This article on CFDs originally ran as issue 018 of our WTF is going on with the Economy?! Newsletter. Are you subscribed? You should be. Check it out!
Have you seen these ads?
I get them quite often on my phone. I took a screenshot of one. Check it out:
This one tells me how I can “Invest in Amazon with just 250 EUR. Calculate how much you’ll earn now!”
How could I not resist that offer?!
Anyways, I clicked on it (and a couple of others), and here’s what I learned.
What they’re selling you
Clicking on these ads takes you directly to a landing page explaining how you can “make money through investing” in the likes of Amazon, Cannabis, or Tesla.
The style of the page varies depending on the marketing style.
One had a “wall of text” filled with finance-related technical terms.
Others contained a “calculator,” asking me to input my initial investment amount. Clicking “calculate” multiplied the number by 5.5.
I filled out the contact forms to get through the gate, and it became clear how I was going to get rich: By investing in CFDs!
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What’s a CFD?
CFD is the abbreviation for “Contract For Difference.”
A Contract For Difference lets people bet on different types of investments without owning the underlying asset.
For example, you think that Amazon’s stock will do well in the next coming days.
Instead of buying shares of Amazon to make this bet, you can buy a CFD that tracks Amazon’s share price.
If your bet is right, then hey, you make a profit. If you’re wrong, you take a loss.
CFDs track almost every type of financial instrument, including stocks, indexes (like the S&P 500 or FTSE 100), futures, and commodities like oil. In finance, we categorize CFDs as derivatives as they “derive” their value from another asset.
A specific subset of investors like CFDs because they trade faster than they could with the underlying asset and allow them to make trades at any point during the day.
More importantly, CFD traders can borrow money, using what’s known as “leverage” to make bigger bets, and, potentially, earn a more substantial return.
For their trouble, brokers offering CFDs make money on lending, interest, and the difference between close and open prices.
Why you probably shouldn’t invest in a CFD
CFDs might sound great on the surface, but risks associated with them means that they’re not suitable for most people. Here’s why:
There’s no official market for CFDs
Regulated exchanges for CFDs don’t exist. Instead, Contracts For Difference trade ‘over the counter’ or “OTC.” Over the counter trading means that a buyer and seller find each other through a private venue — usually a brokerage. Because there is no market, it’s impossible to get transparent prices for CFDs.
Furthermore, because CFDs have no official market, traders can only trade with their broker. In turn, brokers make a ton of money on the “spread” or the difference between what they’ll sell a CFD and what they’ll pay for it.
Margin, interest, and getting put over a barrel
CFD brokers let traders borrow money from them to make bigger trades, using what’s known as leverage. To do so, traders open a “margin account” and deposit money. The broker then lends the trader some multiple of the deposit, letting them buy more CFDs than they usually could.
The best investors (and the ones who can sleep at night) invest within their risk tolerance. Do you know yours?
In the ad I clicked on, the “calculator” said I could have a 550% return. What that really meant was that they would let me borrow 5.5 times my initial investment in Amazon CFDs.
Remember: with great margin comes great risk (or so they say). Brokers perform what’s known as a margin call, meaning that if the CFD loses value, the trader has to top up their account.
Additionally, traders pay daily interest on their borrowed CFDs, which means that holding them for a long time gets expensive fast.
However, costs aren’t what margin traders should worry about. Borrowing money can amplify gains, but it will also multiply any losses. If a CFD trader isn’t careful, they could owe the broker many multiples of their initial investment.
Exotic jurisdictions, exotic regulatory protections
CFD brokers are adventurous types. They prefer to ‘live’ on small islands like Bermuda and Cyprus with relaxed financial regulations than in more traditional financial capitals. For the brokers, this setup is excellent since regulatory costs are low, and there’s less bureaucracy to deal with. Unfortunately, CFD traders lose legal protections since these jurisdictions favor the brokers.
The “house” and professional traders always win
If you go to any CFD brokerage, you’ll see a disclaimer about 80% or so of all contracts for difference losing value. Those numbers make sense. CFD trades happen OTC with a single broker, who acts less like a financial institution and more like a casino. And, just like in a casino, the house almost always wins.
Moreover, like currency trading, professional traders eat the little guy’s lunch. These pros watch markets and financial indicators for signals, then trade using algorithms to make money from retail traders. Good luck constantly beating them.
For most people, recognizing and mitigating these risks requires far too much financial education and time — at least if the goal is to consistently make money.
(Why)TF, are they marketing CFDs this way?
Separating chumps from their money has always been and will continue to be a robust if ethically-questionable investment model.
Brokers use big-name companies like Amazon or trends like cannabis to grab people’s attention.
In short, they’re looking for folks who know that these firms and fads are making money, but don’t understand how investing works. They want to get people to click, sign up for an account, load up on lucrative margin, then make expensive trade.
The brokers really don’t care if their clients get rich or not. For them, their business model depends on fees — it’s the nature of the business. On the other hand, investment advisors help their clients find the right investments and strategies, making money from an advisory fee. Regulators rightfully distinguish between the two.
For the record, there are plenty of legitimate brokers out there who provide valuable services. It’s always worth doing plenty of research when looking for a broker.
How to get rich from Amazon:
So how do you get rich from Amazon?
You can invest directly in Amazon stocks or a fund like an ETF that buys shares of Amazon and many other companies, getting that sweet diversification financial advisors drool over.
If you’re of the entrepreneurial type, you could also sell stuff through Amazon in some capacity. For the record, many of us here are fans of peanut butter, so there’s a market for you to service if you’re interested.
You could also try to become Jeff Bezos, although I’m not sure how that’d work out.
Whatever you do, if you see an ad featuring a lanky dude smiling and holding bundles of rubles remember this:
You’re looking at a depiction of the CFD broker after you’ve traded with him, not one of you getting rich.