What is a CFD (or Contract for Difference)?
A CFD is a tradable instrument that mirrors the movements of the asset underlying it. It allows for profits or losses to be realized when the underlying asset moves in relation to the position taken, but the actual underlying asset is never owned. The difference between where a trade is entered and exited is the contract for difference (CFD).
CFD trading (contracts for difference) requires signing up to a CFD broker. Some examples include CFD brokers at tradingpedia.com or Hantec Markets. There are significant differences, however, and it is important that you distinguish between them. Here are some of the main points to consider and this information should hopefully educate you in understanding more about the aspects behind investments in CFDs.
One reason CFD trading is popular is because it offers the ability to leverage your investments, meaning you can trade significantly larger volumes with a fraction of the capital that would normally be required.
For example, if a stock has an ask price of $50 and 100 shares are bought, the cost of the transaction is $5,000. With a traditional broker (using a 50% margin), the trade would require at least a $2,500 cash outlay from the trader. With a CFD broker (which usually only require a 5% margin), the initial cash outlay would only be $250.
This allows you to make much greater profits in a far shorter period of time. The catch, of course, is that this can amplify your losses as well, so you could end up losing more than your initial deposit. Therefore, it is advisable to only leverage your investment to a level you can afford, and avoid big risks on investments.
The ability to go long or short with CFDs is another benefit enjoyed by those involved in trading them. This means you can profit from a market moving in either direction, depending on what position you take. Therefore, CFD trading is flexible to the needs of the trader, opening up different avenues for investment.
You never actually own the asset you are investing in, and instead are guessing on its market movements. In many ways, this makes CFDs more practical than traditional market investing, as you can flit between markets and swiftly switch between buying/selling a CFD for any given asset.
3. Range of Markets
Not only can you invest in markets which are traditionally more difficult to trade in, but you can diversify your investments to reduce overall risk. This means you can invest in a market which suits your trading style, and potentially see better returns on those which are traditionally steadier.
Since every market has its own trends and behaviours, each necessitates a good level of research to maximize the chances of investment success. If you are an experienced trader, you can quite easily switch to CFD trading in a market you already know inside out, while using higher leverage if you are confident in your investments.
4. Tax/Commission Benefits
On top of higher potential returns from leverage, you will also save money on profits, owing to the tax exemptions for CFD trading. Unlike regular market investments, profits from CFD trading are not subject to Stamp Duty or Capital Gains Tax. This allows you to take all of your profit if an investment comes through.
On top of this, the commissions charged by CFD brokers are usually significantly lower than those charged by traditional brokers. Therefore, successful CFD traders stand to make a lot more money overall, since they will have more capital to reinvest if investments bear fruit.
5. Risk Management
The most significant disadvantage to counterbalance the array of advantages offered by CFD trading is the risk involved. Markets are unpredictable at the best of times, and even experienced traders can lose a fortune to bad luck.
As previously mentioned, this can be limited by reducing leverage, but there is also the possibility of putting down a stop loss order on CFD investments, which will instruct the broker to close your position at the next available opportunity. The best risk management, however, is being wise with investments, and doing extensive research on markets to have a clear idea of their most likely movements.
Is CFD Trading Right for You?
CFDs can be a good investment for the right person, but you need trading discipline to ensure your investments are well informed and your risks are appropriately managed. You must keep an eye out for leverage and choose markets you will be comfortable analyzing. Do not be afraid to research professional trading strategies, as these can be of great help in achieving trading success. For every individual looking for a way to invest money, time, and effort into markets, one must consider the overall aspect behind macro economic movements as it directly affects the industry you are focusing on. Educate yourself on what is happening across a variety of the markets and before you decide what to embark upon, double check the research behind the platforms that are available.
If CFD trading doesn’t sound right for you, then you might just want to take a look at The Ultimate Guide to Value Investing.