Last Updated on 15 October 2020 by F.R.Costa
When used effectively, a contract for difference (CFD) helps investors simplify their trading activities, in particular, when compared with conventional trading. Either buy or sell, get some leverage, pay small commissions and trade everywhere, are some of the characteristics of CFD trading.
One of the biggest differences between trading a CFD and trading the underlying asset lies on the amount of leverage involved. A conventional purchase of shares, usually requires the trader to pay the full amount resulting from the purchase price times the number of shares purchased, Eventually, he may get some borrowed funds from the broker and be allowed to trade on margin, which amplifies his available funds. But, all he can get is to double or triple his funds. The nature of a CFD is different. The trader is not purchasing the asset but instead placing a bet on the direction the price of the asset will move, either up or down. He will win or lose a certain amount per point move. The broker requires the trader to put some money upfront, but it usually translates into leveraging funds 10, 100x, or even more. Thus, by its nature, a CFD is a leveraged product.
But, leverage isn’t the only characteristic that differs between CFDs and conventional trading. Other points are worth considering:
- Global offer – CFDs providers usually offer access to many different markets, all from within a single account. The offer varies from broker to broker, but you can expect something between 1,500 and 5,000 different assets. Some may offer even more and others are willing to add new securities upon request. These assets come from a broad range of asset classes, including equity indexes, ETFs, currencies, stocks, bonds, interest rates, options, and commodities. One great advantage to an investor/trader is the ability to manage risk easily, as he can fill his portfolio with different asset classes. Still, don’t expect to find all stocks from a market, as the smallest stocks are often not available to trade. If you’re looking for niche markets, you should carefully investigate each broker’s offer to see if it matches your goals.
- Leverage – A few years ago, CFDs brokers used to offer extreme leverage. But as legislation changed, they adapted to the new reality. You can still trade on margin, even though the limits are now tighter. In my view, that’s not bad news, as too much leverage is just a quick way to loose money. Most brokers offer more leverage than you really need. Still, leverage should be an asset and an advantage over conventional trading, when used properly.
- Low Commissions – While ignored by many investors and traders, commissions are their worst enemy. Good investors always try to reduce position rotation to a minimum to avoid commissions. In many cases a roundtrip is costly and makes a big difference when you want to turn your gross profit into net profit. CFDs brokers will charge you commissions but these are often lower than what’s found associated with conventional trading. First of all, many CFDs brokers offer a wide range of products trading on tight spreads and without an explicit commission. That’s often the case with equity indexes and foreign exchange. They still earn an implicit commission on the bid-ask spread. But this kind of commission is also involved in conventional trading. For all other products, like shares, you pay a commission per trade. Some brokers charge you a flat rate, others charge you a percentage. However, these commissions are lower than what traditional brokers charge. Additionally, you may have to pay overnight financing fees for carrying open positions overnight. This is because you’re borrowing money from the broker. These financing costs are usually set as a spread over a short-term interest rate and are low. Still, if you plan to carry over your positions for prolonged periods of time, these costs may be significant.
- Easy to Understand – When opting for a CFD on a share, instead of buying that share, you’re placing a bet of some amount per point move. Let’s say you bet €10 per point move on a share trading at 225. If it rises to 240, your gross profit accumulates to €150 (15 points times €10). If it declines to 210, your gross loss accumulates to €150. You don’t really own the stock because this is a derivative product, but the cash flows involved may be similar.
- Easy to Sell Short – While we refer to short positions as the opposite of long positions, technical details and trading issues make them less than symmetric. It is a lot more difficult to sell short an asset than to buy it. Short selling an asset requires borrowing that asset from someone who owns it, which may or may not be possible. Some other restrictions exist. This is easily surpassed with CFDs. Every time you choose some asset in a trading platform, you should decide the direction you want, either buy or sell. Selling short is not more difficult than buying long.
- No Stamp Duty – You don’t pay stamp duty when trading shares from the UK using either CFDs or spread betting.
- Trade In Your Currency – Many brokers may allow you to trade assets in your desired currency. That is, every instrument is quoted in points, with points being your desired currency unit. When this is the case, you don’t need to concern about foreign exchange risk, which is a great advantage, in particular for someone willing to trade global instruments.
- Continuous Trading 24h/day – You can trade all the major equity indices, foreign exchange, commodities and some other assets in an almost continuous base, at any time. Apart from a few minutes every day and Sundays, most markets trade continuously.
CFDs are one of the most effective ways to trade the markets, giving you access to global financial markets from within a single account. However, many traders are lured by leverage, turning trading into gambling. The differences between trading/investment and gambling rarely depend on the object of the action but much more on the attitude of the person towards risk. Depositing €100 into a CFD account, in the hope to earn a few thousand is like buying a lottery ticket. There’s not much strategy involved and even less risk management.