Your capital is at risk
March 10, 2016
You regularly read about the dangers of CFDs. The leverage effect can cause you to lose a lot of money. But you can keep the risk fully under control; therefore CFDs do not have to be dangerous at all.
CFDs are not dangerous by definition, but the person trading in CFDs can make them dangerous.
With CFDs you trade on margin: you take a much larger position than what you invest. If you want to take a shares position of 5,000 dollars, with CFDs you must only invest 500 dollars. The other 4,500 dollars are financed by your broker. If the share rises by 10%, then the position increases to 5,500 dollars. With an investment of 500 dollars you get a 500 dollar profit that is a 100% profit. In this case the leverage is 10.
It all depends on you, how you work with this leverage. If you have 5,000 dollars, you can decide to invest them directly in shares. If you work with CFDs, then you can invest 500 dollars in a similar position and you can set 4,500 aside. In this case there is no problem. The problem arises only if you are tempted to invest 5,000 dollars to open a position of 50,000 dollars. In this case the leverage effect is at the maximum. If the share falls by 10%, then you loose your full investment of 5,000 dollars. Be smart and make sure that your new position can only have a limited impact on your capital, even in the most negative scenario.
Trade wisely in CFDs and limit the risk by using the guaranteed stops.
With many brokers it is possible to loose more money than you have deposited on your account. With Plus500, however, an account can never go below zero and you cannot run up debts. This broker will automatically close your position if your margin gets too low.
How exactly do debts come into being? Let's take the above example again. Imagine that because of a profit forecast, shares suddenly open at 20% lower. In this case the value of the position drops from 50,000 to 40,000. The loss is only 10,000 dollars. Considering you only had 5,000 dollars on your account, you lost this deposit entirely. Additionally, you suddenly have a 5,000 dollar debt with your broker! After all, it is a CFD, a contract for difference. The positive or negative difference is completely on you, the broker only finances the transaction and you basically borrow money from the broker.
How is it possible that Plus500 can guarantee that you can never run up debts? Probably Plus500 is able to make more money in other ways. As to financing costs, for example, Plus500 is much more expensive than IG. It is often said that Plus500 is more suited for beginners who want to trade with a small capital.
There is always a risk of unexpected events. Therefore, you should work with a guaranteed stop. Imagine that, in the above example, you bought 1,000 shares at 50 dollars each. You expect a rise, but set a stop loss in case the share price falls. If the share gets to 47 you want to exit.
Because of the profit warning, the share suddenly fell from 50 to 40. The normal stop would be activated once it fell under 47, but would only be executed at the next rate of 40. With a guaranteed stop, you are sure that your position is closed at 47. In that case your loss would amount to 3,000 dollars. Only with a guaranteed stop, you can know for sure beforehand how much money you risk!
Since you do not put the entire amount on the table yourself, you basically loan from a broker. That's why you pay a small financing rate each day. At the current market condition, this interest rate is only a few percent. Depending on the broker this can be from 2.5 to 6 or 7 percent on an annual basis. Plus500, for example, is much more expensive than IG.
If you keep the CFD for a very long time, then obviously the financing costs increase. Therefore CFDs are suitable for short-term trades of a few days to a few weeks. It is not easy to calculate from what point on CFD becomes too expensive. Yes, there are financing costs, but on the other hand there are no transaction costs on most platforms, which you would have had to pay with an equity broker.
CFDs are a leveraged product. Make sure you understand all the risks involved.
