CFDs are contracts between a buyer and seller that requires the seller pay to the buyer the difference between the current value of a share or commodity and its value when the contract is settled. If the difference is negative, then instead the buyer pays the seller.
Traders can use CFDs to trade commodities, futures, forex, cryptocurrency, stock market indices and individual stocks. When you invest in a CFD, you don’t actually buy the underlying asset as you would when directly trading shares. Rather, you’re trying to profit from their price movements, whether up or down. So even if prices in a commodity are falling, CFD traders can still profit.
What is a CFD?
CFDs are derivative investments that allow traders to bet on the price movements of certain assets, such as commodities, forex or shares. Traders profit if the price of the underlying asset moves in the direction formalised in the contract. So, rather than trading or owning the underlying asset, traders own the CFD contracts.
When you open a trade, you can choose to either go long or go short. Going long means you expect the underlying asset (such as the share) to increase in value, and going short means you expect it to decrease. If you’re correct in your assumption, you’ll be paid the difference in value and if incorrect, you’ll owe the difference. You can also lose a lot more than your initial capital because of leverage (more on this below).
One of the most common forms of CFD trading is in currencies (known as forex trading) and commodities such as iron ore, oil, gold and agricultural products.
How is CFD trading different to buying shares?
When you invest in shares, you’re actually buying the underlying asset. That is, you are buying a share in a company. As a shareholder, you benefit from the capital growth of the shares’ value over time and you may get voting rights in the company. When you sell your shares, you’re selling the actual asset in that company.
However, when you buy a share’s CFD, you do not own the shares; you own the contract provided by the CFD provider. You’re simply speculating on whether you think the share price will increase or decrease without ever owning or trading it. The same is true when you buy physical gold compared to trading gold CFDs. Think of it more like a bet on the asset’s price.
How is margin and leverage used in CFD trading?
Traders are only required to invest a small percentage of the trade’s value to open the CFD trade. This is known as the margin requirement and can be as little as 5% of the full trade value or even less. You could think of this margin as the deposit.
For example, let’s pretend you want to trade a particular company’s shares via CFD, which are hypothetically valued at $10 per CFD. You decide to buy 100 of these CFDs, so the value of the trade is $10,000. With a margin of 5%, you are only required to pay $500 to open the trade.
Even though you only put forward 5% of the value of the trade, you’re entitled to benefit from 100% of the potential gains, which is what makes CFD trading attractive to so many people. Still, it’s essential to remember that because you’re trading with leverage, the same applies if your trade was to lose. You’d be expected to pay the CFD provider for the entire loss, which could far exceed your initial 5% margin requirement. Plus, you could also be charged a commission on the trade by the CFD provider.
What is a stop-loss?
A stop-loss is a feature that helps to minimise a trader’s risk when trading CFDs. Traders can set the stop-loss for a particular price, so when the CFD falls below that price the trade is closed. This helps minimise your losses by closing the trade at a specific point before it continues to decrease in value.
What are the benefits of CFD trading?
- Big potential profits. Because CFDs are leveraged products, you can make greater profits out of smaller investments than normally could with share trading.
- Protection against loss. If think the price of the stocks you own are going to fall in the future, you could offset losses to the value of your portfolio through CFDs instead of selling the shares.
- Commodities. CFDs are used to speculate on the price movements of commodities markets such as gold, silver and oil.
- Broad market access. CFDs allow you to speculate on thousands of financial products and global markets which you may otherwise be unable to access.
- Profit from losses. By going long or short, you can benefit from both rising and falling stock or commodity prices.
- No expiry. Unlike other types of derivative products, CFD contracts don’t have a set expiry date which means you can end the contract to realise a profit or loss when you decide.
What are the risks of CFD trading
- Big potential losses. Because CFDs are leveraged, you could lose more than you initially invested.
- CFDs are complex. The complicated nature of CFDs means that only advanced traders should participate in the market.
- Hidden caveats. Like any contract, CFDs could have hidden clauses that the trader is unaware of.
- Sudden changes. Due to the quick price movements in the market, you could be winning one minute and losing the very next.
There are many risks when you trade CFDs, as highlighted by the Financial Markets Authority (FMA).
Main types of CFDs
If you decide to open an account with a CFD provider, you should decide what type of CFD you want. Here are three key ways to access CFDs.
- Direct Market Access (DMA)
- Market maker
What is a DMA CFD?
DMA is the term used for electronic facilities, often provided by independent firms, that permit particular investors or financial firms to access liquidity to trade securities they want to buy or sell.
Typically, these authorised firms or investors are usually brokers, dealers and banks that act as market makers. Generally, they’re a broker or dealer holding a certain number of shares of a particular security (at its own risk) to facilitate trading in that security.
By using a DMA, the investor can manage its account and trade directly without the intermediation of brokers and dealers, which means that the trader can access the infrastructure of the sell-side firms with lower costs and commission.
What are the pros and cons of using DMA as a CFD?
DMA has opened the door to the individual trader who wants to participate in CFDs rather than handing the order and trade to brokers for trading. The individual trader now has the opportunity to bypass the middle man and send the trade directly to the execution desk to finalise and uphold the integrity of the trade.
The benefits you can get from DMA are:
- You can set your own trading goals and change them when you feel it is appropriate without wasting your time contacting a trading specialist.
- You can take more or less risk depending on your past performance or on your trading skills and experience.
- The electronic environment allows fast transactions and fewer price differences or discrepancies than you could experience if you placed an order with a broker or dealer.
- Everything you do is based on your own decisions: You can use more or less liquidity and buy/sell only when it suits you.
- It is a great resource for skilled and experienced traders; If you are a newbie, it’s better to contact a trading specialist or financial advisor.
The cons are:
- If you are an inexperienced investor you could risk losing profits or even lose money as you might not be able to read trends in time.
- If there’s insufficient trading in the underlying market, you won’t be able to open and close CFD positions.
- There is a smaller offer range than with the market maker.
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What is a Market Maker CFD?
This is a trading company that creates its own market and determines the price range for the underlying asset on which the CFDs may be traded. It creates both the buy and sell price for a financial instrument or a commodity. So, if you buy a CFD over a particular asset you are a price taker (not a price maker as in DMA).
However, the prices do not differ from the market price of the underlying asset, which means you have to deal through a broker or a dealer and do not have access directly to the market as with DMA.
What are the pros and cons of a Market maker?
The pros are:
- The assets gain more exposure as they reach a wider range of markets because of a higher degree of liquidity in the market.
- If you are a newbie, you could get some advice from your broker or dealer on how to invest in these types of CFD.
- Higher liquidity means that you can trade even if there’s insufficient trading in the underlying market.
The cons are:
- Higher brokerage and commission fees.
- The risks are more or less the same as those of volatile markets.
- You must accept the price of the trader (even when it sets a higher price than the market: the so-called extra margin or spread).
- The broker has the right to re-quote the prices after submitting an order.
As you can see, there is a range of possible trading strategies using these different types of CFDs that can you help you achieve your investment goals. Remember to consider your buying power and how the markets are performing before choosing which CFD to use.
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