Published On: Wed, Nov 7th, 2012

Trading Penny Stocks with CFDs: Risks and Opportunities

Generally speaking CFD companies will concentrate on offering CFDs on stocks in major companies. The rationale behind this is not difficult to understand: shares with a large market capitalisation are usually more liquid than stocks of small, relatively unknown countries. Having said that, the odd penny stock now and again makes its appearance in the world of CFD trading.

Why not buy outright?

The following question inevitably arises: Penny stocks are cheap, so why not buy them outright instead of through a derivative such as a CFD? The answer lies in a single phrase: unrealised profits and losses. Unlike with shares, CFDs are ‘marked to market’ each and every day.

This means the profits (or losses) will be credited or debited to the trader’s account on a daily basis. With a stock this only happens when the trader closes the deal. Realising profits/losses on a daily basis allows the trader to use unrealised profits to enter into new positions without the need of depositing additional funds into his or her trading account.

Of course this also works the other way round: unrealised losses have to be funded by the trader when they occur – not only when the stock is sold.

Benefits of CFD trading on penny stocks

Is trading on a penny stock with CFDs any different than trading with on blue chip shares? What are the opportunities and risks?

CFD trading on a speculative stock can be remarkably profitable if the trader selects his or her shares carefully. When buying (or selling) CFDs on penny stocks one should first do some homework. The minimum is to research the company to make sure it has first-class management and a product or service, which should fare well in the marketplace.

A very small movement in the price of a penny stock can result in a large profit for the trader. A $0.01 price increase in a stock with a market value of $1 equates to a 1% move. On a CFD with a 100:1 leverage ratio, this means the trader can double his or her money with a $0.01 increase in the share price.

Risks involved

The benefits discussed above could also mean disastrous losses to a trading account if the price of the underlying share moves in the ‘wrong’ direction. In the example above, if the price of a $1 share drops 1 cent to $0.99 and the trader owned CFDs with a leverage of 100:1 on that stock, this will wipe out his or her initial investment.

Brokers are well aware of the increased risk levels of CFDs on speculative stocks, hence they normally require higher margin deposits on them than is the case with CFDs on blue chip shares. Some penny stocks might even require a 100% margin deposit, but the bulk hover around 75%.

It is recommended that a trader finds a broker who only charges financing on the borrowed amount, not on the full notional value of the open position.

Profiting from CFDs on penny stocks

There are undoubtedly golden opportunities out there on CFDs on penny stocks.
The successful trader will be the one who first investigated the company and who diversified his or her portfolio to spread risk over more than one position.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.