CFD stands for contract for difference. This type of contract allows European traders and investors to gain and profit from the movement of price without having to own any underlying asset. The way it works is by calculating the movement of an asset, from trade entry to trade exit, by calculating the change in price without taking into consideration the underlying value of the asset.
A deal between a client and a trader can be done, without using any stock, forex, commodity or futures exchange. CFD trading is extremely popular because of the benefits gained by the broker as well as the client. According to this article on business24-7.ae CFD trading is one of the most recommendable investments for beginners.
How a CFD Works
Anything explained with an example is always easier to understand. So, to fully grasp the workings of CFD, imagine a scenario where the ask price of the stock is $30.05 and the trader purchases 100 shares.
Now, the cost of this dealing is around $3,005 excluding the payment for commission and fees. Normally, a traditional broker requires a minimum of 50% of the margin account which is $1,502.50. However, a CDF broker deals with a 5% margin account which is $150.25.
When starting, a CFD trade generally appears to have a loss equal to the spread at the given period of the process. To hit breakeven price, it needs to gain back the spread value of, say 5 cents. If you owned the stock prior to starting with the trade, you would have seen a gain of 5 cent on your account, but you would have paid a certain amount as commission as well as paying a bigger capital outlay.
In a traditional account, if the stock’s bid price goes up to $30.25, the trader can easily make a profit by selling it for $50 which is $50/$1,502.50 = 3.32%. The CFD price might have to lower to $30.22 when the national exchange reaches the bid price.
In this case, the CFD profit is lower and the broker has to exit at the bid value. The spread value will also be larger than on the other normal financial markets. In this particular case, a CFD trader may earn an estimated $48 (i.e. $48/$150.25 = 32%) ROI.
In cases like these the CFD broker might want the trader to buy in at a higher price, say $30.07. The $47 to $48 profit made by the trader, is quite a steady net profit, while the higher profits the trader would have made, had he owned the stock from the get-go, doesn’t include commission fees.
Compared to traditional trading, CFD trading is more advantageous and has higher leverage. Nowadays, the margin is in a range of 3% (30:1 leverage), up from a previous 2% margin, and could easily go up to 50% (2:1 leverage).
With lower margins comes less capital outlay for an investor, but also higher returns. On the other hand, an increased leverage also means bigger losses.
Global Market Access from One Platform
In this digital era, you can trade from anywhere in the world, and at any time you so wish. CFD brokers utilize this effectively by selling products all over the globe 24×7. One of the most recommendable CFD broker is Plus500. You can find a full list of the best trading platforms on southafricatoday.net
No Shorting Rules or Borrowing Stock
A number of different markets have rules in regard to shorting. They might require an instrument to be bought before shorting or might have margin requirements before selling short or long. The majority of markets have forbidden shorting but in CFD there is no prevention of shorting since the trader does not own the assets.
Professional Execution with No Fees
Some of the orders offered by traditional brokers are the same as those offered by CFD brokers like stops, limits, If-Done and One-Cancels-The-Other orders. A couple of brokers earn money by offering guaranteed stops. At times they gain back the costs in other ways. Brokers would make money when a trader pays for a spread. In order to buy, a trader pays the ask price, and when selling they must pay the bid price. As you know, the spread varies depending on the underlying asset and there are also fixed spreads available.
No Day Trading Requirements
In order to day trade certain markets impose regulations, like requiring a certain amount for capital or set limitations on certain account by restricting the number of day trades. However, the CFD market do not impose these types of restrictions. Anyone can day trade if they so wish. To open an account, you can do so with as little as a $1,000, although it is better to start with either a $2,000 or $5,000 minimum limit.
Variety of Trading Opportunities
Currently brokers offer stock, currency, asset, index and commodity CFD’s, in order for players in different sectors to participate and trade.
Traders Pay the Spread
Though CFDs offer an advantage in certain aspects compared to traditional markets, they have their share of drawbacks. For one, the fact that spreads are paid on entries and exits, prohibits traders from making profits with little movements in the spread value.
Another drawback is that the spread decreases winning trades when compared to the underlying security and will thus increase losses on the trade. Although compared to traditional markets, CFDs do not charge fees, commissions or set regulations, they still minimize the trader’s earnings through spread fees.
Weak Industry Regulation
The CFD industry is not regulated and thus credibility has to be earned on the broker’s longevity, reputation and his position financially. Therefore, it is very important to first do an investigation of the broker’s background before committing your money.
Regular monitoring is a must in CFD trading. There are risks and margins that you must maintain, because if you cannot cover reduced values, your broker might close your position. This is not a good position to find yourself in as you will have to cover the losses incurred.
The risk of making use of leverages exposes you to even greater losses. Although many CFD brokers offer stop loss limits, it doesn’t guarantee that you will not suffer losses, especially during sharp price movements or market closures.
The Bottom Line
CFD trading is beneficial, especially with lower margin requirements, no rules on shorting and day trading, little to almost no fees and easier entry to global markets. On the other hand, high leverages increase losses, and having to pay spreads when entering and exiting positions also increases cost, especially when there is no price movement.
Because of these the ESMA (European Securities and Markets Authority) placed restrictions on CFDs.