CFDs are the alternative way to trade the financial markets, and hold some significant advantages compared to traditional share dealing.
Best CFD Trading Brokers
What are CFDs
CFD or “Contract for Difference” is a contract between two parties speculating on the movement of an asset price. This method allows traders to speculate on an asset price movements, without the need for ownership of the underlying asset. There is a large range of assets available to trade as CFDs – Shares, Indices, Forex, Commodities etc.
First CFDs or “Contracts for Difference” can be traced to the 1980s when respective contracts were executed through a broker (operator) accepting requests of traders/investors through the phone and then he had to find a counterpart that would be willing to accept the offer in respective time. By the time when such counterparty was found and the deal closed, often even hours passed or even days in some cases, while the trader got the information under which conditions (asset price, quantity, etc.) the deal was concluded after a long time.
In the late 1990s, CFDs were introduced to retail traders. They were popularized by a number of UK companies, characterized by innovative online trading platforms that made it easy to see live prices and trade in real time. It was around the year 2000 that retail traders realized the real benefits of trading CFDs. This was the start of the growth phase in the use of CFDs. The CFD providers quickly expanded their offering from London Stock Exchange shares to include Indices, many global stocks, commodities, bonds and currencies. Trading Index CFDs, such as the ones based on the major global indexes – Dow Jones, NASDAQ, S&P500, FTSE, DAX and CAC quickly became the most popular type of CFD that were traded.
How does CFD Trading work?
CFDs can be traded in two different directions. Opening a “Long” position refers to opening a buy CFD position to profit from a price increase. This implies that you are expected a rise in the asset’s price and will use a sell order to close your position.
Opening a “Short” position refers to opening a sell CFD position to profit from a price decrease. This means that you are anticipating the asset’s price to fall and will use a buy order to close your position.
The quote comprises the bid price and the offer price. The difference between these prices is known as the spread. If you think a market is set to rise, you buy at the offer higher price; if you think the market is set to fall, you sell at the bid lower price.
For example, let’s say we’re currently quoting the S&P 500/USA500 at 2100.00/2101.00.
2100.00 Is the bid price – the price at which you can sell.
2101.00 Is the offer price – the price at which you can buy.
There is no expiry date. Once the position is closed, the difference between the opening trade and the closing trade is paid as profit or loss.
A CFD is effectively renewed at the close of each trade day and rolled forward if desired – You can keep your position open indefinitely, providing there is enough margin in your account to support the position.
Note that even though the CFD doesn’t expire; any positions that are left open overnight will be “rolled over”. This typically means that any profit and loss is realized and credited or debited to the client account and any financing charges are calculated. The position then carries forward to the next day. The rate of interest charged or paid will vary between different brokers and is usually set at a % above or below the current LIBOR “London Inter Bank Offered Rate”.
Leverage/Margin in CFD Trading
Trades are conducted on a leveraged basis or a Margin which means a given quantity of capital can control a larger position, amplifying the potential for profit or loss. A typical feature of CFD Trading is that profit and loss and margin requirement is calculated constantly in real time and shown to the trader on the screen.
Advantages of CFDs
1. CFDs are traded on margin so you can maximize your trading capital – rather than pay the full value of a transaction you only need to pay a percentage when opening the position called ‘Initial Margin’. The key point is that margin allows leverage, so that you can access a larger amount of shares than you would be able to if buying or selling the shares themselves.
2. No Stamp duty is payable – because with CFDs, you don’t actually physically buy the underlying assets, you don’t have to pay stamp duty, saving 0.5% when compared to a traditional share deal.
3. You can profit from falling or raising markets by trading long or short.
4. A single account can give you access to a far greater range of financial markets.
5. You can limit and manage your risk your Stop Losses and Limit orders. A Stop Loss is a price level set by the client on a particular trade that if reached, automatically closes out the particular position at the desired price. A limit order is one that is executed at a better price than the prevailing market price, i,e. for a Long CFD trade when the stock drops to a certain level or for a Short CFD Trade when the stock rises to a certain level.
CFD Trading Risks
Trading CFDs is a flexible way to take a position on the financial markets. But without an effective risk management strategy, it could lead to losses. It is vital to understand risk and learn how to manage your portfolio effectively.
Why do I need to manage risk?
Leverage – Unlike most traditional financial trading services, CFDs are a leveraged product. This means that your initial margin payment gives you exposure to a comparatively larger portion of an underlying market than if you bought the instrument directly (via a stockbroker for example). Leverage is a key advantage of CFD trading: it enables you to profit from a market without having to put up the full value of the position. However, this magnified exposure also means that CFDs can result in losses that exceed your initial deposit.
How do I manage risk in CFD Trading?
1. Understand your market
Before placing a trade, you should know your market and assess its probability for volatile movement. This is crucial in calculating the potential risk of the trade. Historically, some markets have shown a tendency to jump less suddenly, however there are others, such as equities, which are more prone to making quick, pronounced moves (often caused by profit warnings or company news).
2. Monitor your open positions
Volatile markets can move hundreds of points in the space of minutes. A good understanding of your market is a start, but you should actively monitor your account so that you can react to any sudden market moves.
3. Use Stop and Limit Orders
It may not always be possible to micro-manage your open positions, which is why our range of Stop Orders are a vital part of your risk management strategy. The most effective way to manage risk is to use Guaranteed Stops, which, in return for an upfront premium, put a fixed limit on your potential loss without putting a cap on your profit.
Remember, CFDs are a leveraged product and can result in losses that exceed your initial deposit. CFDs may not be suitable for everyone, so please ensure that you fully understand the risks involved.