Contract for Difference
What is CFD Trading?
A contract for difference (CFD) is an increasingly popular way that traders use to speculate on the movement in various asset prices. The CFD is a type of contract taken between a buyer and a seller in which the buyer is required to pay the difference between the price of the asset when the contract is opened and its value when the contract is closed. Many traders prefer using a CFD to speculate on price movements because it allows them to avoid actually owning the underlying asset. It is key to note that the actual value of the asset has no bearing on the CFD, only the change in price from the opening to the closing of the contract.
CFDs are traded directly through a CFD broker and there is no exchange involved in the trading of CFDs. The popularity of CFDs can be linked to the benefits this asset class offers traders.
How does it work?
As mentioned above, the CFD is used by traders who want to speculate on the change in the price of some asset. By entering into the contract with a CFD broker like OBRinvest it is possible to possibly profit when the price of the underlying asset rises or falls. If the trader believes the price of the asset will rise they purchase a long CFD, but if they think the price will fall they will purchase a short CFD. When they end the contract they either need to pay the price differential to the broker if the price moved against them, or they receive profits from the sale of the CFD if the price moved in their favour. However, traders will suffer losses in case where their predictions proved to be wrong.
How to trade CFDs?
Trading CFDs must be learned. Let’s look at an example to see how it works.
Assume there is a stock with an ask price of $50.52 and the trader wants to purchase 100 shares. In a traditional purchase the trader would need $5,052 to purchase the 100 shares. But if CFDs are used, the trader might only need 5% margin or $252.60.
At the time the CFD position is opened it will have a loss that’s equal to the bid-ask spread. If that spread is $0.05, then the stock needs to gain (or lose if it’s a short position(sell)) $0.05 to break-even.
If the stock rallies to $51.52 in a traditional account, the lot could be sold for a $100 profit, or a return of 2%. At the same time the CFD bid price might only be $51.50, so when using CFDs, profit is going to be smaller due to the bid-ask spread.
Due to the spreads the trader will have a $0.93 earnings per share or $93 for the 100 lot. However, because only 5% margin was required to open the CFD position the return is 36.8%. That’s a much better return and over time it may add up.
Advantages of CFD trading
In CFD trading there are a number of advantages that a trader gets over the traditional ways of trading on assets.
Higher Leverage – Due to European regulations most traders will be limited to 30:1 leverage in CFD trading, but that’s still far above the leverage available with traditional brokers. And for professionals or those outside the European Union the leverage can go as high as 400:1. Traders need to keep in mind that the Higher the Leverage is, the higher the losses they may suffer.
No Shorting Rules – Some markets have rules that prohibit shorting, or make it more difficult, but with CFDs you are always free to go short without any limitations.
No Day Trading Requirements – Some markets require a minimum amount of capital before the trader is permitted to follow day trading patterns. There is no such requirement with CFDs and traders can buy and sell as much as they like every single day.
Global Access to Assets – Most CFD brokers offer all the asset classes, including stocks, indices, commodities, and currencies (including crypto). These are also all in one platform, doing away with the need for multiple accounts in order to trade different asset classes.
Professional Execution without Commissions or Fees – While traditional brokers may charge some form of a commission or fee on every purchase and sale made, CFD brokers only gain from the spread and they almost never have a commission. And yet CFD brokers offer all the same order types and rapid execution as traditional brokers.
Disadvantages of CFD trading
As is the case with everything there are also some disadvantages to trading CFDs
Traders are Responsible for the Spread – Because traders are responsible for the spread on every entry and exit it can be more difficult to have some returns from small moves in the markets when trading CFDs. This offsets the lack of commissions and fees to some extent.
Added Risks – CFD trading exposes traders to leverage risks that can wipe out their account balances if not properly understood. There are also execution risks in fast-moving markets that can lead to unexpected losses. There are also liquidity and margin risks that some traders aren’t used to dealing with.