Editor’s note: This article was first published in January 2013. The statements that CFDs are relatively new in Spain, that banks don’t yet offer them, and that SelfBank offered them through Saxo Bank describe the market then. The financing rates are also from then; Eonia was discontinued in 2022.
CFDs (contracts for difference) are a relatively new derivative in Spain, although they are winning more and more followers thanks to the advantages they offer. They also have some drawbacks, of course.
The main advantage of this investment product is the high leverage it allows, and the fact that, unlike futures, options or warrants, a CFD has no expiry date. In other words, we can keep the position open indefinitely.
Another advantage is that we can invest in both directions of the market: long (bullish) and short (bearish) positions on shares from all over the world, indices, commodities, interest rates, currencies and so on (making money whether the market goes up or down). And unlike other derivatives, if a company pays a dividend while we hold the position open, we receive that dividend.
Like any derivative, CFDs are linked to an underlying or reference asset (shares, currencies…) and can even be linked to other derivatives, such as futures and options.
This is the derivative most traders are starting to use for intraday trading, although in my view this product is most useful for investing in a market trend, whether in an index, a stock or a currency.
An example
Suppose we expect Repsol to start rising on the stock market, so we buy Repsol CFDs. If the broker allows 10x leverage on Repsol, with 1,000 euros we can buy Repsol CFDs worth 10,000 euros. Repsol closes higher and we decide to leave the position open until the next day, something we couldn’t do with intraday margin trading.
We need to know that keeping a CFD position open overnight carries interest charges, which vary from broker to broker. The rate is usually referenced to Euribor + 3% a year or Eonia + 2%, among others.
In other words, the financing cost of holding a 10,000 euro position overnight would be about 2 or 3 euros a day, which is not much money. But if we keep the position open for 3 months, that comes to between 180 and 270 euros in interest.
As long as the stock has met our expectations, the investment may have been profitable. Clearly it is a profitable investment as long as the gains are greater than the interest we pay.
In the same way, if we expect Repsol to fall, we open a short position and close it when we think it has fallen far enough.
How to invest in CFDs
For now, banks don’t offer CFDs, although given how successful this instrument is, it won’t be long before they add them to their platforms. Some banks, such as SelfBank, already let you invest in CFDs because they use Saxo Bank as an intermediary, so in principle commissions are higher, as is the interest for holding a position open.
Many brokers have specialized in this type of product, such as CMC Markets or IG.
Now for the ugly side of CFDs
Unlike exchange-traded futures contracts, CFDs have no clearing house to settle trades and act as counterparty, so the investor’s counterparty is the broker itself, that is, the firm you take out the CFD with.
That’s why you need to be especially careful when choosing a broker to trade these derivatives. If the firm (the broker) went bankrupt, you would risk losing not only the money invested in CFDs but also the money you held in your account with them, and nobody would compensate you for it.
Others warn about the danger of leverage, although leverage isn’t really bad in itself. What is good or bad is how we use it.
Before you invest and take on leverage…
CFDs, like the derivatives market in general, are known as zero-sum games: the total profits of the winning investors must equal the losses of the losing investors. Put another way, some win because others lose. If you make 140 euros, it’s because someone else has lost 140 euros. So before investing, ask yourself: will you be one of the winners or one of the losers?
Even so, if you know when and how to use this product properly, it is ideal for diversifying our capital across different products, thanks to leverage and the advantage of having indices and shares from all over the world on a single platform.
P.S. These products we now use to speculate were originally designed to hedge an investment portfolio. That is, if there’s a chance our shares will fall but we don’t want to sell them, we open a short position. That way, if our shares fall, we make money on the CFDs, and if the shares end up rising, we make money on the shares and lose on the CFDs.
Further reading
- Investing mistakes and advice from the experts
- Which investments pay off best on the road to financial freedom
Featured image: Zarateman, CC0 1.0, via Wikimedia Commons.
