A contract for difference, also known as a CFD, is a tradable instrument that mirrors the movements of an underlying asset. When this asset moves in relation to the position taken by the trader, it allows profits or losses to be realized without having to actually own the chosen asset. So who owns the asset then? The answer is your Broker, and a CFD is therefore in fact a personal contract between you and your Broker.
Trading CFD's has several major advantages, of which perhaps the biggest will be the fact that you are able to take on a larger position size with relatively little money in your account.
Let's do some math:
If you are planning to buy 100 shares of a stock, at the price of $35.00, the total amount of this transaction would be $3500. In other words, you would need to have $3500 in your account in order to execute this trade. When using a CFD broker, you will have the option to enter a trade with a margin requirement of often only 5%. This depends on the broker you use, but if this would be the case this trade could in fact be entered for a cash equivalent of only $175.
When this particular CFD trade is executed, the position will always show a loss when opened. This loss is equal to the size of the spread. Spread is in fact the difference between the actual market price, as a fee or profit for the broker. If for instance you are going long and the spread of the particular trade would be 10 cents at your CFD broker, the stock will need to appreciate 10 cents first in order for your trade to reach a breakeven price. If you compare this to a traditional trade, you would own the stock outright and you would have seen a 10 cent gain. But in this case you would have paid a commission and needed a significantly larger outlay of cash.
As for opening a CFD margin position, you will have to keep in mind that since it is a margin trade, you will need to have sufficient capital in your account in order to sustain the trade if the stock price moves against you. The broker will always have the power to close your trade if your margin equivalent exceeds the capital held in your account. Always make sure to follow your trade plan (more on this in the near future), so be sure to know when to open a trade, when to take profit, and most important of all: when to close your trade if going the wrong way (stop-loss). Be sure to have sufficient capital in your account in order to cover all of your trades and won't be stopped out before your stop-loss points due to insufficient capital in your margin account.
The overall advantages of CFD trading are:
- CFDs provide higher leverage than traditional trading. Normally, the leverage in the CFD market can begin as low as 2% margin requirement. Depending on the chosen asset like shares or forex, margin requirements may go up. The lower the margin requirement, the less money will be needed, and thus greater potential returns. Keep in mind however that increased leverages can also increase potential losses.
- The CFD market generally does not have shorting rules. An instrument can be shorted at any time, and because there is no ownership of the actual asset, there are no shorting or borrowing costs involved.
- The CFD market has no requirements on minimal amounts of capital in order to day trade. You are able to open an account for as small as $1000 or even less depending on the broker.
Although CFD trading is very attractive due to the facts mentioned above, there are also some negative aspects. Since you will have to pay the spread on entries and exits of the trade, it eliminates the potential on profit from small moves in the market. Also keep in mind that losses may increase when not following a steady trading plan, due to the leverage on the instruments. Furthermore, the CFD industry is not yet highly regulated, so it is important to choose a credible broker.
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