What is CFD Trading (contract of difference)?
CFD or the contract of difference trading is a form of financial derivative that allows you to trade on the price movement of financial assets, without actually owning the assets. The financial assets used include currencies, shares, indices, commodities, and treasuries. The popularity of CFD trading has grown widely over the past decade following its numerous benefits to traders.
How does CFD Trading Work?
One of the main benefits of CFD trading is the fact that you can trade on margin and decide to go long (buy) or short (sell). In the UK CFDs are very tax efficient as there is no stamp duty to pay. Some traders also use CFD trades to hedge their physical portfolio.
With CFD trading, you do not buy or sell any underlying assets (such as currency pair, commodities, physical shares, treasuries, stock indices…) The trading is based on CFD units. Therefore, while trading you buy or sell CFD units for a given asset depending on whether you think the price of the asset will rise or fall.
When the price of the instrument moves (in points) in your favor, you gain multiples of the number of CFDs you either bought or sold. If the price moves against your position you make a loss.
In addition, the concept comes in two strategies, which are:
- Long Position
Long position is where you ‘buy’ the units of a particular instrument. By buying, it means you are betting on the value of the instrument to increase within the life span of the contract. If the prices of the financial asset move in your favor, you will gain CFD units of the instrument you have bought.
- Short Position
On the other hand, Short Position is where you predict that the value of given assets will decrease within the period of the contract. This means that you will ‘sell’ CFD units of the asset. In case the value of the asset increases, then you will suffer a loss. Usually, losses are calculated by subtracting the opening price of the instrument from the closing price of the instrument within the contract period.
How Much Do You Need To Invest?
Although the amount of money needed to start varies with different CFD brokers, it is mostly quite affordable. Other than that, if you are a beginner at this technique, it is highly recommendable to trade with brokers that have CFD demos. This will help you acquire trading skills quite fast.
Margin and leverage in CFD trading
CFD Trading is popularly known as a leveraged product. This means that it has a low margin requirement. That is, by investing very little amounts, you have the potential to maximize your returns. While else trading on the margin may maximize your profit, it may equally maximize your loss. Thus, it is important that you become fully comprehensive with leverage nature of CFD Trading before investing.
Why CFDs let you earn more
- A Variety of Trading Options
CFD Trading uses various financial assets, also known as instruments for trading. The assets include shares, currencies, treasuries, commodities, and sector. Traders that deal in different assets are all covered if they wish to invest in CFD Trading.
- Negative Balance Protection
In case of a loss, CFD trading has ensured that you do not lose more money than what you had deposited in your account. This regulation came into action around mid-2018 and it is effective for brokers regulated by the EU. Therefore, do not worry about overboard losses in case of any loss. However, this does not rule out the possibility of losing a trade.
- No Shorting Rules
While shorting is accepted in CFD Trading, some markets prohibit it. Such markets require you to borrow the asset before shorting it or meet a certain margin requirement. However, with CFD Trading, shorting can be done at any time and there are no regulations and requirements to be met. This is possible since the trader does not own the financial assets.
- Professional Execution with No Fees
Many CFD Brokers do not charge an additional commission fee when a trader pays the spreads. When buying, the trader pays the asked price only and when selling, they pay the bid price. However, this does not apply to CFD Shares.
- Hedging Potential
This is a risk management approach that enables you to offset potential losses. If your trade is not progressing as you intended, you can open an equivalent trade in the opposite direction. This is popular, especially for short positions.
Disadvantages of CFD Trading – read these!
On the flip side, although CFD is a popular profiting trading technique, it has its drawbacks. They include:
- Poor Regulation
Firstly, note that it is an over the counter market. Unlike centralized markets, CFD Brokers are not efficiently regulated. The reliability of a broker is based on its reputation, financial position, and longevity rather than the government standing, which is more reliable. Therefore, it is important to double-check your CFD Broker before investing.
The leveraging nature is a double-edge sword. While it may grant you large amounts of profits, it also exposes you to potentially large losses. On that account, it is not always a bed of roses.
Cost of CFD Trading
The following are the costs of:
- Spread– this is the difference between the bid price and the asked price. The narrower the spread, the better.
- Market data fee– this is a market data subscription fee paid to view price data for share CFDs.
- Commission– when trading shares, you must pay a separate commission. This cost is only for shares.
- Holding cost– this is a cost subjected to your account if there is an open position after a trading day usually at 5 pm New York Time
CFD trading example
For example purposes, let’s say a German company is trading at 88/90 (88 cents is the sell price and 90 cents is the buy price). Spread is 2 cents.
After researching the market, you think the price of the company is going to rise and decide to open a long position. You buy 10,000 CFDs (or units) at 90 cents. Depending on the broker you choose, the commission charge will vary. For this example let’s say the commission charge for trading is 0.10% (common among brokers). A commission charge of €9 would be applied as 0.10% of the trade size is 9€.
The margin rate of this German company is 3%. This means you only have to deposit 3% of the total trade value. This is called a position margin. Your position margin in this example would be 270€ (10,000 units x 90cents = €9,000 * 3%).
NOTE: If the position moves against you, it is possible to lose more than the margin of 270€ as losses are based on full value.
Scenario 1: a profitable trade
For the sake of this example, let’s assume your prediction was correct and the price moves in your favor. It is trading at 98/100. You decide to close the buy trade and sell your CFD units at 98 cents. Depending on the broker you use for CFD trading, a commission is charged when exiting a trade (usually around 0.10%). A charge of € 9.8would be charged when exiting the trade.
The price moved 8 cents in your favor. If you multiply this by the number of units you bought (10,000) and calculate a profit of 800€. Subtract the commission charge of €18.8 from your profit and you are left with a nice profit of €961.2.
Scenario 2: a losing trade
Turns out your prediction was wrong. The price of the company drops to 85/87. You decide to close the trade and sell at 85 cents (current sell price). A commission charge of 0.10% would apply (10,000 units * 85 cents = €8,500 * 0,10% = 8.5€).
The price moved against you by 5 cents, from the initial price of 90cents (opening price) to 85 cents (current sell price). The total loss for this trade would be (€8,500 (exit price) – €9,000 (entry price) = -€500 + commission at entry €9 + €8.5 at exit = total loss of €517.5
In summary, the above mentioned are features, advantages, and disadvantages. Therefore, if you have been toying with the idea of investing, now you are fully informed, and you can choose what’s best to start with.
CFD trading as a hedge for your physical portfolio
Hedging your existing physical portfolio with CFDs might be a viable solution if you think the price of your shares will decrease in the short term. By short selling CFDs of the same shares you could try and make a profit from the downtrend and recuperate any loss from your portfolio.
Let’s say you own €10,000 worth of shares of a company. You could hold the equivalent value as a short position with CFDs. If the share price falls the loss in value could be covered by the profit made on short selling the same CFD. You would then close the CFD trade to secure the profit and the downtrend of your shares comes to and end and starts to rise.
This strategy is very popular among investors in volatile markets.