CFDs stand for contracts for difference. It is a type of financial instrument that enables you to trade on the difference in price of stocks, assets, and other financial products, without ownership rights of the underlying asset.
The key difference between CFD trading and share trading is that the former belongs to derivatives trading and the latter – to stock market trading. That is why, CFDs are not listed on exchanges like traditional shares, but rather are traded through a brokerage.
According to the CFD definition, you don’t ever own the financial instrument being traded. What is being traded is a contract between a trader and a CFD provider. Under this contract, a seller abides to pay a buyer the difference between the current security price and its value at the end of the deal. The opposite is true if the difference is negative. Stocks, bonds, futures, commodities, indices, and currencies are all available to trade as CFDs. Comparatively, when speculating on the stock market, you buy/sell the ownership right to the underlying asset. In this case shares. The buy transaction, inherent to speculating on traditional shares, results in higher costs because of stamp duty.
With both CFD trading and stock trading, it is crucial to understand the ins & outs of the underlying market to make a smart investment decision.
|Contracts for difference||Traditional shares|
|Traded on exchanges|
|Broad range of assets|
|Free of stamp duty|
|Ownership of the underlying asset|
Depending on how you see the prospects for an asset’s value, you take either a long or a short position in the CFD market.
That is, if you believe the price of the financial instrument will rise, you opt for buying and take the so-called long position. If the opposite is true, and you expect the prices to fall, you will naturally prefer going short, or simply selling.
For example, if you have gone long with XYZ share/commodity/currency, you expect that the value of this asset will rise in the near future, allowing you to make a profit. Yet, if the value of XYZ asset drops, confounding your expectations, the long position will result in a loss. In slang terms, your position will be underwater.
Conversely, if you have gone short with XYZ share/commodity/currency, you expect that the price of this asset will slump shortly. If your expectations are realised, you are free to reap the profits. Yet, if the value of XYZ asset grows contrary to your expectations, you will incur losses.
In a nutshell, if the market moves in your favour, you profit from the change in price. However, if the market performance deviates from your expectation, you may face financial losses.
Leverage is an investment technique that uses borrowed capital to finance a larger market position. Leverage is open to all kinds of assets.
With leverage, investors are able to magnify their market position and hence, their potential returns, while chipping in only a fraction of their position’s total value. The remainder of the sum comes from a broker, who receives a specified percentage, or margin, on the borrowed funds. The leverage technique is popular with short-term investors and those interested in CFD trading to gain access to a wider market.
The traders’ rationale behind buying on margin is that the returns will exceed the interest they have to pay on the debt. Yet, if the market moves other than they expected, investors have to bear ‘magnified’ losses, too.
To be able to use leverage, investors are obliged to set up a margin account with a brokerage – that is, they must deposit a certain amount of money or securities with their broker that can be used as collateral. Traders must comply with the initial margin and maintenance margin requirements, imposed by their broker. The former represents a percentage of the purchase price of securities that is paid by traders using their own funds. Brokerages may lend up to 50% of the purchase price to investors, depending on their leverage ratio. The latter indicates the minimum percentage of the total market value of the securities that has to be preserved on the trader’s margin account. At its lowest, a margin account may drop to 25% of the value of the purchased securities.
Brokers determine a leverage ratio, which indicates the maximum leverage, available to investors. For example, with 1:50 leverage ratio, traders can borrow up to 50 times more than what they have invested themselves. In this case, the initial margin equals 2%. With maximum leverage, traders enjoy more leeway to trade on the market. Yet, the more leveraged the trading, the higher the risks.
Hedging is one of the lowest-risk trading strategies available. It aims to balance out asset exposure and limit future losses. This strategy is especially popular in high-volatility markets – that is, markets with wide-swinging price fluctuations. Hedging can be achieved by taking opposing positions in correlated markets, or buying and selling the same financial product in order to offset exposure to price swings.
CFD trading can be considered a hedging tool against other open positions. Firstly, it enables investors to take advantage of the falling market. Secondly, it allows you to lock in the gains and protect your profit from further price movements, especially if you believe a particular CFD has reached its profit target. In this case, you avoid potential losses but you also turn your back on possible gains. Suppose you own some leading blue chip shares. Then, by opening a short position on the FTSE index, you may preserve your profits during the times of lower risk appetite. Finally, CFDs can be a means of portfolio diversification, too. Due to their accessibility and ability to be used quickly, CFDs can help traders build diversity in their portfolios and gain access to new markets.
For example, if you are looking to hedge a $100,000 stock portfolio, you just need to take out an opposite CFD trade. Taking into account that CFDs are traded in the margin, you don’t have to put out the entire notional value. Instead, you could borrow the funds from your broker and trade on margin.