A CFD (or Contract for Difference) is a well known and popular way of trading. It allows the investor to speculate on the falling or rising prices of instruments like indices, shares, currencies, treasuries and commodities. In this article we look at the basics of CFD trading, how it works and how to start trading CFDs.
What is a Contract for Difference? – CFD Trading Explained
A CFD is, in essence, an agreement or contract between a broker and client to exchange the difference between an underlying asset’s opening and closing prices. These derivative products enable the investor to trade on the price movements of the live market without owning the instrument that the contract is based on. CFDs can be used to speculate on future market price movements, whether they are falling or rising. Traders can either sell (go short) which allows them to profit from a fall in price, or hedge their portfolio in order to offset potential losses in the value of their investments. There are more than 10,000 markets available for investors who wish to trade CFDs, with prices being offered on indices, commodities, shares and currencies. Many of the best brokers, like XTrade, now offer the possibility of CFD trading to their clients, and you can find out more about the services that this broker provides in this XTrade review.
Introduction to CFD Trading: How Does CFD Trading Work?
When a trader participates in CFD trading, they neither sell nor buy their chosen underlying asset. Instead, they sell or purchase a number of units for their chosen instrument depending on whether they believe the price will fall or rise. For each point that the instrument’s price moves in the investor’s favour, the trader gains multiples of the amount of CFD units they have purchased or sold. Conversely, for each point that the price of the instrument moves against them, they suffer a loss, with the possibility of the loss exceeding their deposit.
What are the Costs of CFD Trading?
When participating in CFD trading, the investor has to pay the difference between the purchase and sale price i.e. the spread. The investor uses the quoted Buy price to enter a Buy trade and exits using the Sell price. The less difference there is between the two, the price has to move less in the investor’s favour before they generate a profit, or a loss, should the price move against them. There are also holding costs to pay. At 17:00 EST, any open positions are usually subject to a holding cost charge which may be negative or positive depending on the position’s direction and the holding rate applied. In order to view the broker’s price data or trade in CFDs, a Market Data fee is also often charged, and a broker’s commission is also sometimes applied.
There are several advantages to opting for CFD trading. These include:
CFDs offer a higher level of leverage than other forms of trading, starting at as low a margin requirement as 2% right up to as much as 20%. A lower margin requirement results in the investor having to outlay less capital and enjoying larger potential returns, however it can also result in higher losses.
Access to the Global Market From a Single Platform
The majority of CFD brokers offer a choice of products across all of the major global markets, allowing investors to make trades on any market that they choose from the broker’s own trading platform.
No Short Selling Rules
While some markets have rules that place restrictions or limitations on short selling, CFD trading generally has no rules of this type. Instruments may be shorted without any shorting or borrowing cost as the trader does not actually own the asset.
It is rare for fees to be charged on trading CFDs and many brokers charge no commissions on entering or exiting a CFD trade.
No Day Trading Requirement
Whereas some markets require a minimum amount of capital in order to day trade or limit the amount of day trading for certain account holders, there are no such restrictions on the CFD market
There are many types of CFDs available for trading including stocks, indices, treasuries, currencies, sectors and commodities.
24 Hour Dealing
CFD traders can access their account 24/7, trading wherever and whenever they choose, even if the underlying market is currently closed.
No Stamp Duty to Pay
Since CFDs are derivatives and the trader does not own the instrument, there is no need to pay stamp duty, allowing the investor a saving of 0.5% on each trade’s value.
Start Trading CFDs
According to the Financial Times newspaper, almost 100,000 investors in the UK participate in CFD trading and this goes to show just how popular this form of investment has become. It is easy to start trading CFDs. The first step is to open an account with a broker that offers this form of trading. It is simple to register for an account online, complete the verification process and then deposit funds into the new trading account, depositing at least the minimum required amount. Funds can usually be transferred via several methods including credit or debit cards, bank wire transfers or e-Wallets. Once the account is in credit, the trader can then access the broker’s trading platform which enables them to begin trading CFDs by choosing a market and selecting how much to invest. Trading can be done 24 hours a day, 7 days a week, and often brokers will offer a downloadable app which can be accessed from smartphones or mobile devices to allow for trading CFDs on the go.