A CFD (contract for difference) is a contract between a buyer and a seller and is the easiest and most well-known way to trade commodities and indices because of their simplicity, ease of trade, leverage, ability to short sell and effectiveness. CFDs are cash settled and when you buy a contract you do not own the physical product. Instead you simply profit from the price movement of the underlying.
CFD (Contract for Difference) is an agreement between you and your broker to exchange the difference between the opening price and closing price of a contract. Hence, you bet on price movement of the underlying asset (a stock, commodity, etc.), but you do not own the asset.
The advantages are a higher leverage (you can use even more money), no short selling limitations (can be shorted at any time), variety of trading options (stock, index, treasury, currency and commodity CFDs).
How a CFD Works?
If a stock has an ask price of $25.26 and 100 shares are bought at this price, the cost of the transaction is $2,526. With a traditional broker, using a 100% margin, the trade would require the sum of $2,526 cash outlay from the trader. With a CFD broker, normally only a 0.5-20% margin is required, so this trade can be entered for a cash outlay of only $126.30 (example: 5% margin).
It should be noted that when a CFD trade is entered, the position will show a loss equal to the size of the spread. So if the spread is 5 cents with the CFD broker, the stock will need to appreciate 5 cents for the position to be at a breakeven price. If you owned the stock outright, you would be seeing a 5-cent gain, yet you would have paid a commission and have a larger capital outlay.
- Higher Leverage CFDs provide much higher leverage than traditional trading. Standard leverage in the CFD market begins as low as a 0.5% margin requirement. Depending on the underlying asset (shares for example), margin requirements may go up to 20%. Lower margin requirements mean less capital outlay for the trader/investor, and greater potential returns. However, increased leverage can also magnify losses.
- Global Market Access from One Platform. Most CFD brokers offer products in all the world's major markets. This means traders can easily trade any market while that market is open from their broker's platform.
- No Shorting Rules or Borrowing StockCertain markets have rules that prohibit shorting at certain times, require the trader to borrow the instrument before shorting or have different margin requirements for shorting as opposed to being long. The CFD market generally does not have short selling rules. An instrument can be shorted at any time, and since there is no ownership of the actual underlying asset, there is no borrowing or shorting cost.
- Professional Execution With No Fees. CFD brokers offer many of the same order types as traditional brokers. These include stops, limits and contingent orders such as "One Cancels the Other" and "If Done". Some brokers even offer guaranteed stops. Brokers that guarantee stops either charge a fee for this service or attain revenue in some other way.
- Very few, if any, fees are charged for trading a CFD. Many brokers do not charge commissions or fees of any kind to enter or exit a trade. Rather, the broker makes money by making the trader pay the spread. To buy, a trader must pay the ask price, and to sell/short, the trader must take the bid price. Depending on the volatility of the underlying asset, this spread may be small or large, although it is almost always a fixed spread.
- No Day Trading Requirements. Certain markets require minimum amounts of capital to day trade, or place limits on the amount of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions, and traders can day trade if they wish. Accounts can often be opened for as little as $1,000, although $2,000 and $5,000 are also common minimum deposit requirements.
- Variety of Trading Options. There are stock, index, treasury, currency and commodity CFDs; even sector CFDs have emerged. Thus not only stock traders benefit - traders of many different financial vehicles can look to the CFD as an alternative.
- Potential pitfalls. For one having to pay the spread on entried and exits eliminates the potential to profit from small moves. The spread will also decrease winning trades by a small amount (over the actual stock).
- Trimming traders' profits by way of larger spreads. So while stocks expose the trader to fees, more regulation, comission and higher capital requirements, the CFD market has its own way of trimming traders' profits.
- The CFD Industry is not highly regulated. The credibility of the broker is based on reputation, life span and financial position. There are many fantastic CFD brokers, but it is important, as with any trading decision, to investiage whom to trade with and which broker best fulfills your trading needs.
This is why NAGA Trader only works with the worlds biggest brokers, all of them EU regulated.
The Bottom Line
Advantages to CFD trading include lower margin requirements, easy access to global markets, no shorting or day trading rules and little or no fees. However, high leverage magnifies losses when they occur, and having to continually pay a spread to enter and exit positions can be costly when large price movements do not occur.
CFDs provide an excellent alternative for certain types of trades or traders, such as short- and long-term investors, but each individual must weigh the costs and benefits and proceed according to what works best within their trading plan.