Today, individuals have more choices than ever before when making investment decisions. Although normal market trading via a financial institution or brokerage firm remains a typical model, it is becoming more prevalent for individuals to explore other avenues. CFD trading is one such technique that has gained popularity since it puts people in control of their investment decisions and it enables trading in many different financial assets.
In contrast to stocks, bonds and other financial instruments where traders or investors physically own the assets, Contract for Differences (CFD) trading does not entail the ownership of any assets. Instead, they involve what’s called margin trading, using units that are connected to the price of a specific asset based on the security's market value.
Well, how does a CFD work? Overall, a CFD is essentially the right to speculate on a security's price fluctuations without having to own the asset itself. This type of investment is defined by its name: a contract intended to benefit from the difference in the security price between the contract's opening and closing dates.
Here are some indications that CFD Trading might be a good investment choice for you:
Overall, CFDs are characterised by three primary components: leverage, margin and hedging.
Leverage
CFD trading is leveraged, which means you can obtain exposure to a significant position without incurring the whole cost up front. Suppose you wanted to open a position equivalent to buying 500 Apple shares. With a regular share transaction, you would need to pay the entire price of the shares up front. In contrast, with a CFD, you may just need to put up 5% of the total amount.
While leverage allows you to spread your money further, it is essential to remember that your profit or loss will still be computed based on the total size of your position. In our example, this would be the difference between the price of 500 Apple shares at the time the transaction was initiated and the price at the time the deal was concluded. Consequently, both gains and losses may be greatly exaggerated relative to the initial investment, and losses might outweigh deposits. Due to this, it is essential to understand the leverage ratio and trade within your means.
Margin
Leveraged trading is also referred to as "trading on margin" since the money necessary to start and maintain a position – the "margin" – is just a portion of the position's overall size.
There are two forms of margin used in CFD trading. A deposit margin, or initial margin, is needed to first establish a position, and then a maintenance margin, or variation margin, may be necessary if your trade is near to incurring losses that the initial margin – and any extra cash in your account – cannot cover. If this occurs, you may get a margin call from your provider requesting that you deposit more money into your account. If insufficient funds are added, the trade may be terminated, and any losses automatically realised.
Hedging
CFDs may also be used for hedging, to protect an existing portfolio against losses. For instance, if you hold ABC Limited shares in your portfolio and you expect to see a short-term decline in value due to a poor earnings report (but you don’t want to simply sell the shares at this time), you could mitigate a portion of the possible loss by shorting the market through a CFD transaction. If you choose to hedge your risk in this manner, any decline in the value of the ABC Limited shares in your portfolio would be off-set by the profit on your short CFD bet.
CFD trading fees may include an additional commission, swap or financing charges, as well as the bid-ask spread. Some brokers provide accounts with zero commissions where the cost of trading is included in the (generally very tight) spreads and a small fee.
Other items, such as stocks, may incur the commission as a separate fee. Foreign exchange (FX) and commodities trading often incur no additional fees.
Using Leverage
With CFDs, you can take advantage of a high level of leverage, meaning that you only need to deposit a tiny portion of the overall trade value. This is the initial margin, after which the exposure to the funds is multiplied to increase profits. Using the conventional trading strategy, your investment and exposure are equivalent. In CFDs, your investment is lower, but your exposure is the same.
CFDs provide more flexibility than conventional investments such as stocks and commodities. If the market is declining, CFDs enable you to make profit by shorting the market. The premise of short selling is the expectation that an asset's price will decrease. Put simply, you sell the asset at a high price and (if the price declines) you can make a profit by repurchasing the asset at a lower price in the future.
No Regulations on Shorting or Day Trading
Some markets prohibit shorting, requiring traders to borrow the asset to engage in shorting. There are a few others with distinct margin requirements for shorting or going long. Since the trader does not truly own the instrument (and therefore doesn’t have to deliver anything when selling), assets may be shorted at any moment in CFD trading without the requirement for borrowing.
No Expiration Date
CFDs do not have a fixed expiration date, unlike other forward-looking securities such as futures; hence their prices do not depreciate, and they are less constrained.
Lack of Ownership
CFD trading is not about purchasing actual underlying assets but about speculating on price fluctuations. Therefore, you may own the contract but not the underlying asset, such as a stock or commodity, on which the contract is based. Dividend rights are a benefit of owning shares in a firm, but since CFDs do not confer ownership, CFD traders do not qualify for dividends.
Higher Risks
CFDs have a higher risk profile since both profits and losses are leveraged. For example, if you buy a stock with 20x leverage, you only have to pay a 5% initial margin to acquire the position. If the stock rises by 5%, then you double your initial investment (20 x 5% = 100% profit), but if the stock falls by 5%, then your investment is wiped out. As a result, CFDs are a significantly riskier form of investing than, for instance, directly trading in stocks since the potential loss from each transaction is greater. This is why it is essential to understand how leverage works, and to trade with strict risk management rules.
Considering the flexibility and potential for greater profits from CFD trading, it is a good solution for many traders, especially those who are already well-versed in the fundamentals of trading/investing. The key is to understand leverage and to manage risk carefully, and then significant profits can be made from both rising and falling markets.
