CFD trading is a fairly new concept that many brokers offer in addition to traditional forex trading. Trading CFD’s is ostensibly another active way to trade stocks, commodities and indices. CFD stands for “Contracts For Differences” and in short it means that you trade in the difference between the opening price and closing price of a contract. It makes it possible for you to trade in live movements of the market price of an instrument that you never actually have to own.
You can make a profit from a rising market price by going long (buy) or you can make a profit from a falling market price by going short (sell). From this perspective, trading CFD’s is a way to enable you to trade in a market value regardless of the value direction.
If you own shares in a company that you believe will lose some of its value, you can offset that loss by short selling that value using CFD’s. If your shares then decrease in value you will have offset the loss of the shares with a profit from the CFD trading. This is called hedging.
Below we have put together our top brokers for CFD trading. Further down on the page you can read more about CFD trading.
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Although gaining in popularity with day traders, CFDs are not permitted in all jurisdictions of the world. Where they are offered legally, they may trade on a regulated exchange or have a market determined by a broker and its back-office operation. In many cases, a CFD is almost like trading an option without and expiration date, although some brokers have chosen to force a point of expiration for their own bookkeeping and risk management reasons.
The net effect is that you may trade commodities, but never have to worry about taking possession of the actual asset involved. In a way, the process is very similar to what prevails in the retail forex market, where accounts are reset every evening to prevent the risk of taking ownership of a delivered currency. CFDs can be held overnight, but a broker will typically charge a fee for this occasion.
Since a market maker, i.e., broker, is generally the seller of these instruments, he can also establish liquidity on the spot, which allows the broker to offer leverage, as with forex, but limited to much lower values, usually “20:1”. Since the buying and selling only occurs between the broker and his client and no physical title of an asset exchange must be recorded, the transaction will never affect the actual order flows for a particular stock or commodity. Trading in CFDs for a specific asset will therefore not influence the valuations that the market independently determines.
Pricing Benefit in Contract For Difference Trading
The CFD is in a way like buying an at-the-money stock option, since you are buying a leveraged instrument that will appreciate or depreciate based on the direction that prices move. Since the market-maker is allowed to make his own prices, the trader may suspect that spreads are being manipulated to a degree by slippage or by benefiting from prior knowledge from delays in the process, but at the end of the day, transaction fees are lower than trading an option, stock or commodity in their respective markets. Active traders have been the first ones to appreciate this pricing benefit and recognize that it is a favorable alternative to dealing with discount brokerage houses.
The greatest pricing benefit of a CFD, however, is that you do not need a great deal of capital to play in this game. Since you do not have to purchase the associated asset at its face value, you can determine the amount of capital you want to put at risk, according to the margin or leverage offered by your broker. Actual price movements in the market over a selected period of time then determine your gain or loss, as if you had purchased the entire stock position in the market. Although leverage can increase your chances for gain, it can also magnify your losses, too. It is possible to lose more money than you invest in a given position. Margin calls are still a possibility.
Consider the following example:
Company ABC trades at $100 a share. To buy 100 shares would cost $10,000. You decide to buy 100 CFD contracts with 10% margin (or 10:1 leverage) for $1,000. The price moves to $112, and you decide to close your position with a gain of $1,200, i.e., $12 X 100 shares. For your investment of $1,000, you would have more than doubled your money. BUT, what if the stock had gone down $12? Your loss of $1,200 would exceed your invested capital by $200. Your general account would be charged for that additional amount. There would have been a margin call, and you would have to maintain extra capital to support your trade. In this case, leverage can work for you, but also against you.
For simplicity, we did not include the impacts of fees, commissions or spreads, the way your broker makes money on the deal in the first place. Some brokers charge a fixed fee per trade, along with an interest carry charge for keeping a position open over night. Some also offer “Direct Market Access” (DMA), where you can access true market Bid/Ask spreads, but only if you maintain a substantial balance in your account. The vast majority of CFD brokers, however, make their money by widening the market Bid/Ask spread. You then pay this extra amount when you buy and when you sell. Leverage may increase the effect of these charges, as well. Scalping strategies are not recommended.
What are the risks involved in trading CFDs?
Trading CFDs has become quite popular due to the availability of leveraging gains on all manner of instruments offered by our global financial markets. It is easy to think that this new trading regimen has somehow reduced risk factors, but, in actuality, the risks in some areas require more attention than traditional investment management. The risks fall into four categories:
- Market Risk: Markets can move swiftly in either direction, and prices can often gap significantly from a previous closing value. Liquidity can also cause halts in trading, wider than expected spreads, and price jumps, all of which cannot be prevented, nor foreseen;
- Broker Risk: The safety of your deposits with a broker depends upon a number of factors – capital adequacy, segregation techniques, and internal business practices. Regulatory oversight can help in these areas, but not always. Since many CFD brokers are new to the market and often operate in foreign jurisdictions, you must review your broker from time to time to ensure that it is not having financial problems, nor changing business practices in a negative way that might suggest that trouble is brewing;
- Counterparty Risk: In order to operate, a broker must have several business relationships with other business parties. If any of these counterparties fails to live up to their contract liabilities, then your broker may also have a problem. The crisis in Cyprus in 2013 was due to irregularities at the two major banks on the island, but it impacted every financial services business located there;
- Execution Risk: Lastly, we get to the one area that you can control – your own method of trading in the market. As with any other trading genre, you must approach the market in a disciplined fashion, stick to your plan of attack, block your mind from undermining your decision-making process, and resist greed from destroying your best laid plans. Your objective is to tilt the odds in your favor and produce consistent “net” gains over time, after any fees, charges, commissions, or spread impacts
CFDs offer a new way to trade, which requires less upfront capital, but perhaps more vigilance on the trader’s part to be aware of his risks. Stop-loss orders are one risk management tool to consider, but gaps in market pricing can eliminate that protection. You must still understand the potential for the underlying asset to perform. If the market suddenly trends in one direction, you have other trading options with your CFD broker. You can quickly switch to going long or shorting the appropriate stock index, wherever in the world it might be. Fundamental and technical analyses can improve your chances, too, but always follow the steps of your plan.
Are CFDs right for you? Many traders have jumped upon this bandwagon. To date, the CFTC and SEC in the United States do not officially recognize CFDs as legitimate items for investment, primarily because they are not separately traded in the market. Outside of the U.S., the broker and his CFD provider are working together to manage the odds for these new derivatives in their favor with very little regulatory oversight, except in your major markets. The advantages of lower margin requirements, leverage, access to global markets, and the lack of shorting or day-trading rules appeal to many traders.
What is the best way to proceed? The best approach is always to demo test the product, with ample due diligence performed on the applicable CFD broker in question. Start with small amounts and do not jump in with both feet until you feel comfortable with the product, understand fully how to mitigate your downside risk, and accept the various nuances defined in the broker’s trading agreement. Be clear on how leverage can benefit and hurt you, and be conscious how spreads and fees will affect your results.
CFDs are gaining in popularity as a trading instrument in many countries around the globe, but if you are interested, check for local offerings, if permitted by law, and let caution be your guide.