What is CFD Trading?
For active investors, trading stocks has one major disadvantage – going short is not that easy. For private investors, is involves selling shares that they don’t already own. Nonetheless, with CFD trading, going short is as easy as going long.
What are CFD’s?
CFD stands for ‘contract for difference’ which is a popular type of derivative trading. It enables the investor to speculate on the rise or fall of prices of fast moving financial instruments or markets such as indices, shares, commodities, treasuries, and currencies.
It’s ideally an agreement between two parties to exchange the difference between the open price and the close price of the contract, at the closing of the contract, multiplied by the specified number of shares under the contract. As such, the CFD itself has value – the product of the number of shares within the contract and the price of the underlying shares.
How CFD Trading Works
With CFD trading, you don’t actually buy or sell the underlying asset (such as a physical currency pair, share, or commodity). You only buy or sell a given number of units of the underlying instrument based on your thoughts on whether the price will go up or down. For every point the price moves in your favor, you will be gaining a multiple of each CFD unit you have bought or sold. And you will make a loss for every point the price moves. Keep in mind that here, the losses can exceed your deposits.
The main advantage with CFD trading is the investors don’t have to pay the full price of the underlying value of the contract, and only need to deposit some collateral (as margin), generally 20% of their total investment. This way, when the trader wants to buy a CFD contract that amounts to $10,000 worth of shares, the minimal amount required would be $2,000.
Since the CFD providers might have to take a protected or hedged position in order to counter the position opened by the client, it’s quite uneconomical to deal in the shares of illiquid companies. This makes most CFD contracts to be limited to the shares of bigger companies. Plus, the brokers generally don’t offer CFD services for smaller transactions because they are not profitable for them.
The advantages of CFD trading
One of the most obvious advantages is providing exposure to the share’s performance of a company without having to own the actual shares, or taking physical delivery of shares. Since no share transfer takes place, CFD don’t attract stamp duty. Furthermore, with CFDs, there is no requirement to own a stock in order to sell, thus opening a trading avenue that can be more profitable compared to the traditional directional share trading.
It’s also quite appealing that with CFDs, you can leverage your investment. Most brokers usually work on a 20% margin, meaning that the private individual can trade $100,000 with a margin or a down payment of only $20,000. The investor can therefore to a full portfolio of shares without tying up huge amounts of capital. However, leveraging will only be a good thing if the price goes your way. If a trade goes against you, the losses will be magnified.
Clearly, CFD’s offer significant opportunities for a private investor. Nonetheless, they come with a high degree of risk compared to the traditional shares trading. For this reason, proper education and expert advice are crucial.