The ChoosaBroker Trading Academy
8.1. Types of CFDs
Over the past one decade, Contracts for Difference (CFDs) have become one of the most popular ways for online investors to trade in stocks, indices, commodities, and currencies. As with everything that grows so rapidly, there is a lot of disinformation surrounding the nature and scope of CFDs. Through this lesson, we will go back to the basics and try to learn about the following concepts:
Stock CFDs are the most commonly traded CFD contracts in the financial marketplace. CFDs are derivative instruments and their prices move in tandem with the underlying shares listed on their respective exchanges. So, in the case of a CFD on Apple Inc, which is listed on the Nasdaq Stock Exchange, the price of the CFD will track the price of Apple’s stock in a 1:1 relationship. As a result, CFD trading is very similar to stock trading, except that when you trade a CFD, you don’t own the underlying shares. Another major distinction stems from the availability of leverage. When you buy a stock from a full service broker, you typically have to pay the entire market value of the stocks being purchased. By contrast, CFDs are traded on margin, with margin requirements currently ranging from anywhere between 5% and 20% of the total contract value. This enables a trader to allocate his capital more efficiently. In addition, unlike stocks, there are no restrictions on shorting CFDs, affording the trader the opportunity to profit from both rising and falling markets. Review the best brokers for CFDs for more information and details on the huge selection of CFDs that can be traded.
As the name implies, these types of CFDs are tied to the performance of a benchmark equity index. The primary advantages of trading Index CFDs include the relatively higher liquidity, low trading costs, and easy portfolio diversification through access to international markets. The margin requirements are also comparatively lower than Stock CFDs, with some market makers demanding as little as 1% of the total index contract value. This means that a $1,000 outlay can control a position as substantial as $100,000. The list of Index CFDs on offer is big. Most professional traders prefer to stick to the leading names like Dow Jones Industrial Average, S&P 500, Nasdaq Composite, FTSE 100 and Nikkei 225. It is important to note that all Index CFDs are linked tick for tick not to the underlying index but to the corresponding Futures market, although the actual BID – ASK spread may marginally vary due to adjustments for interest and dividends. Another major attraction for retail traders is that unlike the underlying Futures, Index CFDs can be traded in lots as small as 1X of the index value.
Offering direct access to a diverse array of underlying assets like gold and silver, crude oil and natural gas, copper and agricultural products, Commodity CFDs are an easy way for the average, retail trader to gain exposure in the commodity markets. Long being touted as an ideal portfolio diversifier because of its low correlation with equities, commodities markets, due to the substantial entry costs, were until recently beyond the reach of small traders. The introduction of Commodity CFDs and the low margin stipulations has levelled the playing field to a large extent. Although there are some CFD contracts based on spot prices, most Commodity CFDs are linked to the Futures market. The main advantage of trading commodities through CFDs is that unlike Futures contracts, there is no risk that you might have to take delivery of the underlying asset. In addition, Commodity CFDs trade in much smaller units when compared to their Futures counterparts, making it easier to manage risk. For example, some CFD providers quote U.S. Crude Oil in a single lot size of 25 barrels, while NYMEX Futures have a contract size of 1,000 barrels.
With the global popularity of cryptocurrencies spreading exponentially over the past couple of years, millions of traders have become aware of the profit potential of these volatile assets. By trading cryptocurrencies such as Bitcoin, Ethereum, Ripple and Litecoin in the form of contracts for difference, traders have the opportunity to speculate on their price movements and likely profit from both rising and falling markets. Obtaining cryptocurrencies through the traditional exchange route requires time and dedication to install a wallet where you can store and use your coins. However, frequent breaches in cyber security make these wallets vulnerable. Recognizing this risk, many investors have begun opting for CFDs on cryptocurrencies. These CFDs are bereft of any such security risk as the investors never actually have to own the underlying assets.
Day trading cryptocurrencies through CFDs is generally regarded as a better alternative than trading through crypto exchanges because the former typically offers better spreads. The lower spreads, in turn, make it easier for traders to open short-term positions and capitalize on smaller price moves. What is noteworthy for traders is that the margin requirement for cryptocurrency CFDs is comparatively higher than other CFD assets. According to latest rules formulated by the European Securities and Markets Authority (ESMA), the leverage offered on crypto CFDs is limited to no more than 2:1. This translates to a minimum initial margin of 50% of the notional value of the CFD.
Final Few Thoughts
Each different type of contract for difference has its own unique characteristics and advantages. Depending on your trading style and risk appetite, you will have to decide which is best suited to your temperament. Beginners to the market should start out by concentrating on one asset class, and can gradually look to diversify as they accumulate more market hours under their belt. There are certainly some brokers that focus more on beginner investors.