Over the years, CFD trading has become increasingly popular because of many reasons. In 2017, there was a major change in the regulations related to CFD broking. A lot of emphasis was placed on user security as more and more brokers started providing CFDs as part of their online offerings. It is, therefore, important that you work with the best CFB broker in order to succeed and have a great trading experience.
CFD stands for Contract for Difference and is a tradable contract entered into by a CFD broker and their client. Both the parties agree to exchange the difference between the current value of an asset and its value as of the end of the contract period. At this juncture, it is important to keep in mind the fact that the investors do not have to actually own the asset they are investing in.
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What Are CFDs ?
CFDs are derivatives and they enable you to speculate as to whether the price of assets such as currencies, shares, indices, commodities, and treasuries will rise or fall by the end of a specified time period, referred to as the contract period.
A CFD is a tradable instrument and it mirrors the price movements of the underlying asset. You realize profits or losses when the price of the underlying asset moves with respect to the position taken by you. However, you will never have the ownership of the underlying asset. It is this major advantage of trading CFDs that has contributed to increasing the popularity of these instruments.
History In Brief CFD Trading
Trading in CFDs was developed for the very first time during the beginning of the 1990s in London. It was developed as a kind of equity swap and was made available for trading on margin. Jon Wood and Brian Keelan are widely acclaimed as the inventors of CFD trading. Both of them are from UBS Warburg and they were involved in the Trafalgar House deal during the early 1990s.
Initially, CFD trading was used mainly by institutional traders and hedge funds for exposing their investments in stocks in the London Stock Exchange in a cost-effective manner. The main reason as to why institutional traders and hedge funds used CFD trading was that the margin requirement was very small. Another reason was that exchange of physical shares was not involved at all and this allowed traders to avoid the stamp duty, a kind of UK transaction tax.
How Do CFDs Work ?
The working of a CFD contract is best explained with the help of an example. Let us assume that the ask price of a stock is $25.26 and you buy 100 shares at this price. The total cost of this transaction works out to $2,526. If you are working with a conventional broker that allows a 50 percent margin, you would need to invest $1,263 cash in the trade. In the case of a CFD broker, the margin requirement is just 5 percent. This means that you can enter into this trade with a cash outlay of just $126.30.
When you enter into a contract with the CFD trading brokers, your position will indicate a loss that is equal to the spread. Now, imagine that the spread offered by the broker in the above example is 5 cents. This means that the price of the stock will have to increase by 5 cents in order for your position to achieve the breakeven level. If you have bought the stock outright, then you would see a 5-cent price gain, but you would have to pay a commission and invest a larger amount of money. This is where the tradeoff is.
Now, if the price of the underlying stock increases to $25.76, the bid price, you can sell it for a profit of $50 or $50÷$1263=0.0395 or 3.95 percent. At the point when the price of underlying stock is $25.76, the bid price of the CFD might only be $25.74. As you must exit the trade at this bid price and the spread is likely to be larger in the stock market, you will have to give up some of your profit. Therefore, the profit works out to $48 or 38 percent. As part of the contract, you might but the stock at an initial price of, say, $25.28. Then the profit comes down to $46. In reality, the profit may range from $46 to $48 after accounting for fees and commissions. In this specific case, it may so happen that you pocket more money at the end of the contract period.
CFD Trading Costs
When you trade CFDs, you are required to pay the spread. The spread is the difference between the ask (buy) and bid (sell) prices. You place a buy trade at the quoted ask price and exit at the bid price. If the spread is narrow, the price movement of the underlying asset needs to be less in your favor for you to make it a profitable trade. If the price movement is against you, you will lose the trade. Therefore, choose to work with brokers that offer the lowest spreads.
#2: Holding Costs
At the close of trading every day, all positions that are open in your trading account will be subjected to a charge. This fee is referred to as the ‘holding cost’. This cost may be negative or positive. It depends entirely on the direction your position takes and the holding rate that is applicable.
#3: Market Data Fees
In order to view or trade the broker’s price data of share CFDs, a market data subscription fee is involved. The relevant subscription has to be activated.
#4: Commission (applicable only for shares)
You are also required to pay a commission charge separately when trading share CFDs. The commission payable could start form 0.10 percent. It depends on whether the position has been fully exposed or not. However, a minimum commission amount may have to be paid.
Advantages of CFD Trading
#1: Higher Leverage
CFD trading comes with much higher leverage compared to traditional trading. Margin requirement, starting as low as 2 percent, is the standard leverage when it comes to the CFD market. Margin requirement goes up to 20 percent depending on which underlying asset you are trading in. Lower margin requirement translates to lower capital outlay and higher potential returns. On the other hand, higher leverage has the power to magnify losses.
#2: Access to Global Market from One Platform
Most of the CFD brokers make available products from all the major markets around the world. This means that traders can trade any market, as and when it is open, from the broker’s platform.
#3: No Borrowing Stock or Shorting Rules
Some markets do not permit shorting at specific times, require you to borrow instruments prior to shorting, or specify different margin requirements when it comes to shorting as against being long. Short selling rules are not generally applicable in the CFD market. You can short sell an instrument at any time you want. This is because you don’t own the underlying asset. Further, there is no shorting or borrowing cost.
#4: Professional Execution with Zero Fees
CFD brokers offer order types that are similar to that provided by traditional brokers. They include the limits, stops, and contingent orders like “If Done” and “One Cancels the Other”. Some of the brokers offer even guaranteed stops. Those that offer guaranteed stops either levy a fee for the service they provide or collect revenue in some other fashion.
Very few brokers, if at all any, charge a fee for CFD trading. Many brokers do not levy fees or commissions of any kind either for entering into or exiting a trade. CFD brokers make money through the spread. In order to buy an asset, you pay the ask price and to sell/short the asset you should take the bid price. On the basis of the price volatility of the underlying asset, the spread may be higher or lower. Some brokers offer fixed spread though.
#5: No Day Trading Rules
Some markets require you to put in a minimum amount of capital for day trading purposes or place limits on the number of day trades that you can execute within certain accounts. There are no conditions like these in the CFD market. You can day trade as and when you wish to do so. You can open an account for as little an amount as $1000, though some brokers often ask for a minimum investment of $2,000 or $5,000.
#6: Varied Trading Options
CFDs in stocks, indices, cryptocurrencies, bitcoin, treasury bills, currencies, and commodities are made available for trading by most CFD brokers. Even CFDs in sectors are available these days. This means that it is beneficial not only to stock traders benefit, people who trade traders many different financial instruments can trade CFDs as an alternative.
Disadvantages of CFD Trading
There is no doubt about the fact that CFD trading is an attractive option. However, there are some pitfalls as well. You need to be aware of these cons so that you can be very effective when trading CFDs.
First of all, you have to pay on the basis of the spread at the time of entering and exiting a trade. This potentially curtails your ability to make a profit if the price movement of the underlying asset is not very significant. Further, the spread decreases the profits and increases the losses by a small amount. While the stocks expose you to more regulation, fees, commissions, and higher capital outlay, CFD trading trims your profits in its own way through larger spreads.
Secondly, the CFD market is not a highly regulated market. Therefore, the credibility of a broker will depend on their reputation, financial position, and lifespan. There are a number of great CFD brokers out there in the market, but it is of utmost importance that you investigate the brokers’ credentials and then choose the best CFD broker to work with. Make sure that the broker you are planning to associate with is capable of fulfilling all your trading needs.
How Do You Choose CFD Instruments for Trading?
A CFD broker may offer a wide range of instruments for you to invest in. Now, how can you choose an instrument for trading? Many CFD traders start trading with the instruments they know very well or they choose an instrument about which they easily find information. Experienced traders may choose instruments with an aim to diversifying their trading portfolio, optimizing or manage risk, and maximizing profit potential.
When you are ready to start trading and open the first deal, here are the simple steps to follow:
#1: Choose the Instrument You Want to Trade In
Suppose you are interested in trading crude oil CFDs, then one CFD will be worth $50, for example, if the price of oil is $50 per barrel.
#2: Select Your Deal Size
Suppose the broker offers a leverage of 1:200, you can buy as much as 200 times more crude oil depending on your investment. For example, if you want to invest $100 in crude oil CFD, you will be allowed to buy crude oil worth $100 X 200 = $20,000 or 400 contracts using the leverage.
#3: Choose the Direction of the Trade
When you are trading CFDs, you must be aware that you could profit even if you believe that the price of the underlying asset is likely to go down. For example, if you strongly believe that crude oil price is likely to decline, then you should opt for a “Sell” deal.
#4: Close the Contract and Collect Your Profit
If, for instance, the price of crude oil drops to $49 and you choose to close your contract. You opened the contract at $50 and closed the contract at $49. There is a price change of $1. For 400 contracts, it amounts to a gain of $400. This means that you made a profit of $400 for an investment of $100.