A CFD is a term brandished by many, but what does it actually mean?
A ‘Contract for Difference’, known commonly as a CFD, is the difference between the opening and the closing price of a contract. This type of derivative product allows traders to buy and sale on the basis of real-time market price fluctuations, yet without having to own the underlying instrument in question. In essence, this is the greatest advantage of CFDs, as they allow profits or losses when the asset is moved, regardless of ownership.
A buyer benefits when the difference between the opening and closing price is positive. That said, a seller can also benefit from the transaction through short selling what they have, rather than absorbing a price when in decline.
Moreover, as opposed to traditional trading, whereby there are certain rules for short selling, the same does not apply for CFDs. As such, a trader can short sell an underlying instrument at any time. What’s more, CFDs are not limited to day trade requirements and minimums, so accounts can be opened for small amounts and traders can trade as they please.
CFDs can also be used to speculate on potential shifts in market prices, irrespective to the actual movement of the underlying markets. This allows for short selling, which again means profiting from falling prices, or hedging in order to offset possible losses. With all these factors in mind, another attraction of CFDs is that they allow traders to participate in markets in which they have no prior experience in, which in essence allows exposure to new possibilities for other types of trading.
Another benefit, which has also contributed to the increase in popularity of CFDs in recent years, is the fact that they provide a higher leverage than traditional types of trading. Depending on the underlying asset, margin requirements for CFDs can start as low as 2 percent and go up to 20 percent; this means that at the lower end of the scale, traders only require a small capital investment, while for the upper end, higher returns (and losses) can arise.
Of course, when considering the many benefits of CFDs, it would be remiss to neglect the disadvantages as well. Perhaps the biggest is that as the spread has to be covered, whereby both entries and exits are paid for, gains for small fluctuations cannot be achieved. Winning trades will also be decreased slightly in comparison to the actual stock, while losing trades will be increased by a small amount as well.
Also to note is that CFD markets are not highly regulated, which poses potential risks in terms of trading partners and brokers as well, thereby requiring a level of investigation and evaluation before acting.
As such, there are advantages and disadvantages to CFDs, just as there are for other types of trading; so the question is when choosing whether to participate in CFD markets or their traditional counterparts, what type of risk do you prefer?