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Contract for difference trade suits quick returns investors

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Like with all investments, remember that all forms of trading offer risk as well potential reward and so before you start exploring the world of CFDs, be sure to do thorough research. PHOTO | SHUTTERSTOCK

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Summary

  • Buying a share in a big company such as Amazon would be more expensive than trading on that company using CFDs.
  • CFDs have been enjoying a surge in popularity since 2020 and have made it easier to access global markets at much lower costs.

Now that the global market is wide open through contracts for difference (CFDs), this article is about these instruments. While the name might sound complex, CFDs are actually pretty simple.

You are probably familiar with traditional share trading. When you deal in shares, you’re buying or selling a portion of a company. But when you trade CFDs, you’re instead speculating on the rising or falling price of an asset – without actually owning it.

As you would with shares, you still benefit from market gains and suffer from market losses. So what are the benefits of this style of trading? What kind of investors should be looking at CFDs? And why are they surging? Here’s what you need to know.

There can be a number of reasons to go for CFDs over traditional share trading. A big one is that because they trade on margins, they require less capital investment than buying shares. That can make them a great option if you’re looking for quick wins.

Simply put, buying a share in a big company such as Amazon (closed at Sh367,000 a piece last Friday) would be more expensive than trading on that company using CFDs. So if you believe the stock is poised to rise, the easiest way is to use Amazon CFDs to speculate on its movements.

Secondly, trading CFDs also means you can spread your investment capital across a wider spectrum of shares. You can trade on a huge range of different markets, including shares, indices, commodities and currencies – whether the markets are going up or down. Moreover, unlike physical shares, CFDs have no settlement times, allowing traders to realise any profits instantly.

In terms of benefits, CFDs come with risks. As the trader does not own the underlying share that he is trading, then he does not have the right to vote at a shareholders’ meeting. However, he will receive any dividend paid by the underlying company, and he has to pay the dividend if he is shorting the CFD.

As CFD trading is done on margin, a dealer is effectively borrowing money from his broker to trade. For this service, the trader needs to pay an interest rate to the broker. This means that holding a CFD position for a long time could cut any returns made on the price change of the CFD.

Another risk of trading CFDs is the counterparty risk, a very familiar concept in most of the over-the-counter (OTC) traded derivatives products. Say, for instance, if the counterparty, eg, your broker, is not able to meet the required financial obligations set by the trade, then there is no value associated with the CFD, regardless of the underlying instrument.

In other words, if you bought Apple shares at $50 a share and two years later the share price is at $250 and your broker goes bankrupt before you book profits and withdraw your money then you could lose your profit. That said, CFDs providers over OTC desks are required to segregate client funds to protect customer balances in the event of company default.

CFDs have been enjoying a surge in popularity since 2020 and have made it easier to access global markets at much lower costs - locally, they are accessible through licensed online forex brokers. Like with all investments, remember that all forms of trading offer risk as well as potential reward. So before you start exploring the world of CFDs, be sure to do thorough research.

Mr Mwanyasi, managing director at Canaan Capital