CFD trading is a common type of derivative trading where the trader speculates on the rising or falling of prices in stock indexes, or other financial instruments such as shares, commodities, treasury bills, or currency pairs. The “Contract of Difference,” or CFD is in essence the difference between the price where a trade is entered and the price where the trader makes the exit. The trader makes an agreement with a broker such as CMC Markets, to exchange the difference between the opening price and closing price of the laid down contract.
How Does CFD Trading Work
In CFD trading, the trader may either take a “long” position, betting prices will rise, or take a “short” position, betting prices for the underlying asset class will fall. The trader pays the “ask” price offered by the broker to buy, and the “bid” price offered by the broker, to sell long or short. The ask and bid prices mirror the actual price of the underlying asset, but with a margin added by the broker. The actual asset is never owned, and the entire basis of the trade is the contract between the broker and the trader.
As an illustration, if the trader enters into a CFD with a broker for a stock having an “ask” price of $35.20 and purchases 100 shares, the total value of the transaction is $3520. However, the trader needs to pay just $352, assuming the broker charges a 10 percent margin. If the underlying stock appreciates and the stock reaches the “bid” price of $35.80, the trader may sell the stock for a net gain of $60, which is $0.60 gain for 100 stocks each.
CFD brokers offer most of the same order types that traditional brokers provide, such as the ability to place stop-loss, set limits, place contingent orders, and more. Most brokers do not charge fees or commissions to enter or exit a trade, and rather make money by making the trader pay the spread.
Advantages of CFD over Conventional Trading
A big reason for the popularity of CFD trading is its highly leveraged nature. The trader needs to pay only a small fraction of the total worth of the investment. The margin requirement starts from as low as two percent and the margin rarely exceeds 20 percent, depending on the instrument.
Another significant advantage is the virtually infinite number of financial instruments or market indices on which CFDs may be executed. The trader can, for instance, speculate on the FTSE 100, Dow Jones, NASDAQ, Wall Street Index, Nikkei-225, HSI, SENSEX, USD-EURO currency pair, or anything else, as long as the instrument is offered by the broker. The trader gets all these diverse instruments from all over the world on a single unified platform, with unmatched convenience. Many of these trading opportunities are not available for conventional trading, or would require extensive and near-impossible paperwork to get started.
Another advantage of CFD is its flexibility. Unlike certain markets that have minimum capital requirements and day trading or short selling restrictions, CFD market allows the trader to trade as they wish, for amounts as low as $1000.
With CFD, the trader has the flexibility to exit the deal at the time of her choice. Many traders chose to limit their exposure at the time when there is a strong trend or undercurrent prevailing for the underlying asset class, and exit in a short time.
Many big time investors use CFD as hedging tools, as insurance to offset potential losses in their portfolios. For instance, an investor holding a stock on a long-term basis may short a CFD for the same stock, as means of insurance to factor in a likely short-term fall in price.
Pitfalls or Potential Dangers
CFD trading offers the prospects of making huge profits with minimal upfront investment, but at the same time, the losses can be equally huge if the trader makes the wrong call, or the price moves opposite to what the trader predicts. An element of risk is always inherent in CFD trades.
Also, CFD trading is not strongly regulated. There are several fly-by-night operators luring gullible traders with false promises. As such, it is important to opt for a credible broker, who has an established reputation.