Livemarkets.com
investing-day-v3

Which investment types are right for you? (part 2)

Intro

You have learned that there are many investment vehicles available, such as shares, commodities, funds, bonds, cash, foreign currencies, and the list goes on.

Let’s continue with one of the most popular forms of trading today: CFDs and Spread Bets.

 

CFDs and Spread Betting Instruments

In some ways, Spread Betting and CFD trading have similarities with stock trading. Like shares, Spread Betting and CFD trading, involve two prices, the BID price (Buying price) and the ASK price (Selling price). The difference between these two prices is known as the spread.

However, CFDs (“Contracts for Differences”) are complex instruments that allow traders and investors an opportunity to speculate on the price movement of an asset, without owning the underlying assets. This is accomplished through a contract agreed between an investor and the broker to exchange the value of a financial instrument between the opening of a contract and the close, without utilising a physical asset such as a shares, forex, commodity, or futures exchange.

With Spread Betting, there is an additional element to the trade that the investor must consider, which is the “stake” size. For example, if an investor stakes an amount of £10 for each point in price difference, this means his total profit is the number of points multiplied by the stake amount.

Trading in CFDs and Spread Bets, offers several major advantages that have increased the instruments’ enormous popularity in the past decade, but also has additional risks associated with leverage.

A key difference between more traditional investing and Spread Betting or CFD trading is that you can make money from both rising and declining values of various investments across financial markets.

In general, unless you’re deliberately trying to “short” a stock, you’ll buy investments with the goal being to bag a profitable sell price if the value rises.

Meanwhile, with CFDs and Spread Bets, you can trade on what’s called the “long” or “short” side.

Trading on the long side means that you’re putting your money in with the expectation that the sell price will rise.

By contrast, trading on the short side means that you’re expecting the sell price to fall, and so you’ve closed your position to cash in on a decrease in value.

It’s remarkably challenging to profit from trading in periods of declining financial markets, so the fact that trading CFDs and Spread Bets allows to short them, is one strong benefit of them as a product.

PROS 

  • Access to the underlying asset at a lower cost than buying the asset outright, CFDs allow you to trade expensive investments that you otherwise might not be able to.
  • This also typically means you’ll pay less in fees, especially if these are calculated as a percentage of your investment.
  • Ease of execution
  • Ability to go long or short. With CFDs and Spread Bets, you can ‘go long’ when you BUY, and ‘go short’ when you SELL.
  • Access to leverage, which is a form of credit or borrowing that the broker grants to the trader, allowing a greater buying power and enabling the trader to gain a large exposure to a financial asset using a fraction of their trading capital known as a margin. This increases potential gains, but also potential losses.
  • Investing in different financial markets and assets like these can increase your ability to create a diversified portfolio.
  • Furthermore, the fact that potential gains made on Spread Betting are tax-free for investors residing in the UK, makes Spread Bets an even more attractive investment option.

CONS

  • There’s an immediate decrease of the investor’s initial position, which is reduced by the size of the spread upon entering the CFD or Spread Bet.
  • The need to maintain an adequate capital balance (‘margin’) to cover for the granted leverage in case of potential losses.
  • Leverage magnifies both profits and losses, and these may amount to your initial amount invested.
  • Keeping daily funded Spread Bets or CFD trades open overnight, will result in funding charges, which are interest adjustments made to your account and reflect the cost of funding your open positions. Therefore, it is important to keep in mind these costs if you decide to hold CFD and Spread Betting positions for longer periods of time.

Key takeaway

As they help spread investment risk and eliminate the need to choose individual equities, investment funds might be a more prudent place to start. Compared to individual holding shares, they often provide steadier returns with fewer noticeable ups and downs, but also lesser potential gains or losses. On the other hand, CFD trading and Spread Betting, has become one of the most popular investment concepts in the past few years, with many investors starting to pursue it as an effective short-term trading alternative

In our next delivery tomorrow

Learn how to be a disciplined investor to avoid making common investment mistakes