The ChoosaBroker Trading Academy
2.5. An Introduction to CFDs
CFDs are a widely-popular financial instrument, ideally suited for participants with shorter time horizons. Trade with CFDs from anywhere, anytime, in markets spread across the globe that till a few years ago was outside the range of the average, retail trader.
What are CFDs?
A Brief History of CFDS
Features of CFDs
- Most CFD contracts are unlisted, with trading being carried out over-the-counter through a network of brokers and market makers.
- CFD assets are never physically bought or sold.
- Since CFDs don’t have any expiry date, there is no time-decay.
- The entry threshold is low because the contracts are highly leveraged, typically requiring upfront margin of as little as 5% of the total contract value.
- The minimum contract sizes are also relatively smaller as compared to futures.
- Since CFD contracts are not restricted by exchange definitions or jurisdictional boundaries, they don’t require the payment of any exchange fees or stamp duties.
- See the best CFD Brokers in our review section
How Do CFDs Work?
Benefits and Risks of CFD Trading
Benefits of CFD Trading
- Profit in Rising and Falling Markets
CFDs allow a trader to initiate both long and short positions. This creates greater trading opportunities. Academic studies have shown that financial markets tend to trend almost 70% of the time. When an underlying asset’s price is trending higher, a trader can profit by placing a long trade. When prices are trending lower, going short, without fighting the broader trend, is the prudent strategy.
Leverage enables traders to open a CFD position by committing only a fraction of its actual value. When used with proper money management techniques, leverage can be a great tool to create wealth, especially for small retail traders, who don’t have large starting capitals.
- Portfolio Diversification
Most CFD brokers offer a wide range of underlying assets ranging from equities, indices, commodities and Forex pairs. This ability to invest and trade across different markets help a trader diversify his investment portfolio. When a portfolio is well-diversified, the risk is also spread out; meaning underperformance in one market often gets offset by strength in another. One of the major CFD brokers is Plus500, but other major players such as IG, City Index and Pepperstone are worth considering.
- The Ability to Hedge
CFDs are a cost-effective tool to hedge your open positions. Hedging limits potential losses in the event of market moving against you. For example, if you have a long position on a stock whose price suddenly tumbles, opening a position in the opposite direction using a short CFD can put a cap on futures losses.
- Small Lot Sizes
CFDs have relatively smaller lot sizes when compared to the more traditional assets. As a result, the capital requirement is also significantly lower, allowing greater retail participation.
- No Underlying Ownership
CFDs do not stipulate that a trader own the underlying asset. The advantage to such a structure is that the trader does not carry the risk of having to take possession of the physical asset.
Risks of CFD Trading
- Market Risk
In financial markets, asset prices can move swiftly and unexpectedly due to factors such as macro economic news, corporate announcements, geo-political tensions or natural disasters. Such types of risks are called market risks. There is no way a trader can escape this innate market characteristic. However, he can adjust his trading approach by taking in to account his risk tolerance in case the market moves against him. Money management strategies like initial stop losses and trailing stop losses are essential to counter market risk.
- Counter-Party Risk
Counter-party risk is a risk that the party with/through which you are entering in to a trade may fail to fulfil its obligations. CFDs are “over the counter” products. When you long or short a CFD, the only asset you are trading is the contract issued by your CFD provider. As such, the CFD provider becomes your counter-party. Counter-party risk is especially prevalent when you operate through a broker, who is under-capitalised and unregulated. This makes it important that you trade only with reputable, adequately capitalized, and properly regulated brokers.
- Lack of Voting Rights
Long term equity traders often complain that CFD contract holders do not get the right to vote during the underlying company’s Annual General Meeting. This is considered a significant risk because once a position is initiated; the investor is powerless as regards the future policy direction of the company. There are a number of brokers that are focussed on CFDs such as Plus500 or City index. In addition, we recommend reading the section on Best CFD brokers for further insights.