Trading using contracts for difference (or CFDs) can be a useful way to easily profit on the global market by tracking the price movements of a number of financial instruments and assets. But what are CFDs, how do they work, and how could you benefit from trading with CFDs? Here’s everything you need to know about CFDs to get started on trading with them.
What is a CFD?
A CFD is an agreement between a buyer and a seller that stipulates that the buyer must pay the seller the difference between the price of an asset from the point at which the contract is opened to when it is closed (or the “spread”). Much like spread betting, a CFD investor never actually owns the underlying asset, instead receiving revenue based on the price change of that asset.
How do CFDs work?
Just like a spread bet, you’ll see a two-way price quoted on each CFD market offered. Let’s use silver as an example. Suppose it’s currently being listed by one provider at a spread of 1650/1653 (which is the equivalent of $16.50/$16.53 in the underlying market).
- 1650 is the bid price at which you can ‘sell’ (go short)
- 1653 is the offer price at which you can ‘buy’ (go long)
If you believe the price of silver will rise, you buy at the offer price. Or if you think it will drop, you sell at the bid price. As with a spread bet, you’ll be asked to put up a margin payment as a deposit to open your position. However, things differ when it comes to deal sizes. With spread betting you bet an amount of money per point, but CFDs are traded in standardised contracts, sometimes called lots. The sizes of these contracts differ depending on the asset, often mimicking how that asset is traded in the underlying markets. Going back to silver, it’s traded in a contract size of 5000 troy ounces in the underlying market. Therefore most CFD providers also offer silver in a contract size of 5000 troy ounces. This works out to be the equivalent of $50 per point of movement.
The costs of CFDs
The costs of trading CFDs include the spread of the particular asset being traded, as well as commissions and financing costs in certain situations. There is usually no commission for trading forex pairs and commodities. However, brokers typically charge a commission for stocks. The opening and closing trades constitute two separate trades, and therefore you are charged a commission for each trade. A financing charge may apply if you buy an asset with the expectation of its price rising (“opening a long position”); this is because overnight positions for a product are considered an investment, and the provider has lent the trader money to buy the asset. Traders are usually charged an interest charge on each of the days they hold the position.
Pros and cons
A major benefit of using CFDs to trade is the higher levels of leverage than traditional trading, which can help increase your profits. However, these high levels of leverage can also result in greater losses if the spread is negative. This means that CFDs are susceptible to dramatic price fluctuations, and could pose greater risks in more volatile markets. These risks can be managed somewhat through money management techniques, but are still something important to consider with CFD trading. The profits from CFD trading are trimmed by the need for the trader to pay the spread, which can remove the profits from smaller CFD trading moves. This can be mitigated somewhat through deploying higher degrees of leverage while trading, though as mentioned above this can also amplify your losses. Another pro of using CFDs is the global accessibility of CFD brokers, with a number of markets, assets and financial instruments making use of CFDs, allowing around-the-clock access to CFD trading. However, CFD trading is not heavily regulated and not allowed in the US, which reduces CFD trading options somewhat and means that a CFD broker’s credibility is based on reputation and financial viability. CFDs also allow traders to benefit from asset prices falling as well as rising through taking short or long positions, and remove the need for traders to invest the full amount in any given asset, with the only requirement being opening buying or selling positions on margins. Being based on predicting changes in the spread, CFD trading offers investors all of the benefits of owning a security without actually owning it, but this also means investors have to deal with the drawbacks of owning a security without owning it. CFD trading is also more problematic in the long run when it comes to shares, as owning shares gives you voting rights and potential dividends that you are not afforded with the short-term investments in CFD trading.
Overtrading is also a risk with CFD trading due to the speed and relatively lower cost of the transactions, which can result in unexpected losses across your portfolio. The more CFDs you open, the harder it can be to keep track of movements across multiple markets, which could result in exposure to too many markets at once. CFD trading is an effective way to profit from observing market fluctuations, but these profits come with risks if these observations are incorrect.