The financial industry is full of jargon. CFDs and Leveraged Products are two concepts used interchangeably, but they do not exactly mean the same thing. CFDs are Leveraged Products, whereas Leveraged Products are not necessarily CFDs. In other words, CFDs are a type of Leveraged Products. There is a clear overlap between these two terms but not a 100% relationship.
On top of that, they have no current plans to expand internationally. It’s a pity, we know… But there are some solid alternatives! Keep on reading. We’ve got you covered!
First things first, what are CFDs?
CFDs (Contracts for Difference) are financial instruments that allow people to trade assets without owning them. In plain English, you want exposure to Apple; you buy shares of the company, right? When using CFDs, you are not buying shares, but you are promised that the CFD price movement will reflect what the underlying asset (an Apple share) is doing. In reality, you are making a contract with your brokerage company in which it promises you to pay the difference in the value of a financial product between the time the contract opens (when you buy or sell – short selling) and closes (when you sell or buy – to close a short position). All of this comes with leverage which exposes you to greater potential profits but also greater potential losses.
Let’s bring an example to the table. John wants to buy 100 “shares” of a certain company for the price of 10€, allowing him to get the same exposure to a real share with less of his money or increase the potential returns of his investments (due to leverage). For that purpose, the brokerage firm demands that John deposit 20% in his margin account to open the position. So, the total amount invested will be 1000€ (100*10€), but only 200€ (20%*1000€) will correspond to his own money. The remaining 800€ is borrowed money from the broker. So, you are 5 times leveraged in this case. If the stock price moves up 20%, you earn 200€ (20%*1000€), so you double your own money from 200€ to 400€. However, if the price drops 20%, you will lose all your money, and the position is closed.
CFDs Pros and Cons
Pros
- Easy access to global markets
- Short selling
- Increase potential returns (leverage)
Cons
- Wide spreads may apply
- Weak industry regulation
- The broker may take the other side of the transaction (bet against you)
- Liquidity risks
- Borrowing costs
- Overnight fees
- Increase potential losses (you can even lose more than your original balance if your broker does not have Negative Balance Protection[1]).
[1] Following the August 2018 restrictions in CFD trading by the European Securities and Markets Authority (ESMA), most brokers in Europe provide negative balance protection for Forex and CFD trading on a per-account basis, but only to retail clients from the European Union.
And what about Leveraged Products?
As the name implies, Leveraged Products involve leverage like CFDs. Indeed, it includes all the products that use borrowing proceeds (leverage). Nonetheless, the investor will not pay a spread (the difference between the bid[2] and ask price[3]) which means that it does give you the potential to profit from small moves. In CFDs, that trade is limited due to the spread your broker charges you.
The best example that comes to our minds is the leveraged ETFs. The objective is to amplify daily returns by either two or three times and can be either long (bull) or short (bear) ETFs. For instance, the ProShares UltraPro Short S&P 500 ETF is an inverse ETF of the S&P 500 Index, which is designed to give you 3 times the daily reverse return of the S&P 500. If the S&P 500 drops 3% in a single day, the 3x inverse ETF is expected to gain 9%.
Unlike the CFDs, you do not need to open a margin account, and you are not dependent on your broker’s credibility to proceed with your trades.
Leveraged Products Pros and Cons
Pros
- No spreads
- No margin account required
- Short selling
- Increase potential returns (leverage)
Cons
- Liquidity risks
- Interest and transaction expenses
- Increase potential losses (leverage)
The Bottom-line
CFDs and Leveraged Products are a great way to help you hedge against declines, seek to profit from market movements (up or down), or simply underweight exposure to a market segment but are only appropriate for short-term investing. Long-term investors should be cautious when using this kind of instrument.
Still, the other side of the coin should also be reminded. In the same way, it may increase your expected returns. It will also significantly increase your potential losses if your trades go in the direction you were not expecting. Besides, the two are simple to use but hide considerable complexity.
As with any other tool, both financial instruments may be used for good or bad. Make sure to use each one wisely.
Franklin is a CFA Level III Candidate with 3 years of experience in Wealth Management as a Fund Research Analyst and the Host of the "Edge Over Hedge" YouTube Channel.
