The Basics of CFDs

A contract for difference (CFD) is the difference between when a trade is placed and when it is exited. A CFD is a tool that is tradable and it mirrors the movements of the assets that underlie it. CFDs allow for the realization of profits and losses when there is a movement of the underlying asset about the taken position. However, the actual underlying asset is not owned. In essence, the CFD is a contract between the broker and the client. There are several significant advantages to trading CFDs. These benefits have gained the popularity of the instruments during the past several years.  

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How does a CFD work

If there is an asking price of $25.26 on a stock and there are 100 shares bought at that price, then the cost of the transaction totals $2,526. With a traditional broker, with a 50% margin, the trade would need a minimum of $1,263 cash outlay from the trade. On the other hand, with a CFD broker, you are only required to use a 5% margin. The results for this trade, you would only need a cash outlay of $126.30.

Something to note is that when a CFD trade is enter, its position will show a loss that is equal to the size of the spread. For example, if the spread is 5 cents with the CFD broker, then the stock needs to appreciate 5 cents, so the position to be able to have a breakeven price. If you outright owned the stock, then you would see a 5-cent gain. But, you would have to pay a commission and have a bigger capital outlay, and this is where lies the tradeoff.

If there is a continuation in the appreciation of the underlying stock, and the stock reaches a bid price of $25.76, then the owned stock can be sold for a gain of $50, which is a 3.95% ($50/$1263) profit. Here then, the underlying stock is $25.76, and the CFD bid price is only $25.74. Because the trade needs to exit the CFD trade at the bid price, and because the CFD spread is likely to be larger than in the actual stock market, then a profit of only a few cents may be given up. As a result, the gain for the CFD is an approximate $48 or 38% ($48/$126.30) return on investment. The CFD could also require the trader to purchase at a higher starting price. Nonetheless, $46 to $48 is a real profit gained from the CFD, where a $50 profit that is owing from the stock does not account for other fees or commissions. In this instant, the CFD puts more money in the pocket of the trade.

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The Advantages:

Higher Leverage
Compared with traditional trading, CFDs provide much higher leverage. The standard leverage in the CFD market can begin with a margin requirement that is as low as 2%. Depending on the underlying asset (for example shares), the margin requirements could be as large as 20%. The lower margin requirements could mean less of a capital outlay for the traders and investors, and potentially greater returns. However, the increased leverage could also magnify losses.

One platform for global market access
Most of the CFD brokers offer products in all the market markets in the world. Therefore, traders can easily trade any market while the market is open from their broker’s platform.

The rules of no shorting rules or borrowing StockCertain market prohibit shorting at specific times, and require the trader to borrow the instrument first before shorting or have margin requirements that are different for shorting in contrast to being long. The CFD market does not have rules for short selling. At any time, the instrument is shorted, and because there is no ownership of the existing underlying asset, there is no cost for borrowing or shorting.

Professional execution that has no fees
CFD brokers present many same order types that traditional brokers do. These orders include stops, limits, and contingent orders. Contingent orders can be “One cancel the other” or “If done.” Some of the brokers offer guaranteed stops. The brokers that guarantee sti=ops that either charge a fee for this service or they attain revenue in another way.

There are minimal if any; fees charged when trading a CFD. Many brokers do not charge commissions or brokerage fees to enter or exit a trade. Instead, the broker makes money when they make the trader pay the spread. To buy, the trader needs to pay the asking price and to sell or short; the trader needs to take the bid price. Depending on the underlying asset’s unpredictability, the spread could be small or larger, even though it is mostly a fixed range.

No day trading requirements
Some markets have a minimum requirement of the amount of capital to day trade, or they place limits on the amount that day traders can earn within individual accounts. The CFD market is not tied to these restrictions, and the traders can day trade if they want. Often accounts can be opened for an amount as little as $1,000, but amounts of $2,000 and $5,000 are the most common minimum required deposits.

Variety of trading options
There are many different types of CFDs, from stock, index, treasury, commodity, and currency CFDs. There are even sector CFDs that have emerged. Therefore, the stock traders are not the only ones who benefit, the traders of many different financial vehicles are also able to see the CFD as an alternative.

The Disadvantages:

Paying the spread
CFDs may seem to be attractive, yet they can present potential pitfalls. For one, the need to pay the spread on the entries and exits can eliminate the potential to gain a profit from the small moves. The spread could also cause a decrease in the winning trade by a small amount (over the actual stock), and it can increase the losses by a small amount (over the actual stock). Even though the stocks expose fees, more regulation, higher capital requirements, and commissions for the traders, then the CFD market has a way of trimming traders’ profit through larger spreads.

Regulation discrepancy
Something to note is that the CFD industry is not well regulated. The basis of the broker’s credibility is on his reputation, lifespan, and his financial position. Even though there are many good CFD brokers, it is important to investigate whom to trade with and which of the brokers can best fulfill your trading needs.

The bottom line
Some of the benefits to CFD trading include easy access to global markets, lower margin requirements, little or no fees, and rules for no shorting or day trading. High leverage, however, magnifies the losses when they happen, and the need to continually pay a spread to entering and exit position could be costly if the large price movements do not occur. CFDs are an excellent alternative for certain kinds of trades and traders, like short and long term investors. Each will need to weigh the costs and the benefits, and then they can proceed according to what best fits in their trading plan.

Test your skills with different trading challenges
Try a stock simulator to test your skills. Make trades in a virtual environment before you begin with your capital.