CFDs & ETFs explained

CFDs & ETFs explained

The Contract for Differences (CFD) and the Exchange-Traded Fund (ETF) are two financial instruments that have garnered great favor and popularity with traders. This is justifiably so since the characteristics of the two instruments are perfectly tailored for short-term traders, as opposed to long-term investors. There are a number of brokers that specialise in CFD trading as well as having access to ETFs.

Contract for Differences (CFD)

As market participants, traders and investors have two completely different objectives. Unlike investors that seek to buy and hold a stock until such time that it realizes the value that the investor perceives it to be, or the manufacturer that takes possession of a commodity for the purpose of manufacturing a finished consumer product, or a multi-national corporation making a larger transfer of assets from one country to another requiring foreign exchange, taking possession of the stock, commodity, or currency is the least of a trader’s concern. Most traders generate profit from capitalizing on the volatility of the asset they are trading. The difference in the price of the trade entry with respect to the trade exit determines whether a trader makes a profit or takes a loss. The Contract for Differences (CFD) is specifically designed with this purpose in mind.

A contract for differences is a futures contract that allows a trader to enter a trading position without actually taking physical possession of the underlying asset or commodity. It is an arrangement between the buyer and seller in which the difference in the settlement prices is settled via cash payments. This is a perfect situation for a trader that wants nothing more than the differences in the settlement prices, especially when they’re profitable.

Other Advantages of a Contract for Differences

Nowadays, all major markets worldwide are represented in the CFD sphere. Stocks, indexes, treasuries, forexes, commodities and sector CFDs are all easily accessible via CFD brokers with advanced and secure trading platforms. Also, because the actual exchanges of the underlying asset never takes place, any short-selling rules imposed by exchanges that normally apply when trading the underlying asset do not apply when trading the CFD. However, possession of CFD’s does entitle the holder to receives cash dividend and participate in stock splits associated with underlying stocks, therefore increasing the trader’s potential returns.

Traders typically apply leverage to their trading for the purpose of optimizing the return on their trading capital. CFDs provide higher leverage than typical trading with margin requirements as low as %2. This allows traders to trade with smaller capital outlays per unit traded, and increases the potential for greater returns. Consequently, minimal capital requirements for traders to open CFD accounts are so low that barriers to entry are virtually eliminated.

Disadvantages Associated with Contract for Differences

There are some disadvantages that traders must contend with when trading CFDs, the first of which are the spread and costs associated with holding positions overnight. Brokers typically quote spreads that are slightly wider than those associated with trading the underlying asset directly, and they widen even more in periods of higher than normal volatility. Most forex brokers will charge an overnight interest fee for maintaining an open position overnight. This is why CFDs are not suitable for long-term trading strategies. Also of great concern, is the fact that the CFD industry is not universally regulated. While some brokers do adhere to a government authority, there are many that don’t. Consequently, there are many “shady” brokers out there. Some degree of due diligence is warranted when selecting CFD broker. ChoosaBroker offers a compare the broker service or read our Best online brokers post.

Exchange-Traded Fund (ETF)

An Exchange-Traded Fund (ETF) is very similar to a mutual fund in that it is a marketable security for which its value is based on a basket of underlying assets that make up the fund. Where ETFs differ from mutual funds is that ETF shares trade on stock exchanges much like common stock. An example of a very popular ETF is the SPDR S&P 500 (SPY). Launched in 1993, it is the oldest and most widely known ETF that tracks the S&P 500 Index. Just like stocks, the price of an ETF’s shares will fluctuate throughout the trading day as they are bought and sold by traders.

Just like a mutual fund, an ETF owns underlying assets including shares of stock, bonds, oil futures, gold bullion, foreign currency, etc.) and divides the ownership of the assets into shares to be traded on an exchange. Most ETFs are set up as open-ended funds and are subject to regulatory requirements by a government agency such as the Securities and Exchange Commission (for funds in the U.S.). There is also a very tradable options market that exists for some of the more popular and heavily traded ETFs (i.e. the SPY). This gives traders and investors the flexibility to implement viable opportunities for using ETFs for the purpose of income, speculation, or hedging strategies.

Advantages of ETFs

From an investor’s perspective, ETFs typically have lower fees than mutual fund shares, making them an attractive alternative. The more heavily traded ETFs typically have higher average daily volume than mutual funds. ETFs also have favorable tax advantages. Buying and selling shares of an ETF via an exchange does not trigger the same tax event that would result for redeeming shares of a fund, therefore lowering tax costs. Additionally, investing in an indexed stock ETF gives the investor get the diversification of an index fund. The investor can also take a short position and buy shares on margin. ETF brokers offer accounts that have very low capital requirements, and investors can buy as little as one share. This eliminates barriers to entry for small investors.

From a trader’s perspective, there are plenty of ETFs that have very favorable trading characteristics. For example, the S&P 500 Mini is well suited for trading. It has plenty of volatility and average daily range. It is highly liquid, has reasonable spreads, and is offered by almost every reputable broker. Traders can effectively implement short term intra-day strategies to capitalize on the day’s price volatility without as much “statistical noise” as trading individual assets of the fund. Traders can also implement longer-term strategies that seek to capitalize on a trend. There are plenty of ETFs that are very tradable.

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