What is CFD Trading?
A Contract for Difference is often abbreviated to a CFD and is a popular form of trading on the financial markets. A CFD is a contract or agreement which exists between a trader, who is the client, and the CFD company or broker. The agreement is to exchange the difference between the share’s price when the trade opens to it’s price when the trade comes to a close. The result will either be a loss or a profit for the investor. A CFD is traded on a margin and, like Spread Beating, a profit is able to be made not only when the market is rising but even when it is falling too as the trader actually has no ownership of the shares. In CFD trading, the investor never owns the instrument or asset that they are trading, as it is a derivative product with a value that is based on the underlying asset. CFD trading is a popular financial tool with a range of investors who appreciate the opportunity to purchase the rights to sell or buy a contracted number of shares in their chosen stock at a given price and for a set amount of time.
What is Trading on a Margin?
A trader will provide their CFD company with an amount as a deposit rather than funding the whole cost of all of their shares and this is described as a margin. The allows the investor to have access to a greater number of shares than would otherwise be available to them should they trade on the live market. The concept of trading on a margin is based on the trader only paying a percentage of the given share price. The CFD company will advertise their rate and therefore the trader will only need to front a smaller sum of money to begin with than if they were choosing to trade live on the share market. Often as small an amount as 5% of the overall share price is needed to be put down as an initial payment on the agreement. When trading CFDs, the investor is not required to actually purchase the underlying asset so they are able to hold a greater position that would otherwise have been possible when making a standard investment. CFD online trading has no set expiry date and therefore the trade can be closed whenever the investor believes the time is right to take their profit or alternatively to limit their loss should they start to lose money on the trade.
Recently ESMA has changed the leverage rules on CFD’s. Now in Europe the maximum leverage that is on offer is 5:1. Which means if a share is valued at 500p (£5) you now need 100p (£1) to hold one share. Not only this there is also a minimum amount you need to hold in your account to handle the fluctuation in price in the market movement. This varies from broker to broker. This is called the margin requirement and remember each broker will have their own.
How Does CFD Trading Work?
When trading CFDs, the investor is able to potentially make a profit whether the market moves down or up. If a trader believes that the price of the asset will rise they can “go long” (a term for opening a buy position). On the other hand, if they believe that the price of the asset will fall, they can “go short”, which is the term used for opening a sell position. The way the market performs will affect whether the trader will make a loss or a profit, and will also determine how much loss or profit will be made.
For example, if an investor thinks that their chosen market is likely to rise they may purchase a CFD for trading. The more the market rises, the greater the profit will be, however the more the market declines, the losses will also be greater. That rule is also applicable if the investor backs the market to fall – they will make a greater profit the more the market prices drop, but they will make a greater loss should the market rise further. The investor should also bear in mind however that CFDs are leveraged and therefore can result in a loss that actually exceeds the initial deposit.
Sell and Buy Prices
The CFD company quotes a two way price on the market in the same way as would be seen in the underlying asset market. This will comprise the bid price and the offer price with the difference between these figures being called the spread. Should the investor think that the market will rise they will buy at the higher offer price whereas if they believe it is likely to fall, they will sell at the lower bid price. The spread is the charge from the broker for the service of trading.
In CFD trading there is no natural expiry period. Should the investor which to close out their position they can simply place an equal value trade in the opposing direction. For example, should a trader purchase 100 shares but then the asset price begins falling they may then decide to close their position to limit their losses. In order to do this, they simply sell 100 of the same shares and accept any losses made. Some CFD companies do offer exceptions to this rule, however, such as forward contracts which have a specified expiry date at some future point. Even with these kinds of contracts, there is still no need for the investor to wait until the end of the expiry period before being released from their contract as they may simply trade out at any point before the end of the expiry date.
Which Markets Can be Used for CFD Online Trading?
There are many markets on which CFDs can be traded. These markets include:
- Foreign exchange
- Interest rates
- Stock indices
Although these are the markets that are most popular for CFD online trading, there are many more including trading on the outcome of certain financial data releases and political events as well as Exchange Traded Funds and ETCs.
What are the Advantages of CFD Trading?
There are numerous advantages to choosing to trade CFDs online. Here are some of the most popular reasons for opting to participate in CFD trading:
- Trading on a margin: As trading CFDs enables the trader to hold a greater value than they actually contribute, the investor is able to earn a greater return on their investment.
- No need to buy the actual stock: The trader never actually purchases the underlying asset. As CFDs are just a contract between the broker and the trader which relates to the underlying asset’s value, the trader never needs to have access to the exchange on which they are trading.
- No Stamp Duty: CFDs never require the trader to purchase any shares and so therefore stamp duty is never charged on trades.
- Dividends are paid: If an investor holds a long CFD position on their chosen company when the time comes for the dividend to pay out, their account is credited to the amount of the dividend. CFDs mirror the underlying asset’s value and therefore the investor holding the CFD position receives the benefit of owning the actual stock itself.
- Interest is paid: If the investor holds a short position CFD, interest is paid by the broker on that money. Had the trader sold the stock rather than purchasing a short CFD, they would have been able to make a profit from interest on the sale proceeds. However as that interest is not being earned, the broker credits the investors account to the value of the interest that they would have earned.
- Traders can profit in a falling market: When trading CFDs an investor is able to make money even on shares which lose their value when they make a correct prediction about the movement of the market prices. While this can also be done with other financial instruments, it is especially simple with CFDs as the client has no need to purchase the actual shares before selling them.
- Guaranteed Stop Loss Function: CFD trading is risky and the investor is susceptible to making a large loss should they fail to cover their options adequately. To limit and reduce the risk, CFD brokers offer a Guaranteed Stop Loss function which offers a guarantee to the trader that should their CFD reach a given amount of loss, they will close it automatically in order to ensure that no further loss is incurred.
- After Hours Trading: Many brokers permit investors to buy CFDs after market closing hours which is very beneficial to those who prefer to trade after returning home from their full time job.
- Range of assets: There are plenty of different assets to choose from when trading CFDs. All of the major stocks are listed, as are foreign currencies, sectors, commodities and major indexes. This allows the trader to create a diverse portfolio of CFD investments.
- No exercise date: In contrast to options, CFDs have no exercise date. While options generally have a lifespan of just one month, CFDs can last infinitely until the investor chooses to close the contract out.
What are the Risks of CFD Trading?
Trading any financial market has an element of risk and CFD trading is no different. The primary risk of trading CFDs is market risk i.e. if the market makes a move against the investor, their position’s value will decline. However this is the risk that any trader takes when they participate in any traditional form of trading. An added risk comes from the fact that a CFD is a leveraged product, which increases the chance of incurring large losses significantly. As CFDs are traded on a margin, the investor is able to access the entire contract value for just a small percentage of the cost, however when they make a loss or a profit, these are based on the entire contract value and not only the amount that has been paid in the initial margin. The result of this is that trading CFDs may result in a loss that far exceeds the initial deposit amount. CFD trading therefore requires the investor to have a sensible and responsible approach to risk management. Some brokers are now required to offer a no negative margin option. This means that you cannot go below the amount of of the initial deposit.
Are There any Disadvantages to Trading CFDs?
While there are numerous benefits for traders in choosing to participate in CFD trading, there are some drawbacks too. Here are some of the disadvantages of CFD online trading:
- Interest is charged: When CFD contracts are traded on a margin the broker is, in effect, giving a loan to the trader. As is the case with all kinds of loans, traders have to pay interest on that margin provided by the CFD company. CFDs are therefore most useful in short term trading as if the CFD position is held overnight the trader is charged interest.
- No ownership or voting rights: While CFDs mirror their underlying asset’s value, the aspects of ownership of the real shares is not mirrored in the same way. Therefore if voting rights and ownership are essential to the investor, dealing in CFDs is not an appropriate choice.
- High risk trading: As CFDs are traded on a margin, there is a potential for risk that is considerably more than the amount that the trader has put forward, as only 10% of the entire investment amount is necessary with the rest being supplied on margin. This means that a trader is at risk of losing 10 times the sum that they have initially put down and should they short a stock on a CFD the loss potential may be unlimited.
- Expensive Guaranteed Stop Loss Function: While Guaranteed Stop Losses are extremely useful when limiting risk, they usually are very expensive and have limited lifespan. A trader must take care to pay attention to the expiry period and to monitor the sum being spent on their guaranteed stop loss order to make sure that it is a beneficial arrangement.
- Dividends are charged: Whenever an investor opens a short position on a CFD their account is charged when the company issues a dividend. As a CFD mirrors the underlying asset’s value, dividends are taken into account. Had the trader sold the actual stock rather than using a CFD, the income would not have been received from the divided, so the resulting loss in income will also be represented in the investor’s account.