The difference between where a trade gets entered and the point at which the trade is exited is called the contract for difference or CFD. A CFD is a trading instruments which mirrors the movements of the assets it relates to. In order for profits or losses to be realized when an asset moves, the underlying asset may never be owned specifically. It is, instead, a contract between the broker and the client. There are many advantages to treating like this and over the last several years it has increased in popularity.
How a CFD works
If there is a stock which currently has an asking price of $25.26, and somebody purchases 100 shares at this price, they have to pay a transaction of $2526. In order for your position to reach a break even price point. Using a traditional broker and a 50% margin they would have to have at least $1253 cash outlay as the person making the trade. Using a CFD broker, however, you need to have only 5% margin not 50%. So you can make this trade with a cash outlay of just $126.30. When a CFD trade is entered, the position shows a loss which is equal to the size of your total spread. If you are the owner of that stock out rights, you would see a 5% gain. So should your total spread be five cents, the stock will have to appreciate but you would still have to pay a commission and have a larger capital outlay. This is where that trade-off comes into play.
If your underlying stock continue to appreciate and the total bid price reaches $25.76, the stock you own can be sold for a $50 game or a total profit of 3.95%. At this point your underlying stock is valued at $25.76 but the bid price as a CFD could reach $25.76. Because of the fact that the trader has to exit the CFD trade at this bid price, the spread for your CFD is larger than the actual stock market and you get a few cents in profits out the window. So the CFD return on your investment is actually $48 or 38%.
Advantages to CFD’s
The biggest advantage to investing with CFD’s entire leverage. CFD’s give you higher leverage compared to traditional trading. The standard leverage start as low as 2% margin requirement. Contingent upon the type of underlying asset this margin requirement could reach upwards of 20%. The lower margin requirements means that you do not have to put down as much capital which means that you have a greater potential return. However, it does mean you increase your potential losses.
You also get global market access from a single platform. Many CFD brokers provide products in every major market around the world which means that you can easily trade on any market from your broker platform. You also get professional execution without all the high cost. CFD brokers provide many of the same order types as a traditional broker but they will not charge the same fee or get revenue from you. Very few fees are charged if you make a CFD trading. Most brokers do not charge commissions or charge you a fee to enter your trade or exit your trade. The broker makes money by making you pay for the spread.
There are no day trading requirements. This means that the CFD market is not bound by any restrictions and you can trade during the day if you want. You can even open your account for as little as $1000 as a minimum deposit. Moreover, you can enjoy a variety of trading options such as commodities, indexes, stocks, and get many benefits associated with different financial vehicles.
Disadvantages to CFD’s
There are a few pitfalls associated with CFD’s. The first is having to pay the spreads for your entries and exits is what eliminates your potential to profit from incremental moves. This spread also decreases your winning trades by a slightly smaller amount and increases your losses by a slightly smaller amount. The CFD industry is also not one which is highly regulated. For this reason each broker is someone you want to investigate heavily. The credibility of your broker is based upon financial position, reputation, and lifespan. There are many great brokers out there but you have to figure out which one fulfills your needs before you start trading with them.
The bottom line is that when you trade with CFD’s you get lower margin requirements, you have easier access to international markets, you pay little to no extra fees, there are no day trading goals, all of which can make it very attractive. However there are high leverage issues which magnify your losses if and when they take place but it is up to you to determine what makes the investment worth the risk and what doesn’t. CFD’s are an excellent alternative for specific types of trades especially people who prefer short-term or long-term investments but as an individual you are responsible for weighing the costs and the benefits associated with different types of trading before you get involved. You have to figure out what works best with your particular trading plan before you hire your broker and start spending your money.