CFDs

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CFDs – risks of investing without actually owning the underlying assets

Investors were always tempted to buy popular assets such as major world currencies,  commodities like gold or oil or securities of leading stock exchange indices. There is a way of investing in popular assets unless it is necessary to own them, which seems to be practical especially with commodities. It is called “contract for difference” – CFD. Though CFDs allure investors, many of them do not realize how risky these instruments are.

CFDs are financial derivatives that are used for price movement speculations. In simple words, CFD is created by opening a position and is finished by closing a position. Traders may speculate on price decrease or growth. When closing a position, trader’s speculation is compared to the real price movement, which means a calculation of a profit or loss.

When using CFD instruments, the trader does not become an owner of a physical stock ( or other security, commodity or currency), which means he also does not have any rights to profit or voting rights. CFDs, however, enable the usage of financial leverage.

Leverage trading has a long history with the turbulent present

The first famous trade using financial leverage was a purchase of Pan-Atlantic Steamship Company by the company McLean Industries, Inc., in January 1955. Nowadays these trades are known as leveraged buyout. These buyouts were most popular in 1980s. CFDs as we know them now were introduced in London in 1990s. Brian Keelan and Jon Wood from UBS Warburg are considered as founders of the instruments.

CFDs were frequently used by hedge funds and other institutional traders thanks to the possibility to trade without actual physical owning of the underlying asset. This way they avoided numerous charges. Towards the end of 1990s, thanks to the development of Internet and other means of communication, the possibility to trade CFD reached retail investors.

Internet and other developments enabled watching every price movement and trade immediately. Many new online trading platforms and mobile applications were created subsequently and simplified trading even more. Thanks to easy access, capital markets trading has become a widespread matter. With massive retail investments were the markets flooded with massive loss of capital as well, part of which went to the traders’ lack of experience and financial education, and, also to various modern frauds using online environment, robots, unlicensed brokers etc.

High expectations, high losses

With financial leverage the trade’s outcome can be multiplied, which is enabled by an added amount of external capital to the own capital of the trader. Leverage of 1:2, for example, means that a profit – in case that the trader expected correctly the price movement of the underlying asset – shall be doubled. In case of 1:5 leverage the profit shall be 5 times higher. The prospect might seem to be attractive until we realize that the same logic works for the loss too. Using financial leverage thus means that traders can lose their entire investment even with a relatively small change in the price of the underlying asset.

 

Goldenburg Group discourages any unexperienced trader or an investor with any level of risk aversion from investing their capital in CFDs or other leveraged financial instruments. The cautiousness is even more important nowadays when markets are extremely volatile.

In spite of the warning, if an investor wants to become a trader with these high risk instruments we strongly recommend to study how the capital market and modern financial instruments work prior opening any position in the market. Also, it is indispensable that an unexperienced trader starts with a demo first.

Goldenburg Group is dedicated to long-term education of clients and the market. Follow the educational section at our website.

Goldenburg Group Limited is a fully licensed company, supervised by the Cyprus Securities and Exchange Commission (CySEC), with CIF License number 242/14, providing a comprehensive investment services internationally.

 

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