What is a CFD?
A Contract for Difference (CFD) allows traders as well as investors in Europe to use price changes to make profits without actually possessing the inherent product. Marking the price movement difference between entry-exit points of the product, CFD doesn’t consider the value of the asset in question.
In this article, you will know all about a CFD, its gains, and its drawbacks. Furthermore, we shall delineate the distinction between CFD trading and investing.
Understanding a Contract for Difference (CFD) with example
As the name suggests, CFD is a contract to exchange value differences of a particular product from the time it opens up till it closes. The contract is between an investor and a broker. Let us take an example to understand CFD better.
Let us assume that a trader purchases 100 shares at a rate of $25.26 per share; the cost of the whole transaction then would amount to $2525. At a traditional broker, the trader would need to have at least half of the margin account, that is, $1263 in cash, whereas a CFD requires only $126.30 or a 5% margin.
During the transaction, the CFD trade will highlight a loss equivalent to its spread size. If it is 5 cents, the stock has to gain that much for its position to break even.
In a conventional broker account, if the stock moves up to $25.76 bid price, one can sell it for a gain of $50, which amounts to a 3.95% profit ($50/$1263 x 100). But the actual price may only be at $25.74 by the time this price level is reached by the national exchange. Compared to the regular market, the spread is larger and there will be less of a CFD profit.
In our example, the trader gains about $48 or a 38% return on investment ($48/126.30 x 100). The trader may even be required by the broker to buy at a higher price, let’s say, at $25.28. But, even then, the earnings of $48 or $46 highlight a net profit. This way the CFD trader ends up making a bigger profit.
Pros and Cons of CFDs
Let us go through some of the benefits and drawbacks associated with CFDs. First, let us take a look at how CFDs benefit a trader or investor.
Compared to conventional trading, there is much larger leverage in CFDs. This is dependent upon regulation. When there is a low margin requirement, the trader has to have less capital on hand and can get greater returns.
There is 24/7 access to the world’s major markets and products provided by CFD brokers. Furthermore, since the trader doesn’t possess the asset, at any time they want, they can short the CFD instruments.
All the order types that are offered by conventional brokers are proffered by the CFD brokers too. They make money only when traders pay the spread; many of them don’t charge anything at all in terms of fees.
There are many markets that place limitations on trades or won’t allow them without a minimum capital amount. But, this is not the case with the CFD market. One can trade without these restrictions. Though $2000 and $5000 are some common deposit amounts, they can also be opened for as little as $1000.
There are multiple drawbacks to CFDs as well. Making profits from small moves is all but eliminated since the trader has to pay for the entry-exit spread. This decreases profitable trades while exacerbating loss when compared to security.
Furthermore, there is not much regulation within the CFD industry. A broker’s credibility is entirely based on his/her prior reputation and position financially. There are multiple risks associated with this type of trading as well.
If you cannot cover the reduction in values, your position will be closed by the provider and you’ll be forced to meet the losses, regardless of what happens to the product.
The potential for losses is as great as the potential for gains with high leverage risks. Even though CFD provides make available the stop-loss limits, profits are not guaranteed, especially when there are sharp price movements. Lags in trades may also exacerbate execution risks.
CFD trading vs. CFD investing
Those who have a short-term outlook would benefit from CFD trading while those who favor a longer-term outlook would be ideally suited for CFD investing.
With CFD trading, the ability to use leverage is highly beneficial as it allows you to get complete market exposure while committing to only an upfront deposit. However, as mentioned before, leverages carry with it the inherent risk of amplifying both profits as well as losses.
With CFD investing, you can benefit from price movements if you own an asset. You will also be required to commit to the positional value of the asset upfront since leverage is not available when one is directly investing. However, this also means that the value of the position automatically caps the maximum risk that you’re exposed to.
It is good to reiterate that when you trade CFDs with leverage, both your losses as well as profits are amplified due to increased exposure, which is highlighted in the image above. Profit and loss are not calculated by using the initial deposit or cost but by using the full positional size.
Below we highlight key differences between CFD trading and CFD investing:
CFD trading allows you to go short; CFD investing doesn’t.
Deposits on CFD trading are around 20%-25% of total position size; in CFD investing, you pay the full value upfront.
CFD trading gives no shareholder privileges; CFD investing grants voting rights and receiving dividends.
CFD traders have to pay tax on profit; CFD trader has to pay stamp duty on deals as well as on profits.
The Bottom Line
There are many CFD trading benefits but the pitfalls and losses are also worth taking note of. High leverage exacerbates not only gains but losses as well. The basic market that should dictate whether one should trade or invest in CFDs depends on their outlook. If it’s short term, opt for CFD trading, when the outlook is long-term, CFD investing is better suited.