What Is CFD Trading and Why Is It Important?
In the 1990s, a London-based brokerage firm called Smith New Court created CFDs in order to fulfill the needs of hedge funds who desired to short the market utilizing high leverage to place large bets.
Consequently, CFDs gave these hedge funds a means to avoid stamp duty without any actual shares being bought. CFDs then quickly garnered further attention despite still being subject to Capital Gains Tax charged on the income earned from closed contracts.
Years later, a company called GNI brought CFDs to retail investors on a mass scale through their online trading system called GNI Touch.
The ability to trade assets on the London Stock Exchange as CFDs was welcomed as volatility was the norm and long-term investments were deemed unnecessary at that time.
Over time, traders began to understand the advantages of CFD trading over traditional share trading as it is a lot more efficient trading the contracts rather than the actual shares. As CFDs are essentially a form of derivative trading – trading on the price differences of the contracts, with no physical delivery of the underlying assets, it is also a cost effective way of gaining exposure to a company stock as it requires only a small margin to purchase a CFD, as compared to a stock purchase.
Eventually, CFD offerings began to extend to asset classes like indices, commodities, treasuries, and currencies.
What is a CFD?
A CFD (contract for difference) is an agreement between parties to exchange the difference of price movements in a financial instrument –at the closing of the contract.
CFDs are derived from the difference between the opening and closing prices of an underlying share, index, currency, or commodity, and multiplied by the number of shares detailed in the contract.
In essence, with CFDs, a trader doesn’t own real shares of a company, or asset.
Instead, they just maintain the right to purchase or sell a number of shares or contracts on margin, which could result in a profit or loss for the trader, depending on the extent to which the trader’s forecasts are accurate.
This means CFD investors can reap the rewards of trading financial assets, like equities, without actually having to purchase any shares.
What is CFD Trading?
CFD trading is basically the buying and selling of CFDs. CFD trading activities enable traders to speculate on short-term price movements within different financial markets like shares, forex, and commodities – without having to own the underlying assets.
It’s also noteworthy to know that CFDs are always settled in cash, in contrast to traditional future contracts that are paid in either cash or the delivery of a physical commodity.
Additionally, CFD trading cuts across to global equities, metals, energy, and other market sectors.
Over the years, CFD trading has become a popular option for traders aiming to diversify their portfolios alongside forex or shares.
How does CFD trading really work?
CFD trading revolves around allowing investors to trade in the price movement of securities and derivatives. Derivatives are financial investments ‘derived’ from an underlying asset.
That being said, traders employ CFDs to ‘place price bets’ as to whether the price of an underlying asset, or security will fall or rise.
For example, traders who expect an upward movement in price will buy CFDs, while those who see the opposite downward movement will sell at an opening position. Because CFDs fundamentally work in a speculative format, with this two-fold mechanism, CFD traders can make a profit during both uptrends and downtrends.
For better context, if the buyer of a CFD sees their asset’s price rise, they will offer their holding for sale.
Consequently, the net difference between the purchase price and the sale price will be netted together. The resultant net difference representing the gain or loss from the trades is settled through the trader’s brokerage account.
On the other hand, if an investor speculates that a security’s price will drop, an opening sell position will be placed. In order to close the position, the trader must then purchase an offsetting trade. In the same vein, the net difference of the gain or loss will be cash-settled through their brokerage account.
Pros of CFD Trading
- CFDs allow traders to use leverage through margin. CFD investors can place a small deposit to fulfill their margin requirement, thus holding a better position than they would without leverage. As such, amplifying their returns/losses on their investments.
- CFD transactions don’t attract any stamp duty since traders don’t purchase the underlying assets nor need access to the actual stock exchange to transact.
- CFDs have no time expiry as there are no limits to how long or short you can hold a position.
- CFDs can be applied for just about any asset class. This means that any trader has an opportunity to hedge their overall portfolio utilizing CFDs.
- With CFDs, dividends are always duly paid, as owning a CFD is similar to owning shares.
- CFDs trading can occur after the market for the underlying asset is closed (after-hours).
- CFDs allow investors to short shares, thus to profit on falling markets.
Cons of CFD Trading
- Despite its pros, leveraging through margin in CFD can be disadvantageous. This is primarily because, despite traders being able to hold larger positions than they would without leverage, they can still potentially lose a higher rate, if not all of their investment.
- Incurring interest or financing charges: Since CFDs are typically traded on margin with funds borrowed from a CFD broker, interest on the margin is charged to the trader’s account.
- Despite being similar to owning shares, CFD traders have no voting rights as a shareholder would.
- CFDs are not widely available or legal in all countries. For instance, CFD trading is banned in the U.S as it is considered an over-the-counter product, and as such, does not pass through regulated exchanges.
Photo by Jason Briscoe on Unsplash
Types of CFD Products
CFDs exist in three principal categories, namely: indices, shares, and commodities/FX
Indices: Indices represent the value of a major grouping of stocks, and serve as a baseline for the group’s overall performance. Indices are classified in multiple ways, for instance, by the exchange on which they trade, by region, or a specific sector of the market.
Shares: This type of CFD is based on the stocks of individual companies, and enables traders to focus on the price movements of specific companies. Shares CFDs essentially allow investors to trade a company’s stock with lower capital requirements without owning them.
Commodities: Commodity CFDs focus on tracking the market movement of physical commodities such as platinum, oil, and copper. They are primarily impacted by shifting trends in the global demand for physical goods or energy or even geopolitical issues that affect the oil markets.
FX: FX spot trading entails trading the differences between currency pairs, instead of buying and selling of the actual currencies.
CFD Margins and Leverages
Margin and leverage are critical considerations when trading CFDs as they enable traders to deposit a small percentage of the total trade value. Consequently, these fractional deposits can be utilized as collateral to control a larger position size.
Despite CFD brokers varying in the margins, they require for different assets, typical initial margin requirements start from as low as 5% of the total value of a position (or 20:1 leverage). As such, CFDs are known as a leveraged product that is ‘traded on margin.’
However, it’s always important to remember that while trading on margin provides the opportunity to magnify returns, losses will also be magnified depending on the full value of your position. This means that a trader can risk losing all of their capital, but since most CFD accounts have negative balance protection, traders rarely lose more than their account value.
Is CFD trading safe?
Like most financial instruments, CFD Trading entails a significant level of risk, thus may not be suitable for all traders. Any speculative market that can yield an unusually high return on investment is usually subject to a heightened risk of loss.
That being said, CFD Trading requires a deep understanding of other financial markets, as well as careful consideration of one’s objectives, market experience, and risk appetite.
In some instances, traders who take risks with CFDs are encouraged to utilize surplus funds for trading that won’t negatively impact them in case of a loss.
Risks Involved in CFD Trading
- Overtrading Risk: Many traders get caught up in the excitement and tend to get sloppy with their risk management and methodologies, thus overtrading (excessive buying and selling of CFDs) and risk losing all their capital.
- Excessive Leverage: In many instances, many CFD traders are prone to using higher leverage, which significantly increases the risks of CFD trading. This is because leverage works as a double-edged sword. This means that the amount of margin initially pledged against a trading position and the total equity in a trader’s account can be depleted entirely, or become negative if excessive leverage is used.
- Market Risk: Market risks primarily revolve around price movement of the CFD traded, which can come from economic changes or even company, environmental, or political conditions.
- Technology Risk: These are risks associated with using online trading systems, such as hardware failure, software glitches, or poor internet connection.
- Liquidity Risk: This risk is typically a result of decreased liquidity of a CFD due to unforeseen economic, environmental, or political changes. Such declines in liquidity can result in “fast market“ conditions where volatile up/down patterns occur with sharp movement in prices or market gaps.
Conclusion
Using CFDs, traders can invest in disparate types of markets without having to own the actual assets or having to inject a substantial amount of capital.
Thus, instead of purchasing and selling the actual assets, CFD traders can take advantage of the efficiency and trade on the potential price changes of the assets in the secondary market.
While such trades tend to come with the aforementioned risks, having a professional fund manager that has experience utilizing CFDs to trade conservatively will help you get access to an alternative investment that can provide quality diversification to your investment portfolio.
For more information, reach out to us at Salzworth
