Trading Stocks With Cash Account? Or Alternative Instrument?

Most people have the wrong idea that stock trading is a rich man’s game and requires a large capital to begin with. This is absolutely a misconception!!

In my definition, the rich can temporary manipulate the market the way they want it to be and we, the commoners, will simply follow suit with what the big boys do. Large capital is not necessary to build your investment portfolio given that we have a new instrument type called CFDs (Contract for Difference) available in today’s market.

CFDs enable investors to pay only a fraction of the contact value amount with indefinite time frame. Furthermore, you are allowed to long or naked short any counter in any market situations. Therefore, giving us the opportunity to profit in whether a bull or bear market. Before you rush off to open a CFD account, please ensure you have fully understood the instrument CFDs, the benefits and risks involved when trading with CFDs.

Know The Instruments You Play At Your Fingertips

You need to know the risk involved when playing with CFDs. CFD is often accompanied with margin trading, hence, to a certain degree, they carry a higher risk than trading in cash market. When you borrow for bad investments, the consequences may not only make you lose all your own capital, you might end up owning a debt as well. So what exactly is a CFD?

In layman terms, buying shares on margin is akin to borrowing money through a margin loan to buy stocks. It is the same logic as buying a house using a mortgage where you are not required to pay the full purchase price in advance, rather, only a down-payment.

Let me give you an example. Let’s say you have $10,000 spare cash for investment. You decide to play on margin since you only need to pay a fraction of the contract value amount unlike normal cash account. You went on to buy Stock A which is priced at $10.52. It has a 10% margin and you decided to buy 2,000 shares.

Contract value = 2,000 x $10.52 = $21,040

10% margin = $21,040 X 0.10 = $2,104

Instead of using $21,040 to buy Stock A, now you only need to use $2,104 to buy Stock A. In margin trading, you get to maximum your money value compared to trading via cash account where you are required to pay $21,040 on due date. Apart from gearing, the plus point is that you get to put your money into better use.

Drawbacks

As margin trading is considered high risk, if ever your investment starts to lose its value or even ends up worthless, you are likely to face a margin call. Using the same example, let’s see the difference in terms of the percentage losses/gains if you trade on margin and cash account.

Scenario 1A

Suppose Stock A issues profit warning and stock starts to plummet. You purchased at $10.52 but it is trading at $10.10 now. Assuming you have not exited at $10.10.

On Margin

Paper loss = ($10.52-$10.10) x 2,000 = $840

Percentage loss = ($840 / $10,000) x 100% = 8.4%

On Cash Account

Paper loss = ($10.52 - $10.10) x 2,000 = $840

Percentage loss = ($840/ $21,040) x 100% = 3.99%

Scenario 1B

Stock A is performing well and making new highs. It is trading at $11 now. Assume you are still in position.

On Margin

Paper gain = ($11 - $10.52) x 2,000 = $960

Percentage gain = ($960/$10,000) x 100% = 9.6%

On Cash Account

Paper gain = ($11 - $10.52) x 2,000 = $960

Percentage gain = ($960 /$21,040) x 100% = 4.56%

Your percentage returns while trading on margin is bigger since margin trading helps to magnify your potential gains; likewise, it magnifies your losses too.

In Summary

Remember, margin trading is a double-edged sword. It cuts both ways. Know your risk appetite and risk accordingly to your tolerance level. Please do not be greedy and borrow up to the maximum. Only invest with your disposable cash and ensure you have the cash flow to cover repayments should the investment fail you. Last but not least, know the cost of holding a CFD position overnight and always check your spreads before entering your trades.