What are CFDs?
What is a CFD?
CFD is an acronym for Contract for Difference. It’s a contract between two parties to trade a financial derivative. A derivative is the value of an underlying asset such as a stock exchange or commodity price like oil and gold. You are not trading the asset itself like buying shares or a company stock on an exchange.
When you purchase a CFD, you are entering a contract between yourself and a CFD provider. Both parties agree to pay the difference in price movement from the opening position to the closing position. A CFD essentially allows traders to speculate on price movements of an underlying asset without committing long-term to the investment. CFDs also give traders access to indices and commodities that may not be available in their local market or time zone.
For a simple example: A trader buys and holds the price of an index like the ASX200. The index increases in value and the trader closes the position. The CFD provider pays the trader the difference in value from the contract’s opening price to the closing price. But if the index declines in value, the trader could risk losing money and possibly owe the CFD provider more than their initial deposit.
CFDs and leverage
A Contract for Difference is a leverage product. This means CFDs only require a small percentage of the underlying asset’s value as a deposit to open a position. The deposit, also known as margin, can then be used as leverage to open larger trades. As result, leverage can magnify trader’s gains but can also magnify losses.
Unlike the stock market, where traders must pay the full share price to invest, CFDs require as little as 5 per cent of the asset’s value. This is part of the reason CFDs are attractive to many traders. Leveraged trades can apply to indices, oil prices, gold prices and crypto-currency prices.
Trading a CFD
CFDs are not regulated and decentralised, which means they do not trade through an exchange. To engage in a Contract for Difference, traders must first open a trading account with a CFD broker such as Eightcap. Once an account is opened, clients gain access to software trading platform MetaTrader 4 (MT4) and MetaTrader 5 (MT5). Using this software, traders can open and close a position to buy or sell a financial instrument with or without leverage.Traders deposit funds directly into their trading account instead of using a clearing house and agree to the terms of the contract, set by the broker.
Eightcap clients have access to 10 of the major global market indices, including the Dow Jones Industrial Average (US30), the S&P 500 (SPX500) and the Australian Securities Exchange (AUS200). Eightcap traders can also speculate on the price of gold (XAUUSD), the price of silver (XAGUSD) and the price of WTI crude oil (USOUSD) as well as Brent oil (UKOUSD). Instead of trading crypto-currencies like Bitcoin on an exchange, traders can speculate on the asset’s price movements through Meta Trader 5 (MT5).
Costs of trading a CFD
Like most financial investments, there is a small cost to trade CFDs.
Traders must pay a spread when buying or selling financial derivatives. A spread is the difference between the buy and the sell price and is usually represented as pips. A spread replaces traditional brokerage fees and while a spread might be small, it decreases the profit of a winning trade. A spread is paid once a position is closed.
A swap rate, also known as a rollover rate, is a fee or interest that is charged on positions that are held overnight in foreign exchange trading. A swap rate is not a set rate. It’s determined by the difference in interest rates between the two currencies used to trade.
Advantages of trading CFDs
CFDs are becoming increasingly popular with retail investors because of the advantages over trading stocks.
Margin and Leverage
This is the biggest drawcard for retail investors. The ability to trade large positions on a small deposit means CFDs are more affordable for small investors. By using leverage, traders magnify their gains for every pip or point the instrument moves in their direction.
Access to global markets
CFDs also give retail investors access to financial instruments they usually wouldn’t be able to trade. For example, index CFDs allow traders to speculate on the movement of the London FTSE or the Paris CAC without having to buy stocks in the indices. Like Forex trading, CFD’s can also be traded 24 hours a day, 5 days a week, moving across major interbank sessions. Longer trading hours makes CFDs more accessible than stock trading, which only takes place during exchange opening times.
Hedging and Scalping
CFDs can be used to hedge or scalp trades; two different types of techniques used to offset or reduce risk. Direct hedging involves opening two positions, a buy and a sell, on the same financial instrument. This is not always possible with stock trading. Scalping relates to buying and selling very small positions, very fast, in a bid to profit off small price movements. Again, this is not always possible with stock trading as some firms require a minimum hold time.
Another benefit of trading CFDs is the ability to trade the financial instrument short at any time. Some markets have rules or restrictions on shorting and require traders to buy the instrument first.
Risks of trading CFDs
While there are plenty of advantages to trading CFDs, there are also risks that every trader should be aware of.
Low margins and high leverage can magnify gains, but it can also magnify losses. If a financial instrument moves against your position, traders may lose more than their initial deposit. While stop loss limits can be used when trading, it doesn’t guarantee any losses.
With high liquidity come fast-moving markets. An economic release or political comment can drastically move the market and if traders aren’t monitoring their positions closely, they can be at a loss. Scalpers in particular need to be fast when closing trades if they wish to make a profit on small moves.
Is a CFD right for you?
While it’s not compulsory, traders are urged to seek financial advice before making any large investments. Eightcap offers a platform for traders to buy and sell financial derivatives including CFDs, but it’s important to note we do not offer financial advice to clients. No financial investment is without risk and you should consider whether this product is appropriate for you.