Understanding CFD trading

Be it fairly or unfairly, financial derivatives continue to have a reputation among retail investors for being risky. 

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The complexity of such instruments as compared to the vanilla variety such as stock trading, makes them more susceptible to misunderstanding or misinterpretation.

Nonetheless, there is still an increasing popularity in trading these financial derivatives, such as contracts for differences (CFDs).  Financial market research company, Investment Trends, noted there was a 21.3% rise in the number of individuals who placed a trade on CFD and/or FX, between September 2014 and August 2015.

While the complexities of the CFDs may not have really deterred retail traders, their existence may pose potential problems. CFDs are often marketed as financial instruments which allow you to take both sides of a trade – buy or sell – without having to pay the full amount of the underlying security that you are trading. However, the advantages of CFD trading, also considered a form of margin trading, is not without its risk


Risk of CFD trading

With Singapore shares, you can get a leverage of up to 10 times of the stock value, which means you have to deposit at least 10% of the traded amount. With S$10,000 in your IG trading account, you can build positions up to a value of S$100,000.

Assuming you have S$15,000 in your account, and you have opened a long CFD position for S$100,000 in a blue chip Singapore share, which has a 10% margin requirement. 10% of this amount or S$10,000 is used for margin, while the remaining S$5,000 less off any transaction costs you have incurred for the trades, are ‘Available to Deal’, or available to place new trades.

While the exact amount to meet the margin requirement clearly moves in tandem with stock prices, a fall in the nominal value, if you have opened a long CFD position, is more concerning than a rise in the share price. If the share falls 5%, the nominal value will drop to S$95,000, and the minimum deposit becomes S$9,500.

However the amount you have ‘available to deal’ will decrease by a sizeable amount, which would be the net amount of the unrealised loss (-S$5,000), and the lower margin required (+S$500). If the amount goes up to $105,000, your minimum deposit needs to be S$10,500, which is less of a concern because your running or unrealised profits (+S$5,000) will help cover the margin requirement.

One thing you should be aware of is that you absorb the full gain or loss on the position. In the previous example, you will have to pay for the loss of S$5,000 for a 5% drop in share price. Instead of the initial S$15,000 in your trading account, now you have S$15,000 - S$5,000 = S$10,000.

Clearly this is not the end of the world, but the problem really starts when the amount available falls near to zero. If the stock price continues to fall, you will get into a situation where your equity (funds after adjusting for any profits or losses) is insufficient to cover the margin required for your position. This will trigger a margin call from your broker-dealer, where you either need to top up your account to meet the margin requirement or close your position.

Using the same example, instead of a 5% drop, the share price falls by 6%, the nominal value of your long position becomes S$94,000, and you would have a loss of S$6,000. Your equity would be S$9,000. However, you would need to maintain the 10% margin requirement or $9,400 to keep the trade open. This is more than what you have in your account, so you would receive a margin call.


Managing risk

Evidently, a margin call is not desirable, as it forces you to top up your account, or face closing your position too early. To minimise such incidents, traders may use a couple of trading rules to increase the chances of success.

One way is to increase the proportion of your deposit available for margin, which would allow for greater volatility. Do note that the percentage you have chosen is also an implication that you are willing to tolerate up to this percentage of losses on your account.

For example, if you decide to never use more than 60% of your deposit for margin requirement, and keep 40% available for margin, it means that you are willing to accommodate up to 40% of losses on your trading account.

Another rule is one which many traders fail to do due to the psychological impact of trading.  You should always consider cutting your losses early and let your profits run. As soon as you see that your trading direction is wrong, you should consider closing the position and take the loss. This is particularly important in CFD trading because of the risk of chalking up losses which exceed your deposit.

Traders may use stop-loss orders to close their trade if it is going against them and hit a certain level. Setting these orders helps to remove the emotion out from trading, which would often than not impair good judgement.

However, stop-loss orders may sometimes not be filled at the level you selected, particularly in the event of price slippage. This is why IG offers another type of stop-loss orders known as guaranteed stops. As the name suggested, your stop-loss orders are guaranteed to be filled at the level you set.

Trading in the very short-term means you are likely to encounter much higher market volatility, so managing the danger of margin calls might help you be more successful at trading in the long run.

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