CFD Trading Introduction
The Contract For Difference (CFD) allow European traders and investors to make a profit from price movement of financial assets without owning the underlying asset. The way it works is that it calculates the asset movement between the trade entry and exit. In order to trade in this way there is a contract between client and broker and it does not utilise any stock, forex, commodity of futures exchange. Trading CFDs has lots of advantages and this is why it’s popularity has increased significantly over the last decade.
How a CFD Works
Let’s for example imagine a stock has an ask price of $25.26 and the trader buys 100 shares. The cost of the transaction will be $2,526 plus commission and fees. This means that a trade will need at least $1,263 in cash at a traditional broker in a 50% margin account. Well, with a CFD broker you just have 5% margin which in our example will be $126.30. A CFD trade will show a loss equal to the size of the spread when the transaction is made. The stock will then need to gain 5 cents for the position in order for the client to hit the breakeven price. If you actually own the stock you will see a 5-cent gain but then you would have to still pay a commission and also have a much bigger capital at disposal.
Let’s say that the stock get to a bid price of $25.76 in a traditional broker account. In this case it can be sold for a $50 gain which will work out to be around 3.95% profit. However when the national exchange touch that price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader will need to exit at the bid price and the spread is bigger than the one on the regular market. In our example the CFD trader will earn around $48 which is 38% return of investment. So in the CFD trade you get a net profit while the $50 profit from owning the stock doesn’t include commissions or other fees which means more money will be in the CFD trader’s pocket.
The Advantages of CFD Trading
CFDs allow higher leverage compared with traditional trading. The standard leverage in the CFD market is at 2% margin and can go up to 20%. Lower margin requirements means that the trader need to place less initial investment. On the flip site if things goes badly it will magnify losses.
Global Market Access from One Platform
Many CFD brokers allow to access the world’s major markets, every time and from a single trading platform.
No Shorting Rules or Borrowing Stock
Some markets have rules that do not allow shorting and that require the trader to borrow the instrument before selling short or have other margin requirements for short and long positions. CFD instruments have no limitations in this sense and can be shorted everytime without borrowing costs. This is possible because the trader do not actually own the underlying financial asset.
Professional Execution With No Fees
CFD brokers allow lots of different executions like traditional brokers like stops, limits and contingent orders like ‘One Cancels the Other’ and ‘If Done’. Because CFD’s brokers make a profit when the trader pays the spread they don’t need to charge any commission sor fees of any type. In order to buy the trader has to pay the ask price and in order to sell/short the trader must pay the bid price. The spread can change depending on volatility of the underlying asset and there are also fixed spreads available.
No Day Trading Requirements
There are some markets that require a minimum amount of capital to day trade or they do put some limites on the amount of day trades that can be done with some accounts. The CFD market do not have any restrictions and every account holder can trade whatever they want. Accounts can be opened with just $1,000 and some CFD’s brokers also allow lower minimum deposits.
Variety of Trading Opportunities
CFD brokers offer stock, index, treasury, currency, sector and commodity CFDs so for traders there are a huge amount of opportunities to trade.
Traders Pay The Spread
Even if CFDs are a very good alternative to traditional markets they do have some disadvantages. The first one is that you have to pay the spread on entries and exit and this means that you will not be any profit from small moves. The spread will also overtime decrease winning trades overtime and will increase losses by a small amount. So while in the traditional markets trades need to pay fees, regulations, commissions and have higher capital requirements, the CFDs trims traders’ profits with spread costs.
Weak Industry Regulation
The CFD industry is not as regulated as the traditional market. It is important to ensure you are getting a reputable broker that has been established for a while and has a strong financial position. There are very good CFD brokers out there but it is important to investigate brokers before opening an account and invest money.
The Bottom Line
So to recap the main advantages that CFDs trading has compared with traditional markets is that they do have lower margin requirements and provide a very easy access to global markets. In addition to this there are no shorting or day trading rules and normally no fees are charged. On the flip side the disadvantages of CFDs trading is that the high leverage can magnifies losses and also that you will have to pay a spread to enter and exit positions: if large price movements do not occur this can result in high costs.