Introduced in the not-so-distant 1990s, CFDs quickly gained popularity among investors around the world and remain in high demand today, not only among novice traders but also professionals. There are many reasons for this, but to understand them, it is necessary to know what this financial instrument is and how to work with it. We offer you a brief insight into the world of trading, the most speculative product of modern times.
First Introduction to CFD
Many traders have already tried this financial instrument and appreciated its wide range of possibilities, but there are also speculators who hesitate to try it. It’s hard to say what causes these doubts. Perhaps fear of trying something new or excessive caution, or maybe just a lack of reliable information. In any case, it is necessary for everyone to familiarize themselves with the principles of CFD trading. Who knows, maybe this instrument will be your key to profitable deals.
Contract for Difference (CFD) is a margin product that allows you to make profits from price increases or decreases of the underlying asset without actually owning the asset. The underlying asset can be all instruments quoted by the broker (stocks, indices, commodities, futures, etc.). The profit is calculated as the difference between the opening and closing price of the position, minus commission fees. Thanks to its numerous advantages, the CFD contract has gained recognition worldwide and has become very popular among a large number of traders.
7 Reasons to Start Trading CFD Contracts
1. Use of Leverage
One of the features of the CFD contract is that leverage is provided during trading, allowing the trader to make deals with amounts far exceeding the size of their margin deposit. Usually, this amount is about 5-10% of the contract value. For better clarity, let’s take an example. If the leverage is 1:10, then to conclude a contract to buy stocks worth $30,000, the investor needs to deposit only $3,000. Moreover, the profit from the price change of the underlying asset (as well as the loss) will be multiplied by 10 according to the leverage size.
2. Ability to Open Long and Short Positions
This is an important advantage that allows the trader to make money not only on the increase in the asset’s value, but also on the decrease. Calculations for transactions are carried out much faster than when trading physical assets.
3. Receiving Dividends on CFDs on Stocks
If you hold a long position on a CFD on a stock that pays dividends, you receive a dividend payment, as if you were the owner of this stock. However, in the case of a short position, the dividend amount is deducted from your account.
4. Minimal Commission Fees
For making a stock exchange transaction, the trader pays a certain fee (custodial service, stamp duty, etc.). In the case of CFD, this amount is minimal and ranges from 0.1-0.5% of the contract value, and sometimes it is even absent. This feature (along with the absence of the need to physically own the underlying asset) makes this investment instrument an ideal option for short-term investors.
5. Risk Hedging Opportunity
If you own stocks or commodity futures and do not want to sell them even when their value declines, you can open a short position on CFDs for these assets. Thus, losses from the original positions will be offset by profits from the contracts.
6. Narrow Spreads
When trading CFDs, market spreads are obtained without any expansion. This allows trading at the same prices at which stock exchange traders trade.
7. Real-Time Quotation Flow
The price of buying and selling changes every second automatically. The computer provides the quotes, and the order execution time is 0.01 seconds. You simply press a key – and you already know at what price the deal is made.
A Few Words About the Drawbacks
When talking about the advantages of CFDs, one cannot ignore one drawback.
Being a margin product, CFDs carry certain risks. Using this financial instrument, the trader should understand that providing a large leverage may lead to an increase in both income and losses. It is very important to be aware of the high level of risk and adequately assess your financial situation.
How to Choose a Reliable CFD Broker?
For traders intending to trade CFDs, one of the main points to pay attention to is choosing a reliable broker. When trading with this financial instrument, the contract is concluded directly with the broker, and the trader does not own the underlying asset directly. Therefore, if the broker is unreliable, his clients may lose their investments.
Today, many brokers and investment companies offer direct access to the exchange. The simplest way to choose a reliable broker is to refer to the list of leading market operators according to various representative publications. However, do not limit yourself to this action, because ‘popular’ does not always mean ‘best’. Try to consider all possible candidates. Carefully study their background, legal data, and the conditions under which they operate, and then make a decision.
Legal Aspects
When talking about the legal aspects, the first thing that comes to mind is the presence of the necessary licenses, regulation by government agencies, and financial guarantees of associations, funds, and governments. A broker with a license is completely transparent. He does not hide his articles of association and financial reports. And the regulatory body fully controls his activities.
Currently, the most valuable licenses are those issued by the following international organizations:
- FSA – Financial Conduct Authority;
- NFA – National Futures Association;
- CFTC – Commodity Futures Trading Commission.
In Russia and CIS countries, such licenses are held by about a dozen brokers.
Additional factors to consider when choosing a broker include the length of its operation, the presence of a client liability insurance system, and an efficient internal risk management system. Moreover, a reliable broker should be reputable and have branches throughout the country (if it is a Russian broker) or around the world (if it is a foreign broker).
Financial Aspects
Regarding the financial aspects, when trading CFDs, attention should be paid to the following factors:
- minimum commission requirements;
- minimum margin deposit;
- guaranteed execution of pending orders;
- wide range of instruments.
It is extremely important that the broker provides a convenient and modern platform, granting access to multiple marketplaces using a single trading account. This helps avoid the ‘dispersion’ of funds and the occurrence of so-called margin deficit – a situation where there are not enough funds on one of the accounts to maintain open positions.
Moreover, if we are talking about a foreign broker, other advantages play a big role, such as round-the-clock Russian language support, the presence of a personal manager, and high-quality European-level service.
Today, CFD contracts are widespread around the world. They provide an inexpensive way to trade on a large number of financial products without the need to buy and sell them. Nevertheless, do not consider this instrument as a complete replacement for the stock market. The risk of losing money when trading CFDs is no less than when trading stock market instruments, especially if the market moves against the trader’s position with a small deposit.
However, the opposite approach is also incorrect. CFD is
FAQ
What is a CFD contract?
A CFD, or Contract for Difference, is a financial instrument that allows traders to profit from price changes of an underlying asset without owning it.
What are the advantages of trading CFDs?
CFDs offer leverage, the ability to go long or short, minimal fees, and real-time pricing, among other benefits.
What risks are associated with CFD trading?
CFDs carry high risk due to leverage, which can amplify both profits and losses, requiring careful risk management.
