Q: I have a small portfolio of unit trusts and I am exploring to invest in other instruments. I have seen advertisements on Contracts For Differences (CFDs). What is it and how does it work? Is it suitable for new investors?
A: Contracts For Differences (CFDs) originated in the early 1990s as market participants seek to short stocks without having to undergo the protracted and costly process of borrowing the respective stocks.
A contract for difference is a contract between two parties, typically described as 'buyer' and 'seller', stipulating that the buyer will pay to the seller the difference between the current value of an asset and its value at a specified future date.
It is a tradable derivative that mirrors the price movements of the underlying asset that may include stocks, currencies, bonds and market indices.
Several major advantages of trading CFDs contributed to its popularity over the recent years. CFDs offer the flexibility of cash settlement - the investor shares the benefits and risks of owning a security without actually owning it. CFDs also enable the client to short the underlying asset without having to engage in stock borrowing or take on increased funding. In addition, they offer tax benefits and as a margined product, increased leverage.
CFDs may appear attractive but they have potential risks. For one, the high leverage associated with CFDs magnifies any losses and the spread imposed to enter and exit positions will erode any profits if there are no large price movements. The CFDs market is not highly regulated as well.
For investors who own a portfolio of investments, investing through CFDs can potentially help to further diversify or hedge the portfolio to generate greater returns. However, this is likely to benefit the more savvy investors who are familiar with the intricacies of CFDs.
New investors are encouraged to be familiar with leverage, understand one's risk tolerance and financial limits and most importantly, carry out due diligence on the different CFD brokers in the market.
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