If you’ve taken a cursory glance at investments, then chances are you have come across this term ‘CFD’. A CFD, or Contract for Difference, is a way to invest in an asset without ever actually owning it. Instead of purchasing and selling the asset itself, a CFD creates profits or losses when the asset moves in value, compared to the position taken.
So how do CFDs work?
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To take an example to illustrate how CFDs work, take a stock with an ask price of $30. Let’s say you purchase 100 shares from a CFD broker. Immediately, you would display a loss that the stock would need to appreciate to make up for, as you would need to cover the spread. If the spread is 5 cents, then you would see a 5 cent loss. If the stock appreciated to $30.50, and you sold, you would again have to pay on the spread, losing a couple of cents. You wouldn’t face either of these if you owned the stock yourself. Instead of making a $50 profit on the 100 shares, you might make $47/48.
That doesn’t sound particularly great does it? Already starting off at a loss no matter what, and getting less of a profit than if you owned the stock itself sounds bad, but it doesn’t tell the whole story. When purchasing and selling stock, you will pay commissions and other fees that aren’t present with CFDs, so the CFD option is likely to put more money in the trader’s pocket. Additionally, with trading platforms such as Stern Options, their user-friendly dashboard makes it easy to track your investments and market performances.
Advantages of CFDs
There are further advantages to trading CFDs. The Contract For Difference’s provide higher leverage compare to other traditional trading, with leverage having as low as a 2% margin requirement. This is in strong contrast to the 20%+ margin requirements often seen in traditional asset trading. A lower margin requirement means lower capital outlay needed and greater returns, trading this off against higher potential losses.
There are also fewer rules regarding trading CFDs, with no day trading requirements or short selling rules. An instrument can be shorted whenever, and with no transferal of ownership of the underlying asset, there are no borrowing/shorting costs. In strong contrast to certain markets, with CFDs there are no restrictions regarding day trading, and accounts can be opened for as little as a $250 deposit.
CFD Disadvantages
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Whilst CFDs certainly present many advantages, there are some key reasons not to opt for CFDs. Paying spread both on purchase, and when you sell the CFD means there is little potential to profit from small moves. Whilst the fact that the CFD market isn’t as regulated as traditional trading certainly provides a number of benefits, this brings with it the big disadvantage – credibility of the broker is far more important. Investigating the reputation, life-span and financial positions of any potential brokers is important anyway, but this is magnified with CFDs.
So are CFDs for you? Potentially, if it lines up with your trading plan. They can be a brilliant financial instrument if used correctly, but they are certainly no ‘get rich quick’ option. Consider CFD’s as a potential high risk, high reward element of your financial plan.
