If you are considering trading CFD products, or have found yourself here looking for some simple information on CFDs, you need to know firstly what a CFD is.
What is a CFD and how do you trade CFDs?
Firstly, CFD stands for “Contracts for Difference”. A CFD is exactly as the name depicts, it is a contract for the difference in price of a financial instrument.
A CFD is a derivative product. Derivative products derive their values from an underlying asset and allow you as the trader to speculate on their value. With all forms of CFD trading, you do not physically own the asset, but you can still profit from the price fluctuations. This has the added advantage of not having to purchase directly and pay the commissions or fees associated with owning the asset.
CFD trading is an agreement between a trader, and a CFD broker to exchange the price movement of an asset. Contracts are traded between the opening and closing prices of the underlying, and any profits or losses incurred between these times are borne by you as the trader. CFD trading has the potential for large profits, but with any type of trading, large profits also carry the risk of significant losses if you are on the wrong side of the equation.
What are the various assets for CFD trading?
There are a huge array of instruments that you can trade as a CFD but some are more popular than others. See a list below of some of the main assets you can speculate on via CFD trading:
- Forex trading is often undertaken via CFD and as the largest asset by daily traded volume, makes up a strong percentage of CFD trades. Whilst there are a huge range of currencies that can be traded, more than 80% of daily forex trades include the USD currency as one side of the pair. Other popular currencies for forex trading by volume are called ‘majors’ and include EUR, GBP, CHF, AUD, JPY.
- Individual Shares are also a strong component in the daily CFD trading volume. Depending on the broker you are trading with, you will usually have access to different underlying shares based.
- Indices are very popular for those looking to benefit from price movements across entire indexes. It is good way to holistically cover an entire index if you do not have a particular view on the individual shares within. Those feeling that a particular stock market or region will perform well (or badly) are able to speculate with a single contract rather than having to trade multiple individual shares to achieve the same goal.
Some Popular Indices
Europe – FTSE100, DAX, CAC40, SMI, STOXX50.
North America – DJIA, NASDAQ composite, S&P500.
Australia – ASX200.
Asia – SSE, HSI, Nikkei225, KLCI.
- Commodities trading as a CFD is becoming more and more popular especially for retail traders seeing as there is no need to take ownership of the underlying asset. In the case of some of the most popular commodities that is a pretty big advantage to avoid logistical issues and costs.
Popular commodities for CFD trading include metals such as gold, silver and copper. Alongside this you will find energy and crops such as WTI & Brent crude oil, natural gas, corn, and soybeans.
- Cryptocurrencies shot to huge CFD trading volumes in the year of 2018 and has various spikes in activity during volatile periods. Whilst in theory cryptocurrencies can be traded against any other currency, you will find most brokers price these against USD or EUR.
There are a growing number of interesting cryptocurrencies but the most popular include Bitcoin (BTC), Ripple (XRP), Dash (DSH), Ethereum (ETH), Litecoin (LTC), Bitcoin Cash (BCH).
- ETFs are not as heavily traded as a CFD as the above instruments but the option to do so is very interesting for those who want all the benefits of a fund without the administrative requirements. An ETF when covering a particular segment provides a rather unique way for a person to profit.
We are seeing an increased demand in ETFs that are property led, canabbis driven and tech related. Some of the more interesting tech driven ETFs are focused on the next big predicted growth sectors such as AI, Biotech, IOT, and those companies involved in 5G. There has also been a bit of a surge in users looking for Covid-19 related stocks including pharma and stay at home/work from home related companies. Some of these include Netflix, Amazon, Zoom and the like. Various trading platforms have created ‘ETFs’ related to these topics so that you as a trader need execute just 1 trade rather than many to share in the growth or drops in any group.
10 Advantages of trading CFDs vs direct ownership
CFDs have gained popularity within the last decade due to the accessibility of the internet. Online brokers and trading apps have capitalised on the needs and wants of potential traders who were interested in investing and trading but never had the same level of options available to them. The variety of brokers and assets that can be traded as a CFD are wide and the potential advantages of CFD trading are many.
1. Lower administrative costs and logistics efforts.
Without owning the actual asset, your initial cost outlay is much less, and you are still able to profit from price movements without the hefty cost involved from buying the asset itself.
Lets take a look at gold as an example. To invest in gold directly, you would have to take ownership of the physical asset at the minimum weight sold. You would then have to deal with the logistics of receiving the gold and when it came time to sell, replicating this process again. This no physical ownership can be quite attractive to potential traders who do not have large funds to speculate, or the time to organise all the logistics but still want a piece of the action.
2. Option to buy a fraction of the underlying asset to reduce entry cost.
If you are wanting to get involved in the movements of a costly stock such as Amazon but balk at the minimum entry level of nearly $3000 for a single share, CFD trading could be the way in. You are able to buy a tiny fraction of a share with CFD trading and set your own minimum level which could be as low as $5 instead of $3000.
The same applies to other assets such as Bitcoin which has a price of more than $9000 at the time of writing. If you wanted to speculate on BTC but didnt want to put up $9000 as a starting point, crypto CFDs allow you trade from as low as around $200 making entry a lot more feasible for all levels of traders.
3. Leverage options for CFD Trading.
Having the option to use leverage in your CFD trading gives you a couple of advantages. Firstly, you are able to minimise the amount of initial risk capital needed as a deposit for the same purchase power. The next thing is that you are able to experience greater exposure and therefore greater return potential than you would get for the same sized equity in a real asset.
4. Reduced quality risk (owing to not being the physical asset).
The variance in quality of the underlying asset is not an issue here as you do not own the asset itself but are just speculating on the price of the value. In the case of metals where there can be quality differences and associated value differences, taking ownership of the physical asset exposes you to more quality risk. You can not be certain in these cases that you what you are buying is of the expected quality, and when it comes time to sell, CFD trading minimises any scary surprises on this front.
5. Speed of transaction and liquidity of market.
The speed of executing trades when actioned on a trading platform are as close to instant as you will find. This ensures you are able to take advantage of market movements are really short notice rather than having to plan a particular purchase in advance. You can usually action trades 24 hours a day which helps to give a lot more flexibility over when you can make trades.
The liquidity of CFD markets is usually provided by the broker themselves and essentially allows you to always find a buyer for your asset when it is time to sell. This gives you the capacity to get out of the markets as quickly as you got in. In the case of physical asset, you need to find a willing buyer and the market is not created for you.
6. No tax liability from stamp duty on CFD trading.
As you do not own the asset, you do not pay any stamp duty. Minimising taxes is always a win in our books..
7. Flexibility to trade multiple assets in one trading account.
As you would expect, CFD trading brokers allow you to trade many different instruments and assets all from one account easily. This eliminates the need for different accounts for each asset you trade, and removes the hassle of transferring funds from one portfolio to another and having to wait for receipt. All in all, a smoother process when you can trade with multi-asset brokers.
8. Able to minimise transaction fees with a group of assets together (in ETF or indices)
In the instance of ETFs where you are trading a group of stocks/assets, being able to make a single trade, rather than many, reduces the fees you experience. This has the capacity to drastically bring down your trading costs further.
9. Being able to trade against the asset
When trading CFD contracts, you have the option to sell the asset and profit in price drops, aswell as buy the asset and profit in price rises. This is something that allows you a lot more flexibility in your trading.
If you have a view that an asset is going to decrease in value, having the option to profit from this side of the trade is traditionally something that was only available to professional traders. Opening this up to the retail market is a great equaliser.
10. Hedge existing owned asset positions
You can use CFD trading to hedge the actual assets you already own. This is a risk management strategy used by the pros for many years and is another tool you can add into your basket.
During periods of volatility, being able to hedge to limit risk without having to sell your owned assets, really does open a new wave of possibilities.
Disadvantages of trading CFDs
As you would expect, there are a couple of correlated disadvantages you can associate with CFD contracts if you are not fully familiar with this type of trading.
Increased risk from leverage
Whilst trading with leverage has its’ advantages, for those amongst you that are not experienced traders, the more leverage you use, the higher the risk of seeing big swings in your account balance.
Whilst enhancing your trade size increases your potential for growth, it directly increases your potential for loss when you are on the wrong side of a trade.
Trade with leverage very carefully, and if in doubt feel free to use a broker where you can reduce the amount of leverage being used on each trade down to 1:1 (to bring yourself in line with same performance movement as you would see on real asset ownership).
Cost of financing long trades
If you are holding an asset with leverage, you typically are going to find you are paying overnight charges or costs associated with financing the difference between your trade and the leveraged asset value.
If you are trading short-term this is not an issue, but if you are planning to buy and hold an asset for an extended period, CFD trading may not be the best way to do so, unless you can reduce the leverage to 1:1.
No dividends on stocks or voting rights
As you are technically not owing the underlying asset, you are not treated the same as you would be if you were an actual shareholder in a company. This means you would not qualify for dividend payments, or hold the right to vote in any AGMs.
CFD Trading Review
When evaluating all the above, it is clear that CFD trading is providing more advantages than disadvantages to traders. The thing you need to take care of when trading CFDs is the amount of leverage you are using, always making sure you have a clear risk management strategy in mind.
CFD trading has brought trading to a whole range of users that historically would not have had the possibility to share in the markets. Removing entry barriers on cost, simplifying access to markets by way of user friendly trading apps, and eliminating stamp duty taxes are all great plusses that users in 2020 take for granted to a certain extent. The days of trading being in the hands of the few brokers with market access who charged you transaction fees on everything they were doing is very much in the rear window.
We need to be careful when trading CFD products but the same can be said for all types of trading and investing. Never stake more than you can afford to lose, keep a close eye on your trades, and manage your risk well. If you are interested to take a closer look at a few CFD trading platforms, see below some of our top recommendations.
Top CFD Broker
Trade Forex, Stocks, Cryptocurrencies, Commodities, and Indices with eToro as CFD. You can use leverage up to 1:300 under the safety of a broker with FCA, CySEC and ASIC regulation.
This CySEC regulated broker has a great array of options to trade including forex, stocks, indices, commodities, cryptocurrencies all under one easy to use platform. Millions of traders already using IQoption.
Join the UKs most popular CFD broker with Tier 1 regulation from FCA and ASIC. You can trade forex, commodities, stocks, cryptocurrencies, indices all as a CFD with Plus500.