What you should know about CFD trading

by Alexander Zane Financial Analyst

The world of trading can sometimes be a complicated and unwelcoming place. If you have just started and do not know where to look, we have a great recommendation for you. Trading in a CFD (contract for differences) is a strategy we recommend for all new traders who do not know where to start. A CFD is a common type of derivative, alongside forwards, futures, options, and swaps.

Derivatives

A derivative is a sort of contract that allows you to profit on the change of the value of an asset without owning the said asset. They are essentially a type of bet, although you can obviously make better predictions on what the outcomes will be. Most are set up between two parties, with some sort of intermediary (i.e. a broker) to deal with the details.

Derivatives are quite attractive to traders, as they can ensure that a transaction can be completed without any push-back. This is because, as we stated earlier, you do not own the underlying asset so you do not have to convince a buyer or seller to trade. As long as the requirements of the contract are fulfilled, the trade can go through.

Why CFDs are Unique

What makes a CFD unique from other derivatives is that it allows investors a lot of control over their investment. These contracts do not expire, so you can keep hold of them until the asset reaches the desired position. You will not be forced to buy or sell in a position that is highly disadvantageous for you. They are under fewer regulations, meaning that they are more flexible. This means when you go to a broker to arrange your CFD, you can arrange the contract at practically any price. Some brokers will in fact allow you to trade with as low as $1,000 since you are not buying an expensive asset. You can also arrange the CFD around any asset. This can be forex, a stock, a commodity, or whatever you can think of.

Brokers dealing in CFDs also often allow for trading on margin or leverage, basically allowing for a loan. When investing in a CFD, you can generally borrow at around 2 to 20% per investment. This means you can make somewhat larger investments without having to use as much of your own liquidity.

The flexibility of these contracts, combined with the fact that brokers will allow you to use leverage, make them a nice entry into the trading world. They are quite complicated, but as long as you choose the right broker the details can be explained to you quite easily.

You can make these investments in whichever direction you choose. By this we mean you can either profit from a rise in the price of an asset or the decrease in the price. This is going long and going short on a CFD respectively.

Possible Drawbacks

While CFDs can be a good gateway into the trading world, as with anything there are disadvantages. After all, if there were only advantages almost everyone would be using them, right?

Choosing a CFD broker

So first off, remember how deregulated this sector is? This does come with some disadvantages. Regulations are used for a reason after all. Since there are fewer regulations in this sector, you will have to look long and hard for a reliable broker. With most brokers, there is a central body regulating their practices whose credentials you can check to confirm the validity of the broker. For CFDs, however, you will have to do the investigation by yourself. How well does the brokerage preform? Have their previous clients made profits? What do the reviews say?

Additionally, as you can practically choose your own trade, you will have to be certain of your trade before you make it. The broker can advise you but at the end of the day, it is your decision. If you insist on a bad decision, the broker cannot help you.

CFD Fees

Secondly, while the fees for a CFD investment may initially seem low, as commissions appear low, they tend to be higher. This is because brokers are actually unlikely to charge you using a commission. Instead, they rely more heavily on the spread of trade. What is the spread you may ask? The spread is the difference in the price a broker will charge you between the asking and selling price. So, they will charge you more for the value of the underlying asset at the asking price, and less at the selling price. So when dealing with the other party, they will use price closer to the actual value, and you pay the difference to pay their fees. A spread can be very costly. If your investment is very low stakes with small profits, it is likely that you will not make any profits at all.

There are additional fees you may be required to pay as well. This can be the holding and market data costs. Holding costs are paid at the end of every day depending on how the underlying asset is doing. They can go in or against your favor depending on the asset’s performance. The market data cost covers a broker’s fees for analyzing the market. Even though the spread tends to be the largest fee for an investor, all of these smaller costs can add up to a considerable sum.

Volatility

Even though CFDs do not expire, this does not mean that you will not have consequences for investments that go sour. If your investment is going against your preferred trend, you may have to pay margin calls to your broker. Essentially a charge to keep the brokers from getting too worried. A highly volatile market can also make brokers nervous and result in charges or higher spreads. This is also quite a likely scenario because the CFD market is often highly volatile (again owing to its lack of regulation). This volatility means you will have to pay close attention to your investments to ensure profits.

Finally, we should mention that the relative volatility in the CFD market means that they are not available everywhere. While widespread in Europe, for example, the United States has outright banned these sorts of trades.

Conclusion

If we were to summarize, we could say that you have a lot of relative freedom, but this freedom can come at a cost. Due to all of the above factors, we would strongly advise you to consider exactly why you want to enter the CFD market. If you are just starting you are unlikely to make high profits, you do not want to make high investments. This is, in fact, quite okay because what you should really be doing is learning. You can get a feel for how the trading without being tied down to real assets. In this way, you can improve your skills and become comfortable trading.

When you are comfortable with the trading world, the CFD market still has plenty to offer you. You can invest in any area you deem to be potentially profitable. You can set your own prices. As long as you are careful in your investments and are sure of the large profits you can be quite successful.