Introduction
Contract for differences trading may sound like a complex thing. However, it dominates most online trading globally, from FX to precious metals. This is because CFDs allow us to trade numerous instruments without owning them.
We can also go ‘long’ (buy) or ‘short’ (sell), which is impossible through physical ownership. Overall, CFD online trading is the most accessible way to invest or speculate in the financial markets.
Let’s cover this topic in more detail.
What is a CFD in trading?
A CFD is simply a broker-trader arrangement to exchange the difference between a financial asset’s opening and closing price (hence ‘contract for difference’ or CFD).
The broker will pay the difference in profit based on the closing price at the end of the position. On the other hand, if the position is not favourable to the trader, the broker will debit their account.
Let’s make a simple example to demonstrate CFDs online trading. Suppose you took a buy forex spread bet position at 7114.5 at £10 per point.
Consider two scenarios: if the market moved 35 points and you closed the trade at this point, your broker would credit your account with £350 (35 X £10).
Conversely, if the market moved 37 points against your set-up and you exited at this stage, your broker would debit £370 (37 X £10) from your account.
We commonly refer to contract for difference trading as derivatives, meaning that the financial instruments are derived from real-life assets. Essentially, it’s trading a ‘replica’ without actual possession while being able to make profits and losses from it.
Key components of CFD online trading
Now let’s look at the standard elements of CFD trading accounts.
- Leverage: This is, of course, the most attractive ingredient to CFD online trading. Leverage or margin allows you to trade the full value of most markets using a relatively small account balance using ‘borrowed’ funds from your broker.
In this way, you can invest with far less capital compared to trading the same instrument in an unleveraged spot trade. (You can find more about the difference between spot and margin trading here.).
Below is a simple visual to demonstrate the difference.
Although leverage is a capital amplifier, your profits and losses are based on the entire
value of whatever you’re trading. Leverage magnifies both equally, a significant concern when it comes to losing.
We express CFD online trading leverage as a ratio (e.g., 1:100 or 100x), and these vary widely depending on the broker, market and specific country regulations. For instance, if the value of a position was $10 000, 100x leverage means that you would only need $100 to open this trade (10 000 / 100).
The margin in CFD trading forex pairs is, by far, the highest of any financial instrument. It’s common to receive ratios from 1:100 up to 1:1000 (or sometimes unlimited). The leverage in other products like CFDs in commodities and CFD stock trading is often on the low end of the scale.
Something also worth mentioning is that some markets, like futures, have further margin requirements. So, in addition to the initial margin (or the amount you need to open the position), you also need a maintenance margin to hold the position.
Lastly, because leverage equals borrowed funds, interest is necessary, also known as a swap or rollover. In most cases, this applies to every night a position is held. But some exceptions exist, like with crypto futures, where the rollover applies every four hours.
Sometimes, it is possible to earn from swaps, particularly in forex, where you buy a currency with a higher interest rate and sell it against one with a lower rate.
- Long/short duality:
Another massive appeal to CFD online trading is that you can buy and sell a particular market (in many cases, you can do this simultaneously. While this may seem like an everyday thing, it’s not possible when you own the physical version of a financial instrument.
For instance, you buy a cryptocurrency like Bitcoin (BTC) from an exchange at $20 00 at 1 BTC. At some point, you decide that the price will drop from this point, and eventually, it does.
With contract for difference trading, you would have been able to open a sell position at $20 000 and profit from the drop.
Buying the actual coin means you can only profit from selling it to the exchange at a higher price than $20 000. On the other hand, a CFD allows you to sell a market without having bought it or buy a market without having sold it.
- Unlimited duration: Theoretically, you can hold a CFD position for a limitless time, provided you have enough margin to maintain it. Therefore, CFDs are suitable for all trading styles, from scalping and day trading to swing and position trading.
- OTC trading: All CFD online trading happens ‘over-the-counter’ (OTC). This means that markets are provided between private dealers or brokers without a central exchange.
OTC trading allows higher margin and lower capital requirements compared to an exchange. Also, you can expect more experimental trading products like binary options and unlimited leverage in forex.
Most popular types of CFD online trading
Let’s look at the most common CFD online trading you’ll find.
- Foreign exchange: CFD trading forex is speculating on the prices of different foreign currencies.
- Stocks: CFD trading stocks is buying and selling shares or equities listed on numerous stock exchanges worldwide.
- Crypto: speculating on the prices of many digital currencies.
- Options: these CFDs offer you the right, but not the obligation, to trade various markets at a certain expiry time.
- Futures: these CFDs allow you to buy or sell a particular financial instrument at a later expiry date and time.
- Indices: the trading of such CFDs involves indexes primarily from stocks (but also forex, commodities, crypto, etc.)
- Bonds: these CFDs include trading government bonds like the US 10-Year Treasury Note, UK 10-Year Gilt and Japan 10-Year Government Bond.
Advantages of CFDs trading
By this stage, you can confidently answer the ‘what are CFDs in trading?’ question. Now let’s look at their benefits.
- Leverage: As stated earlier, this feature is the most attractive part of trading CFDs. Leverage is the only method of making substantial profits in the shortest time.
It also means you can start with lower capital and achieve better returns compared to unleveraged trading. But, if used irresponsibly, leverage can quickly lead to massive losses.
- No physical ownership: No trader wants to hog around gold bars or keep a stash of currencies in a safe (both of which are expensive). CFD online trading is an efficient way of creating wealth without physically owning many different financial assets.
- Duality of going long and short: This is another substantial plus to trading CFDs. You never have to own any market to buy or sell it. Also, this duality means you can hedge your positions (i.e., buy and sell several securities at the same time).
- Diversification: CFDs allow you to trade a variety of unrelated markets on one platform or broker.
Disadvantages of CFDs trading
Of course, there are two sides to every story. So, let’s look at the downsides.
- Potential for over-leveraging: The main drawback of CFD online trading is the ease at which you may lose substantial amounts of money quickly. You can withstand drawdowns for an extended period without leverage because you often have to invest more.
- Overnight fees: As stated earlier, swap fees (along with spreads) are the direct costs of trading CFDs. Although these are typically minimal, they can add up to a sizable amount for long-term positions.
In some cases, they can also be higher than the average, e.g., with exotic forex pairs.
- Lack of regulation with some CFDs: Anti-CFD proponents often label the industry as the ‘Wild West’ due to the decentralized or OTC structure of CFD trading. In many markets, it’s common to find unregulated brokers or the deceptive promotion of certain products.
Conclusion
Ultimately, CFD online trading is best suited for short-term trading. While some experts will advocate for buying unleveraged physical financial assets, this is not something everyone can do. The main reason is, of course, the amount of required capital.
Also, tangible ownership in some markets comes with extra costs for storage (as with commodities) or safekeeping (as with digital currencies).
Each avenue is suitable for certain groups of people. Some prefer long-term investing, so they will benefit from owning certain assets in their actual form. Conversely, others, particularly the younger generation, desire short-term capital gains.
Overall, despite the immense benefits, CFD trading certainly has more risks involved, which you should be aware of at all times.
