A CFD or a contract for difference in full, is a contract that a seller and a buyer have between them, which states that the buyer has to pay the seller the difference between the value of an asset at the time of the contract and its current value.
CFDs are offered by brokers/sellers, alongside other types of common assets like spot metals, forex and commodities. CFDs afford investors and traders opportunities to profit from a movement in price, without owning the asset in question.
The value of these contracts doesn’t consider the underlying value of the asset in question, only the change in price between trade exit and entry. This means that there’s no delivery of securities or physical goods with CFDs.
CFDs are advanced trading strategies commonly used by traders who are experienced, and they help them avoid some of the costs and disadvantages of traditional trading.
How do CFDs Work?
This form of derivative trading allows investors to bet on whether the price of a security or an underlying asset will fall or rise. Traders can therefore make bets on a downward or upward movement. If a trader who’s purchased a contract for difference observes an increase in the price of an asset, they may choose to offer their holding for sale. The difference of their gain from the trade will then be settled via the brokerage account held by the investor.
However, if they see a decline in the value of an asset, they may place an opening sell position and purchase an offsetting trade, so as to close the position. The difference of the loss they’ve incurred from the trade will then be settled via their account.
It should be noted that in some countries like the United States, CFD trading is not allowed. They are, however, permitted in listed, OTC markets in major trading nations like the Netherlands, Denmark, Thailand, Norway, Canada, Singapore, Switzerland, Germany and the U.K. Not to worry though, you can open a trading account with us and benefit from the other legally accepted tradable securities or currencies.
What are some of the costs of CFDs?
The trading costs of these contracts includes the spread, which is the difference between the price at the time of trade and the price of purchase; a financing cost, which only applies in certain situations; and a commission, which also applies in some situations.
Usually, financing charges apply if a trader takes a long position, as these positions are considered to be investments. In these cases, traders are charged an interest on every day they hold the position.
What are some of the advantages of CFDs?
They offer a variety of opportunities. Brokers usually offer commodity, sector, currency, treasury, index and stock CFDs, which allows speculators who may be interested to trade CFDs.
Have no requirements for day trading. Some markets place limits on the number of trades in a day that a trader can make or require a specific amount of capital to trade. The CFD market isn’t bound by such restrictions, which allows account holders to trade whenever they wish to. Additionally, those who don’t have accounts but would like to participate in the market can open accounts for as little as $1000.
No borrowing stock or shorting rules. Various markets have regulations which have different margin requirements for long and short positions, require that the trader borrow the instrument before shorting or even prohibit shorting. With the CFD market, instruments can be shorted whenever desired without traders having to incur borrowing costs, as they don’t own the asset.
Provides global market access from one platform. Most brokers participating in the CFD market provide their products in all major markets around the globe, which affords interested parties around-the-clock access.
Offers higher leverage. CFDs offer higher leverage in comparison with traditional trading. Lower margin requirements also grow the chance of higher returns. However, one should keep in mind that higher leverage also increases the chance for loss.
Disadvantages of Contracts for Difference
Risks. Despite being an alternative to the traditional markets, CFD trading has margins and liquidity risks that one needs to maintain. It also needs to be monitored closely, as providers may close a trader’s position if they don’t cover reductions in value.
Traders may also have to meet the loss incurred, no matter what happens to the asset in question. Leverage risks also expose traders to higher potential profits but also losses. The use of stop-loss limits may also not guarantee that a trader will not incur a loss, especially if a sharp movement in price occurs or there’s a market closure. Additionally, execution risks may occur because of lags in trades.
Lack of regulation. The CFD industry isn’t highly regulated, which means that a broker’s credibility isn’t based on liquidity or government standing, but on financial position, longevity and reputation. This is why buyers are advised to conduct a thorough investigation on a broker’s background before they open an account.
Reduces trader’s profits. Traders have to pay the spread on exits and entries, which eliminates the possibility of profiting from small moves. In most cases, spread costs are incurred on a trader’s profits.
High-Risk Investment Warning: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to trade foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial adviser if you have any doubts.