CFD trading is becoming more and more popular everyday. But how does it work exactly and what are the advantages and disadvantages? We answer all your questions related to Contract For Difference trading in this comprehensive CFD trading Guide.
A Contract For Difference (CFD) is arrived at by calculating the difference between the value of an asset when a trade is entered and its value at contract time. The trader doesn’t actually own the underlying asset. Rather the CFD mirrors the price movements of the underlying asset. Depending on the position taken, the trader will earn a profit when the price of the asset moves up or, incur a loss if the price drops at contract time. Contracts For Difference are always settled in cash rather than a tangible asset.
CFD trading require two parties, a buyer and a seller. The contract stipulates that the seller pay the difference realized at contract time if the price of the underlying asset increases. On the other hand, if the price drops, the buyer will pay the difference. As one of the increasingly popular ways to trade in financial instruments, CFDs offer a number of advantages which will be covered later.
Detailed example showing how Contracts For Difference work
Important terms you should know
– Ask price – This is the price quoted by the seller.
– Bid price – This is the price a buyer is willing to pay for a security.
Both the ask price and bid price are quoted together at the time of entering a contract. The bid price is always the lower of the two.
– Spread – This is the difference between the ask price and the bid price.
– Margin – This refers to the amount you’re required to invest when entering a trade. It’s calculated as a percentage of the current value of the underlying
asset you want to trade in.
Now to the example.
Suppose you want to trade in a stock that has an ask price of $33.46 and decide to buy 100 shares. The total investment required will be $3346.
If you were trading through a traditional broker offering a margin of 50%, the amount you would be expected to invest would be $1673. Online CFD brokers on the other hand offer margins that can be as low as 5%. This means for this trade, you’ll be required to invest $167.30.
Supposing that the bid price for the same stock is $33.50 the spread will be $0.04. The position you take at trade entry will show a loss equal to the spread. Therefore, the stock must appreciate by at least 4 cents to be at the breakeven price.
Assuming that the stock price continues to appreciate and reaches a bid price of $33.96, you can now sell it at a $50 profit.
This means that you can earn a potential return of 1.49%. However, it’s more realistic to assume that the spread quoted by the CFD broker is likely to be larger than the
actual spread quoted in the stock markets. Therefore rather than $33.96, the bid price might actually be $33.94. If you sell at this price, you’re still going to earn $48 profit. When calculated using your $167.30 investment this means you have earned a 26.89% return.
Still assuming the spread differences between what’s quoted by the CFD broker and the actual stock markets, the broker might quote an ask
price that’s slightly higher, say $33.48. Even then, you’re still going to make profit from your trade if it’s successful.
So why would the CFD broker quote an ask price that’s slightlyhigher and a bid price that’s slightly lower than what’s quoted in the stock market?
Many CFD broker earn money by making the trader pay the spread amount. The small differences between ask and bid price are meant to
enable them minimize losses on trades.
Advantages of trading CFDs
CFD brokers offer higher leverage
Leverage refers to the amount of money the broker lends you in order to enter into a trade. This is the opposite of margin which means the minimum amount of money the broker requires you to invest before entering intoa trade. Using our example above, since buying the 100 shares requires a capital outlay of $3346, with a margin of 5%, you’ll invest $167.30 while the broker “loans” you the remaining $3178.70.
A lower margin means that you can “borrow” more money on a trade and risk less of your own money.
This increases profit potential per trade. On the other hand, higher leverage can also magnify your losses.
Easily access global markets from anywhere
CFD trading gives you access to financial instruments that include stocks, treasuries, currencies, sector CFDs, indexes and commodities. Online CFD brokers give you access to all major markets across the globe. As long as aspecific market is open, you’ll be able to access it via the broker’s platform.
No short selling rules
Many financial markets have shorting rules which are to thedisadvantage of the trader. For example, going short might expose you to a
different margin (which requires more capital outlay from you) or even requirethat you initially borrow the instrument.
These rules are meant to discourage traders from going short. CFD markets generally don’t impose such rules thus
allowing you to go short as a way of protecting your profits or minimizing losses on a trade.
Trader friendly order types
The order type provided by your broker will go a long way in determining how well you can manage risk. Modern CFD brokers offer the same
order types as those provided by your traditional broker. These include stops and limits. Some brokers will also provide guaranteed stops at a fee.
It’s however recommended that you first identify the different order types provided by a broker before investing your money with them.
Little or no fees
Fees and commissions can easily eat into your earnings. CFD markets are structured such that brokers earn revenue by making traders pay the
spread amount. As such, your broker is unlikely to charge you commissions or fees on trades executed.
You’re not restricted to day trading only
When trading in CFDs day trading is an option. Some markets will require that you place a maximum amount of trades per day or even place caps
on the amount of capital you can invest on trades per day. Opening a CFD trading account usually requires a minimum investment of about $1000 although
this largely depends on your broker.
Disadvantages of CFD trading
You’ll pay the spread amount
CFD brokers earn revenue by making traders pay the spread amount. This will reduce your earnings on your winning trades as well as
increase the loss amount on losing trades. However, the spread amount charged is usually quite minimal.
Getting in and out of trades often can prove costly for traders since the spread amount is paid on every trade.
CFD trading is not heavily regulated
Some markets such as binary options trading are highly regulated due to high incidences of fraud. CFD trading on the other hand isn’t highly
regulated and investors are advised to be cautious when selecting the broker to work with. A good way to find a credible broker is to check their reputation
and track record as well as the different features they offer on their platform.
CFD trading FAQ
Are CFD profits taxable?
Yes they are. Trading in CFDs assumes that you want to earn profit. In countries such as the UK and Australia, profits earned are treated as capital gains tax. If CFD trading is your primary source of income, profits may be treated as income tax. On the other hand, losses incurred while trading CFDs may be used to offset any gains made. Since you don’t actually own the underlying assets, CFDs are exempt from stamp duty.
Whether your CFD profits will be taxable also depends on your country of residence and how much profit you earn per year.
It’s advisable to seek legal advice if you’re not sure.
Are CFDs tax free?
Buying and selling CFDs doesn’t require that you pay taxes such as stamp duty. The reason for this is that you don’t own the underlying asset being traded. However, the profits you earn from trading might be subject to taxation provided they reach a specific minimum as provided by the law.
Are CFDs safe?
Trading CFDs is considered safe. However, there are two main factors which will determine whether your money is safe or not.
First, consider whether the broker you invest with is regulated or not. For example, if you’re trading within the UK, consider
whether your broker is regulated by the Financial Conduct Authority (FCA) or CySEC within Europe.
Second, consider how you approach CFD trading. As with any financial market, there’s the potential of losing your investment. Sound research
and use of a good trading strategy will allow you to minimize risk. You should also use broker provided tools such as limits and stops to minimize losses
incurred on trades.
Can you trade CFDs in the USA?
Currently, CFD trading is not permitted within the USA. Legislations such as the Dodd Frank Act heavily put restrictions on trading
of over the counter financial instruments including CFDs. In addition, the different exchanges currently regulated by the SEC and CFTC
do not offer CFDs to US citizens.
Do CFD traders make money?
Contracts For Difference makes it possible to make huge returns through leverage.
Like with other financial markets, making money trading CFDs largely depends on how well you
can speculate the price movement of the underlying asset you’re trading.
Do CFDs have an expiry date?
The expiry date of CFDs depends on the type of instrument you’re trading. The expiry date can be every end of the month, every quarter and so
on. The expiration date is usually indicated by your broker. Common CFDs that have expiration dates include oil, gas and copper.
If you have an open account at the expiry date, it will roll over to the next trading cycle. On the other hand, majority of the CFDs do not have an expiry date since they’re treated like a cash product. This allows you to hold position for as long as you’d like.
How are CFDs priced?
CFD prices are designed to mirror those of the underlying market for a particular index or asset. However, you’ll notice that the bid and
ask price for a CFD will vary from broker to broker at a specific time. This priceis arrived at after the broker factors in a “fair value” component where the
price is weighted to cover any anomalies present in the underlying market.
Weighting is done by either imposing overnight financing charges on leveraged positions or, charging a commission on every trade.
How do CFD brokers make money?
Majority of Contract For Difference brokers will not charge commissions or fees. Their main way of generating revenue involves making the trader pay the spread amount. It’s worth noting that in many instances, the spread amount quoted by the broker is slightly larger compared to what’s quoted
in the underlying market.
How do CFDs work?
Contract For Difference is a financial derivative described as a contract between two parties (buyer and seller).
The price of a CFD mirrors the price of the underlying asset being traded. As such, buying a CFD doesn’t
require that you own the underlying asset.
CFDs work by allowing traders to speculate price movements of the underlying assets and therefore providing opportunities to make profit
or losses. If the buyer correctly predicts the price movements, the seller is required to pay the price difference at contract time and vice versa.
This difference is arrived at by subtracting the price of the CFD at the time of trade entry and its price at trade expiry.
Is CFD stocks a scam?
CFD stocks are legally recognized in a number of countries including the UK, Germany, Italy and Australia.
However, due to their highly unregulated nature in some regions, scam CFD providers are operating online.
It’s therefore advisable to carefully research the different CFD brokers before investing your money.
Is CFD trading gambling?
Many people would argue that CFD trading is a form of gambling. However, there are a number of differences.
Although both gambling and CFD trading are tightly regulated in many countries, the bodies regulating these industries are usually different.
With gambling, the only loss you can incur is the money placed on a bet.
With CFD trading losses can exceed the amount you invested especially if you don’t use leverage wisely.
Should I trade CFDs?
Trading CFDs opens up opportunities to make huge profits from small investments. Some of the reasons you should
consider trading in CFDs include:
1. You can make a huge profit on a trade with a small investment thanks to leverage.
2. You don’t own the underlying asset but many of the benefits the actual asset owner gets such as getting dividend and interest adjustments.
3. CFD markets don’t have numerous restrictions compared to other financial markets.
However, CFD trading does require that you have a good understanding of global financial markets.
Instances where you shouldn’t trade CFDs include:
1. You’re a citizen of a country where trading CFDs is
2. You have no prior experience or knowledge in trading
What does CFD mean?
CFD is an acronym that stands for Contract For Difference.
When do CFDs expire?
Majority of CFDs will not expire and you can hold position for as long as you like. The expiry of a CFD depends on the underlying asset you’re
trading. For example, if you’re trading in copper, the expiry period is after two months. The expiry date of a CFD is usually provided by your broker.
When was CFD invented?
CFDs were invented in London by Brian Keelan and Jon Wood in the 1990s. Their main purpose was to hedge traders and hedge funds from
exposure to stocks on the London Stock Exchange.
CFD trading bottom line
Contracts For Difference are one of the popularly traded financial instruments available today. As a CFD trader, you can easily gain
access to global financial markets and use leverage to make huge profits by investing a small amount. CFD trading also shields you from certain taxes such
as stamp duty. Like with any other financial instruments market, trading CFDs carries some risk. Most notably, a losing trade that utilized a high leverage
could easily lead to loss of more than your invested amount.
Overall, CFD trading can be a good way to earn profit by speculating price movements. However, it’s upon you to do the necessary market
research and build a suitable trading strategy to make money in this market.
Thank you for visiting, please also have a look at our other CFD article. ”Top 5 CFD Trading Mistakes You Must Avoid to Make Profit”
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