In the category of derivatives i.e. A trading instrument which is derived from a fundamental asset, a stock or an index, is the CFD. CFD stands for “Contract For difference.” This is a regular growing sector in the trading world and perfectly suited to day trading.
The benefit is that a CFD is a leveraged method of trading stocks and many indexes. They are also of benefit because you can gain control over individual stocks without having to buy the physical stock.
You can buy (go long) i.e. you expect the stock price to go up. You can also sell (go short) i.e. you expect the stock to go down in price. Going short is something that stock traders are not usually able to do, and therefore they are left to watch the downturns in the market without being able to benefit. Short selling is one of the principal attractions of CFD’s
When a market crashes as in the GFC, short selling may be stopped in order to prevent the severe fall in prices.
Like futures, options and Forex the leveraged nature of CFD’s allow you to hold a much larger position than would be possible if purchasing physical stocks. e.g. if you had $100,000 to spend you could buy that much worth of a blue chip stop or $2,000,000 of the same stock as a CFD. Assuming the CFD was offered at 5%. This varies according to the viability of the company. Some CFD’s will be offered at 20% or up to 50%, the latter being perceived as more speculative
If the market where to rise 10% you would make $10,000 from your physical shares, but you would make $200,000 from your CFD’s. You could have also bought just $5000 worth of CFD’s, which would have produced the same profit as the $100,000 of physical stock.
However if the market were to drop 10% then your $100,000 worth of stock is now $90,000. You could sell and take a loss or as most investors do, they lick their wounds and wait and hope for the market to return to higher levels.
Your $2,000,000 of CFD’s have now realised a loss of $200,000. And your broker will want that margin paid anytime as long as it is now. You have ceased to be buddies. So you have invested $100,000 and have a $200,000 loss.
Your $5000 CFD trade has now lost $10,000 i.e. 10% of 100,000! You are down $5000 beyond your original investment. Again this margin must be paid immediately.
There is a way to limit your loss with a leveraged instrument. By using a stop loss you could place an order to exit should the market move 2% against you (this is an example and stops have to be carefully considered) In the first instance the $2,000,000 trade would be down $40,000. So you risk $40,000 to make $200,000. Is that acceptable?
In the second instance your $100,000 CFD trade would be down $2000. You risk $2000 for a $5000 reward. Can you live with that?
Some brokers will allow a stop loss on a physical stock trade. If you lose $2000, by being stopped out but have access to the remaining $98,000 to use again, some would argue that this is a smarter use of your investment capital than waiting for who knows how long for the market to return.