Have you ever been beckoned by the big profits of CFDs? Then it’s time to learn more. Unlike a typical stock market transaction where you own a share, with contract for differences’ you get the difference in the products price over the time the position is open without actually owning the stock. This is great for people with low funds, but there are aspects of CFDs that can catch you out.
What is a CFD?
CFDs or contract for differences are an investment type that allows investors to profit from price movement without owning the asset. This security essentially calculates the asset’s movement over the time the position is held rather than basing profit on the trades underlying value. So why is it called a contract? Excluding the true value of an asset is only achieved by a contract between the broker and trader, excluding stock exchanges. A CFD is thus an agreement between a trader and broker to exchange the difference in price at the time the contract opens to the point it closes.
If you trade CFDs you don’t actually own the asset, instead you earn profit from the change in price. For example, if a stock has an ask price of £10 then 1 share is £10 plus any commission or fees the broker may charge. This means you must have £5 free in cash to carry out the transaction in a typical investor account, where a broker holds a 50% margin. If you were carrying out this transaction as a CFD, brokers require only a 5% margin, equivalent to only 5 pence, that needs to be available as free cash.
Why are CFDs so popular?
You can access the asset at a much lower cost than if you were to actually buy it, making it much more affordable. This is as CFDs have a much higher leverage than traditional trading. Leverage in the CFD market is controlled by regulators and could be anywhere from 3% to 50%. A lower margin requirement means you need less free cash to invest with and therefore can achieve higher returns than a traditional account with the same cash.
Furthermore, you can short CFDs at any time without borrowing costs. This is one of the perks of not owning the underlying asset!
Another great thing about CFDs is there tends to be less fees. There are normally no transaction fees and no limits on trading over more than one day. This is great news as usually beginner traders are off put by brokers taking their money. Although you must note the ‘fee’ for the transaction is taken by entering you at a negative position at your buy point.
Short falls of CFDs
However, there are a few short falls to trading CFDs that you should be aware of. Although the profit you can achieve from CFDs for the same economic cost is much greater, when you take out a CFD, your initial position is decreased with a loss equal to the size of the spread at the time you enter the contract. This starts you off on a bad stead. For example if the spread is £1 at the time you choose to enter the position, then the asset needs to gain £1 in the market for you to break even. Whereas, with a typical market transaction where you actually own the stock, then a £1 move in the market would be profit!
Another disadvantage is there is higher risk when trading CFDs than stock markets. There tends to be weak industry regulation, poor liquidity and the need to maintain a margin. You may have heard of stories of people pouring and pouring their money into CFD accounts to keep their contracts open. A big catch is that you can trade assets worth a greater price than your portfolio. For example if an asset falls, and falls below the float held in your CFD account you have to make a stressful decision. This means essentially you must close a position at a huge loss or are in debt to the broker if you keep the contract open.
If you hate transaction fees and don’t have a large starting fund then CFDs might just be the answer to your prayers! Always understand the risk before you trade. Or practice with BullBear.