What is CFD Trading?
CFD trading is a term used in trading markets referring to Contract For Difference, which is the agreement between two entities to exchange the entry and exit process of a trade. The contract for difference mirrors the underlying asset making it a tradeable instrument. Therefore as a CFD trader, you will make a profit or loss when the underlying asset moves in relation to the position you take even though you do not own the actual asset.
CFD trading is often a contract between clients and brokers. You do not have to buy or own the underlying instrument, and you just trade on what you expect to be its price movement. With CFD trading, you can profit from falling prices by either selling or offsetting potential losses in your investment by hedging your portfolio. You can find so many markets to trade and CFD allows you access a higher level of exposure in trading. You can deal with CFD is shares, forex currencies, commodities, indices and many more.
How CFD Trading Works
Going long or short
In CFD trading, you can choose to sell, go short, if you predict the market price will fall or buy, go long if you predict that the market prices will rise. If you sell, your profit increases with any fall in that price, even if it is just by a couple of cents. However, if the market moves against the position that you take, your loss will also increase. CFDs enable the trader to benefit from any move whether the market process is rising or falling.
You can use CFD to hedge your current trading portfolio. If you predict that your portfolio will lose some of its value, you can go short on your CFD to offset the loss. An example, if you own $300 worth of shares in a certain company and predict that the price of these shares will fall, you can go short on the equivalence of $300 CFDs. Therefore, whether the prices of these shares eventually fall, whatever losses you make in your shares will be offset by the profits you make while going short in your CFD trading. As an investor, CFD can be very valuable for hedging in volatile trading commodities.
CFDs can also be tax efficient for offsetting Capital Gains Tax Liabilities in losses. However, this depends on your circumstances and you need to get independent investment advice.
With the nature of CFD trading, it is important to have your eye on the markets on a 24-hour basis. You can trade whenever you want, 24 hours a day, seven days a week. In the volatile markets, prices move very quickly and 12 hours could make a world of difference.
Margin and Leveraging
Margin refers to paying a portion of the total value of the trade to open your position in the CFD. This kind of leveraging in CFD trading helps to magnify returns on investments. This is because the full trading exposure is more than the portion deposit you made to open your position. The only risk is that losses are magnified in the same way if the market moves against your position. In fact, you stand to lose more than the capital you put in. It is important to have risk management strategies in place when it comes to margin and leverage.
Cost of CFD trading
Various costs are involved in CFD trading. They include:
The spread: In any trading market, you need to pay the difference between the buying and selling price, which is called the spread. CFD trading is no different. The cost of the spread depends on how narrow the differences between the entry and exit prices are.
Narrow spreads mean you only need the price to change slightly in your favour in order to make a profit.
The holding cost: Any positions still open in your account at the end of the trading day may be subject to a holding cost. The end of the trading day is usually 5 O’clock New York time. The holding cost is negative or positive depending on the holding rate and the direction of your position in the CFD.
Commissions: If you are trading in share CFDs, you may be required to pay commission charges.
Benefits & Risks of CFD Trading
There are many reasons why Contract for Differences has become a popular tool for trading over the years. CFDs are slowly replacing traditional stock trading as most people consider them cost-effective, flexible and transparent. Let’s look at the main advantages, along with some of the risks of CFD trading.
The Benefits of CFD Trading
Easy to understand: Contract for Difference (CFD) is a very simple to understand the trading instrument. This is especially true for investors who are already familiar with share trading. This is because the prices of shares and the price of CFD usually move together. You just need to understand these price movements.
Get profits in volatile markets: With CFD trading, you can benefit from any market conditions. You can make huge profits when the markets fall by going short. You can do this by selling a CFD on a share that you do not own. When the market conditions are not so good CFDs allow you to make profits and the good thing is that they do not have expiry dates like other financial instruments such as stock options.
Low commissions and margins: Compared to stock trading, where the broker requires you to pay the entire amount for the transaction, CFD trading has very cheap commissions. You are only required by the broker to deposit the amount required for the deal. In most cases, this amount is much less than 10% of the total cost of a transaction.
Convenience: A single CFD trading account can be based on stocks, commodities or indexes. You are the one to choose the type of underlying asset you would wish to invest in.
Hedge other investments: Another benefit of CFD trading is that it can help you to protect your portfolio in case of price drops. The fact that you can go short or long whenever you find it suitable allows you to ensure your assets against poor market conditions. If you have a long-term portfolio that has been exposed to some short-term risk, you can use a CFD to hedge your position. This means that the returns you get from your CFD can cover for any losses in your portfolio.
Choose from thousands of financial markets:With CFD trading, you are able to choose from thousands of financial markets. You can invest in commodities like gold or oil as well as equity and currencies on the Forex market. You are even able to access markets such as stock indices and interest rates that are usually unavailable to retail investors.
Leverage your returns:CFDs can allow you to make significant gains with less cash as an initial investment. You can trade on the markets having a deposit that is significantly lower than the value of your trade. You are only required to pay a certain percentage of the total transaction as a margin deposit which makes it affordable to most retail investors. This ability to trade with leverage is what makes CFD trading a lucrative financial instrument.
Risk management:Even the best investors will always find themselves at situations where their speculations were wrong and the markets are moving against them. CFD trading can help you to manage risks effectively and stop losses or limit the impact they have against you.
Check out our review of one of the leading CFD Trading software’s, Plus500, to see if it is any good.
The Risks of CFD Trading
Although there are as we have said, a number of benefits to trading in CFD’s, there are of course risks.
Not Suitable for Long-Term Investment
CFD’s are not suited for long-term investment. By holding a CFD open for a long period of time, you will see the associated costs involved, increase. This will have a negative effect on the return you could expect.
A counterparty is a company that provides the actual asset in the CFD trade. Whenever buying or selling CFD’s it is the asset that is actually being traded in the contract provided by the CFD provider. What this means is that you are exposed if the counterparty fails to fulfill their financial obligations. In the event that the provider is not able to meet their financial obligations, the value of the asset is no longer relevant and becomes worthless.
Just like any other type of investment, i.e. shares or forex, the value of your trade is completely dependent on the movement of the market. Because of the nature of CFD’s, even the smallest movement in the market can have a huge impact on the returns obtained. If there is a negative effect on the value of the asset, the provider may request what is known as a second margin payment. If this occurs and the margin payment can’t be paid, you may have to sell at a loss.
In the event that there are not enough trades being made on a particular asset, your contact may result in becoming illiquid. What this means is that the asset can’t be sold or exchanged easily without there being a substantial loss in the assets value. If the asset happens to become illiquid, the CFD provider could require additional payments or close contracts at a lower price.
There are further risks so it is important to remember that CFDs are in fact a leveraged product. This means that the result you get could be the loss of your entire capital. Trading CFDs is not for everyone, in fact if you are a beginner in trading, it may be best to get trading experience first before dealing in CFD’s.
It is important that you note that CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money