Unlike any other financial instrument on the market, CFD trading doesn’t involve any form of asset ownership. The actual value of a Contract for Difference (CFD) is only the difference between its opening and closing prices. This aspect results in very low entrance costs and many more benefits compared to traditional Forex trading and other financial instruments.
How It Works
A CFD is an official short-term agreement between a broker and an investor to exchange the difference between the opening and closing prices of a certain financial instrument (a derivative or security). CFDs are considered a high-risk tool, but it doesn’t require traders to poses any underlying assets. All the revenue is generated on the underlying asset price movement. Let’s use oil as an example. Using CFDs, you don’t have to buy them, but you can speculate on the price swing.
In simple words, CFDs let you bet about whether the asset cost rises or falls by the closing time of the position. As a trader, you can bet on the price to rise or fall and benefit if your prediction appears to be true. Otherwise, you are supposed to lose the difference. The initial probability of both results is 50%.
CFD Regulations Worldwide
Currently, CFDs are not permitted in the United States (for residents only) but allowed in OTC (over-the-counter) markets in such powerful trading countries as France, UK, Germany, Spain, Canada, Italy, Norway, Netherlands, Belgium, Denmark, Switzerland, Singapore, Hong Kong, Thailand, South Africa, and more.
The cost of a CFD includes 3 main components:
- Commission – usually low or zero;
- Financing cost – relatively low or zero;
- Spread – the difference between the purchase and the offer prices at the time of the trade.
If you trade Forex pairs or commodities, there is usually no commission, while stock CFDs are mostly under a broker commission. A financing cost usually appears when you open a long position as overnight CFD positions are automatically considered an investment and charge an interest rate every next 24 hours the position remains open. The overnight cost is usually the LIBOR interest rate + 2,5%. If the commission applies, you will have to pay it when you open the position and when you close it as well. As a result, your net profit equals the profit minus fees, which can be up to 10% in total.
Advantages of CFDs
Here are the advantages that attract so many traders to CFD trading:
- High leverage – CFD leverage is higher than the leverage of any other traditional instrument. This is simultaneously a huge benefit and a potential loss magnifier. Depending on the country, the permitted leverage can be 50:1, 30:1, and even as low as 2:1. Lower leverage reduces the potential losses and makes the market safer for traders.
- Global access – there are many CFD brokers that provide access to all or most markets worldwide. This means that you can trade 24/7 if necessary.
- No shorting rules & borrowing – you can short CFDs without borrowing costs any time. All because you don’t have to own the assets to trade.
- Low or zero broker commissions – CFD brokers earn when traders pay the spread and usually don’t charge any commissions or fees. In most cases, you can pay fixed spreads.
- Low day-trading limitations – unlike many other markers, the CFD market doesn’t require you to have a large entry capital. You can usually open an account with a relatively small amount of capital ($1,000-$5,000).
- Diverse opportunities – CFDs are usually based on stocks, currency, indexes, sectors, and commodities. This makes CFDs a highly exciting instrument for forex traders as they can access multiple products aside from currency pairs.
Disadvantages of CFDs
While the advantages of CFDs may seem very attractive, you should always remember that the risks are equally high and involve:
- Potential leverage losses – while the leverage can multiply your earnings, it can do the same with your losses. Always use a stop-loss limit to avoid enormous debt.
- Fast pace – this market is rapidly changing and requires you to consider liquidity risks and margins. You should also be able to cover value reductions, or the broker has the right to close your positions, which can cause losses.
A Thrilling Product
Although the CFD market still lacks international regulations and involves high risks, this tool remains manageable and potentially highly profitable. If you feel skilled and knowledgeable enough, this can be a perfect additional source of income in your investment portfolio.