Financial Spectrum’s Brenton Tong authored this article for Canstar. You can view the original article here.
The differences between shares and CFDs are staggering, however they are also still deeply related to each other. Here’s a breakdown of how they work, explained by financial adviser Brenton Tong.
What are shares?
On the one hand, we have shares – tried and tested, and just about every Australian will have exposure to them either directly or through their superannuation fund. Whether you know it or not, you’re likely a share investor. While they can often be seen as a touch opaque, they’re usually straightforward to follow in that they have a price which can go up or down, and sometimes they will pay out some income – called a dividend.
What are CFDs?
CFDs, also known as contacts however, are a whole different beast. Firstly, you don’t own the stock – you’re essentially betting on an outcome. This could be likened to a race horse – if you win, or if you don’t win, you still own the horse. But if you’re at the track betting on the horse winning, you only get your money back if what you’re betting on comes to fruition. If the horse loses, you lose your bet.
So, why would you want to take such big risks betting on one particular outcome, when you could possibly own the horse and keep it for another day, maybe another win? The answer is a matter of magnitude. It will cost you a lot of money to own the horse. Compared to the cost of buying and maintaining it, the winnings from a race could just be a fraction of the costs of owning and maintaining the horse. In contrast, with betting on an outcome, you could outlay a fraction of what it would cost to buy the whole horse, and potentially win multiples of it.
How do CFDs work?
CFDs are highly leveraged financial instruments. A share could move just 5%, but if you’re betting on it moving 5% up (or down), you could see your return magnified. Further to this, each CFD will have a margin that you can trade at, meaning you don’t even need to put down all the money that you’re betting. It’s a bit like an IOU – which means you can put up even less capital, and if the share moves in your favour, the returns are even larger.
You can view CFDs in two very different lights. They can either be an investment by themselves – where you allocate money that is at risk of a 100% capital loss for the pursuit of very high gains, or you can use CFDs to compliment an existing portfolio or protect it.
Setting up your investment portfolio
When considering how to best build your portfolio, it’s usually a sensible idea that if you’re looking to invest into CFDs, you would ideally already have shares as a financial foundation. While a share price will be volatile, ultimately you still own the asset and its value will sit on your balance sheet. The desire is to see that share value increase over time, and possibly provide an income stream which you can then use to either invest further, or diversify. When it performs well, you see your wealth grow. When it performs badly, you see your wealth fall. However, the key to understanding this is that while your wealth may fall, you still have wealth.
Shares or CFDs – which one is riskier?
A CFD has the chance of absolute loss. While in theory, any share could potentially be worth zero. But in a well-diversified portfolio it’s unlikely that all your shares will drop to zero. A well run company will have cash, assets and strong business, so it’s unlikely that even a moderate portion of a portfolio will drop to nothing. This means even in the bad times, when the market is falling, your shares are still worth something. All CFDs have the potential to reach zero value if the market moves the wrong way.
If you have a portfolio of only CFDs, then there is a much greater chance that all your holdings could drop to zero. There is also a greater chance that you could see your portfolio value increase much faster than what straight shares could. While they may be marketed as a sensible investment decision, they really are very high risk, high return.
How you can use CFDs
Offsetting your other investments
Where CFDs are sensible to use is to either compliment or protect a portfolio. As an example, if you own shares in a company that you bought a long time ago and you’re worried that the shares might drop but don’t want to sell for tax reasons (since you think they are still a good long-term investment), you could enter into a CFD contract where you’ll benefit from a fall in the share price. Should your hypothesis come true, you’ll profit from the CFD when the share price falls, which covers your losses on the actual shares.
Potentially making double
Similarly, you can use a CFD to double down on the upside. If you own shares in one company, and you think the price is going up, rather than buying more of the shares you can enter into another CFD contract to benefit from the upside. Again, if the price moves your way, you profit. However if the price does not go up, you lose the value that you’ve invested into your CFD.
You can also use CFDs to give you exposure to other markets or possibly competitors. Take for instance a situation where you have two players in an industry where if one wins, the other loses. If you purchase shares in the company you expected to win, and you bought CFDs betting against the company you think would lose, you would either make a profit on both your long position (owning the shares), as well as your short position on the losing competitor. However, if things don’t move in your favour, you still own the shares in the losing company, and you’ve lost the total value of your CFD. In this situation, you have at least still maintained some of the value of your shares. This would be preferable to having both positions as CFDs.
So should you invest in CFDs?
You can certainly have a share portfolio without any CFDs or other derivatives. In fact, that’s what most investors will have. You can also have a suite of CFDs and no underlying stocks, however the difference between those two approaches are cavernous. In reality, if you do have CFDs without shares, you should consider propping up your portfolio with some underlying shares to back your convictions. At least that way, you’ll still have some money left at the end of the day.