When it comes to investing in CFDs, there are a few things that you should always remember before making your decision. This article will cover some of the critical things you need to know before purchasing a CFD in the UK.
What is a CFD?
A contract for difference (CFD) is an agreement between two parties to exchange the difference in the value of a financial instrument between the time the contract is entered into and when it expires. CFDs are traded on margin, meaning you only need to make a small deposit. This deposit is typically just a fraction of the trade’s total value, which allows you to gain exposure to a more significant position than would be possible with traditional investing.
It would help if you considered whether you understand how CFDs work and whether you can afford to risk losing your money.
What is leverage?
Leverage is when an investment’s potential return is magnified by borrowing money to finance the position. For example, if you were to invest in a stock worth $100 using a leverage of 5:1, you would only need to put down $20 of your own money while the remaining $80 would be borrowed from the broker. Your potential return would be five times greater than if you had invested the same $100 without leverage. However, it also means that your potential loss would be five times greater.
Leveraged trading can result in losses that exceed your deposits. You should ensure you understand the risks involved and seek independent advice, if necessary, before entering into any leveraged transactions.
What are the risks of CFD trading?
CFDs are complex financial instruments that carry a high degree of risk, and the following are some of the critical risks associated with CFD trading:
The risk that the underlying asset will move against your position. This risk is magnified by leverage, as even a tiny move in the underlying asset can result in a significant percentage change in your position.
The risk that the other party to the contract will not honour their obligations is only an issue with Over-the-Counter (OTC) CFD providers as exchanges act as a central counterparty, meaning they take on the counterparty risk themselves.
The risk is that you will need more time to close your position at an acceptable price. This is typically only an issue in illiquid markets or when attempting to trade significant positions.
How can I minimise my risks?
There are some actions you can take to help minimise your risks when trading CFDs:
Start with short positions and increase the size of your trades as you gain experience.
Use stop-loss orders
A stop-loss order is an instruction to close your position at a specific price, which can help limit your losses if the market moves against you.
Manage your leverage
Using too much leverage is one of the most common mistakes made by CFD traders. Ensure you understand the risks involved and only use as much leverage as you are comfortable with.
What are the tax implications of CFD trading?
CFDs are classed as financial instruments for tax purposes, which means that anything you gain or lose from CFD trading will be taxed similarly to other investments. In the UK, Capital Gains Tax (CGT) is payable on profits above the tax-free allowance, which is currently £12,000 per year. You will be liable for CGT at 28% if you are a higher-rate taxpayer.
The bottom line
CFDs are very complex financial instruments with a high degree of risk. They are only suitable for some, and you should ensure you understand the risks before trading. Remember to start small, use stop-loss orders, and manage your leverage to help minimise your risks. Finally, be aware of the tax implications of CFD trading in the UK.