The world of forex, shares, and index trading is fast changing. Today, with the advancing technology and efficient internet, investors can engage in online trading right in the comfort of their homes. Have you heard of CFD trading? Wondering where you can start to venture into this industry?
It takes a lot to understand what is in CFD trading, but in this article, we make it simple for you. We will explain what CFD trading is, its merits and risks, and what is involved in the process. Stay put on learning more about this venture before you start trading.
What Is CFD Trading?
CFD trading is the buying and selling of CFDs. CFD is an abbreviation for Contract for Difference. A CFD is a derivative product, allowing to speculate on a financial product like currencies, shares, and other commodities without owning the assets.
A CFD is an agreement between two parties, a seller and a buyer, indicating that the buyer should make some payments to the seller equal to the difference between the face and market values of an asset. When trading on CFD, you benefit as a seller from an asset’s price fluctuations without having to primarily own the asset.
How Does CFD Work?
When trading on CFD, you agree to exchange the difference in the price of an asset from the point of opening to closure. One advantage of CFD trading is that you are free to speculate on price movements or changes in whatever direction. You can make a fortune when you are good at predicting price changes.
You make a loss or profit in CFD trading depending on your accuracy in forecasting. Something worth noting is that the value of a good CFD contract does not depend on the value of an asset but the price change at a trade’s entry and exit.
CFD trading is mainly accomplished through a contract between the client and the broker: it does not utilize any stock, commodity, forex, or futures exchange. Trading CFD has many benefits that have made most financial instruments popular in the past decade.
Today, it is not that difficult to find a platform where you can trade CFDs, with many platforms ready to take you in as an investor or online trader.
The idea behind CFD trading is not that difficult but may look complex to a beginner. Simply put, CFD trading involves a buyer or seller paying the other party, through a clearing house, the cash difference between an asset’s opening and closing values. Both parties stick to a payment direction as indicated by a trader’s P&L account.
Example of CFD Trading
If you buy a CFD contract, and the price of this contract shoots above the entry price, you make a running profit. Now, if you sell the particular contract, you gain the cash difference between the closing and opening prices.
Alternatively, you will incur a loss if you buy an index contract and the price of this contract moves against your odds or falls way below the opening level. Suppose you decide to close the position at this point. You will make a loss. You will have to pay the other party a sum of cash equivalent to the difference between this trade’s opening and closing prices.
The cash difference is multiplied by the number of contracts or the lots you have traded to establish the final value of the payment due.
Being more informed about the finance market makes you smart in decision-making, increasing your accuracy in forecasting price movements but never eliminating risks, though.
CFD Trading on Leverage and Margin
You can leverage CFD trading or simply trade on a margin. This means that a deposit by a trader is magnified or geared by the broker. It allows a broker to control a large amount of an underlying instrument that any unleveraged deposit will not permit.
For instance, let’s say you wanted to open a trading position that is equivalent to 500 shares of a company. With the prevailing share price, it would mean that you have to pay the full cost of the shares upfront. Now in the case of CFD, you will only be required to invest up to 5% of the total cost.
This may be one reason CFD has become popular in the financial markets today. For instance, by the mid of the new millennium’s first decade, research has shown that at least 50% of the daily turnover in the London Stock Exchange was primarily driven by CFD trading.
In most cases, brokers would charge interest fees on their clients to provide leverage. However, this would only happen if the positions were held overnight as day traders paid no financing charges.
What Are the Advantages of CFD Trading?
Here are some of the reasons why you should consider CFD trading today:
1. High Leverage
Most traders would opt for CFD trading because it offers higher leverage than traditional trading. In the CFD market, standard leverage is normally subject to restriction. The current standard leverage is at a range of 3% or 30:1, and it could shoot to 50% or 2:1 leverage in coming years.
A lower margin requirement means less capital outlay and a higher return on investment. Alternatively, increased leverage can also magnify your losses as a CFD trader.
2. Access to a Global Platform
Another reason why you should consider CFD trading is because it gives you access to a global market. Most CFD brokers will offer products in the leading world markets. This grants you all-time access to different markets.
3. No Rules To Prohibit Shorting
Certain markets come with rules to prohibit shorting. The platforms require a trader to borrow an instrument before selling short. They may also have different margin requirements for long and short positions. CFD instruments allow you to short any time because a trader doesn’t own the underlying asset.
4. No Minimums on Day Trading
Some markets limit the minimum amount of capital you can trade or the number of day trades you can make on a specific account. With CFD trading, there are no such restrictions, and you can trade using your account the whole day if you want to. However, there are minimum deposits you are required to pay before you can start trading.
5. Access to a Wide Range of Trading Opportunities
When you venture into CFD trading, you have access to various trading opportunities. Most CFD brokerage platforms offer index, stock, currency, treasury, commodity, and sector CFDs. Therefore, if you are interested in different financial instruments, you can trade in CFD and make some money.
What Are the Disadvantages Of CFDs?
1. No Strict Regulation
The CFD industry is not highly regulated in most countries. Some countries don’t permit CFD trading because of poor regulation. That said, when choosing a CFD broker, you are most likely to look into their years of service in the industry, reputation, and financial position instead of their liquidity and government stand. Before opening an account with a CFD broker, you should find out if they have a good reputation in the industry.
2. High Risk
CFD trading is a high-risk venture that requires close monitoring. Therefore, when you want to invest in CFD trading, you should research widely and beware of all the risks involved in trading.
You have to maintain margins and liquidity risks to make money as a CFD trader. Your provider may close your position if you can’t cover value reductions. If there is a market closure or steep price movements, you will likely make huge losses. There is no guarantee that you won’t suffer losses, although some CFD providers may offer stop-loss limits to caution against the loss.
3. Spread Costs
You will pay for the spread as a trader when dealing with CFDs. The spreads present a pitfall because, as a trader, you have to pay for a spread on entries and exits, reducing your chances of making money from a small move. A CFD will trim your profits through spread costs just like a traditional market does through regulations, commissions, and fees.
There are many benefits of CFD trading, as explained above, which makes it a popular venture today. With CFD trading, you have easy access to the global market, a low margin requirement, no shorting rules, no fees, and commission.
However, with little or no government intervention in global CFD trading, it is riskier than traditional trading. If you plan to venture into this activity, you should subscribe to a reputed regulated broker to reduce your financial risks and increase the chances of making profits.
*Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. **The vast majority of retail client accounts lose money when spread betting and/or trading CFDs.** You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
*Marketing for CFDs and spread betting is not intended for US citizens as prohibited under US regulation.