less risk, future and options would be a better option for you. We can conclude that CFDs are overall a well-balanced option for a new trader but they have no significant advantage in any particular area.
Created on Feb 28th 2020 03:13. Viewed 187 times.