An investor is faced with a multitude of choices when trying to determine how to initiate risk. There is the cash market and the contracts for difference market. Additionally, there is the over the counter market and the futures market. Each market has its own features. While some are highly regulated, others provide the opportunity to track an underlying market using leverage. There is also a plethora of brokers that offer different types of securities. Before you risk your capital, you should get an idea of what each security offers.
Cash Oriented Investments
Most investors are familiar with stocks. These are shares in companies that allow you to take an ownership stake in the company. To purchase shares from a stock broker, you need to open an account and deposit enough capital to purchase each share. For example, if you wanted to buy 1-share of Apple at $170, you would need at least $170, plus commission. The benefits of purchasing shares with cash is that in most cases you are eligible to receive a dividend. A dividend is a payment from the company shares that you own back to investors. The dividend is part of your return on your investment.
Contracts for Differences
The returns you receive from cash investments are unlevered and therefore are less risky than assets that provide leverage. Since the reward you receive is based on the risk you plan to take, a more risk tolerant investor might want to enhance their returns using leverage. Leverage is provided through a margin account or specific types of securities.
A contract for differences (CFD) is a security that incorporates leverage. They have the potential to provide you returns that are a multiple of the cash you have in your account. For example, a CFD on Apple shares would likely require that you put down 20% of the capital needed to buy a share with a stock broker. This means that if you trade with leverage, instead of posting $170 to buy one share, you might need to need to post only $34. You can trade CFDs on a broker’s CFD trading platform.
How Your Returns are Affected
A CFD is a security that tracks the movements of an underlying asset. For example, a CFD on Apple shares will move in tandem with Apple stock. While the change in the stock price is the same as the change in the CFD. The returns you receive are enhanced because of the leverage that is added to a CFD. This differs from some securities since the movement of the security is a multiple of the change in the price of the underlying asset. For example, if the price of Apple shares increased by 5% from $170 to $178.5, the increase in your cash portfolio would be 2%. The return in your CFD position would be 10%, which is 5-times greater than your cash return. Obviously, this cuts both ways. If you only post $34 dollars to control $170 of Apple shares, a 2% decline would wipe out your capital.