CFD, CDF, ABS, MBS, do you know what all these financial abbreviations stand for? No sweat, even sophisticated traders don’t know every single product in the market. However, I believe you should know this one: CFD, or “Contract for Difference”…not a very creative name, I know, but trading is not a poetry slam.
You should know what a CFD is, because it can make you money. I guess that’s enough reason. They offer a variety of advantages, but they also bear certain risks. Read on and learn how to use them to your advantage.
CFDs mirror the price movement of an underlying asset
Basically, a CFD is a contract between you and your broker. It mirrors the price movement of an underlying asset, for example an index or a certain stock. Let’s say you buy a CFD on the price movement of 100 Ford shares. Right now, the stock is sold at $11.45. You won’t own the stock, but you will receive/pay the price difference once you terminate the contract.
However, CFDs are fundamentally different from futures contracts. They have no fixed expiry date. Instead, your positions will be renewed at the close of each trading day and as long as you have enough money in your account, they may be rolled forward indefinitely.
Ok, back to our Ford example: Let’s say the stock goes up to $11.95, you’ll get $50. If it drops to $10.95, bummer, you’ll loose $50. That will be the same as if you buy the stock in the market, but there are some important differences.
CFDs offer higher leverage
If you buy a stock in the market, you will have to pay the full price. Many brokers will offer you a margin, let’s say 50%, so you only have to pay $572.50 to buy 100 Ford stocks. However, CFD brokers offer far lower margins, often as low as 5%, so you can operate with a much higher leverage.
In this case, you’d only need $57.25 to buy 100 Ford stocks. Remember: Leverage can boost your earnings, but it can also accelerate losses. Operating with leverage is risky, so you need to know what you are doing.
Spreads are higher in CFD markets
You must exit a CFD at the bid price. However, spreads (the difference between the bid and the ask price) in the CFD market are likely to be wider than in the actual stock market. As a result, you will lose a fraction of your profit. If your Ford stock reached a bid price of $11.95 in the stock market, it may only be $11.93 in the CFD market. Hence, your profit will be $2 lower.
Less commissions and fees, but you’ll pay the spread
Most CFD brokers will charge less commissions or fees to enter or exit the trade compared to common stock brokers. However, that’s not because they want to be nice to you. They earn their money with the spread, which will be wider than in the stock market. Take a close look at your brokers fees to make sure you know what your costs are.
I guess you got the overall point. The major trade-off is the following: If you buy a stock in the traditional way, you will have ownership rights, but you will also need much more cash and you will have to pay more commissions and fees.
In the CFD market, you can operate with much higher leverage and your main cost will be the spread. Furthermore, you have access to a wide variety of assets all around the world.
The advantages of CFD trading are obvious. That’s why they have become increasingly popular and more traders are using them in their daily trading. However, especially beginners should be careful. CFDs are sophisticated instruments and should be traded with care.