Market Basics: CFD Trading
A CFD, also called ‘’contract for differences’’ is a derivative security which enables investors to take positions on indexes, stocks and even commodities. If an investor purchases a CFD, they do not possess the original security, but merely one which reflects the fluctuations of the underlying security very closely.
The good sides of CFD trading
One core advantage of CFDs is that they allow for very high levels of leverage (up until 100x as sizeable as private capital), which can provide otherwise untapped opportunities for investors. To illustrate this, broker accounts typically accept leverage opportunities on classical stocks with levels up to 5 times private capital. As a result, CFD trading allows investors to take on large amounts of capital, and take extreme positions on securities.
A second advantage is that CFD grants access to an vast range of securities, ranging from commodities (such as coffee) to stocks, and further enables investors to both short and long the security without owning the securities. Shorting means that the trader will reap profits by betting on the fall of the price of the security, with going long being the opposite. When adopting a short position, the investor sells stocks they do not own, thus betting on prices dropping. When the expected price drop materialises, the investor will buy back the stock and, hence be left with a profit.
A further advantage is that CFDs enable traders to purchase individual parts of securities for a minimal fee. Furthermore, they allow investors to sell aftermarket closure. In this case, the broker will evaluate your security based on other exchanges which are still open at time of closure.
The last advantage offered is that in periods of extreme volatility, brokers can close possibilities for investors to short, or to long unhedged positions. CFDs are not impacted by these measures, and thus allow the investor to take on unhedged positions.
The cons of CFDs
As mentioned above, as CFDs provide extremely high levels of leverage, they can expect above-average returns, but also should anticipate high levels of risk. AMSA recommends it only be used by experienced investors, as the selected risk level can materialise within seconds after trading, causing the investor to lose borrowed money on the leverage. Moreover, the majority of hedge funds adopting CFD trading as method filed for insolvency after just two years, further highlighting the risk involved.
In addition, as CFD is a copy of the original security that the broker will aim to mimic in its essence, there will be micro variations between different brokers. Exactly mirroring the chart is a very complex task for the broker, and thus nigh impossible to achieve.
As CFDs are a relatively new form of investing, relevant industry regulations are weaker than for typical broker investing. This lack of legal and infrastructural frame makes trading riskier, but in turn provides huge potential advantages. Additionally, as margins are increased when taking on a CFD account, the investor must monitor his positions constantly. If positions range in the wrong direction for a period of time, the broker can decide to close these positions if he is sceptical that the investor will replenish his margin account. In such a scenario, losses will be unavoidable, and the positions will harm the trader’s equity.
How to trade CFDs
The CFD derivative security is predominately suitable for short-term positions, and day-trading due to it demanding constant monitoring. Therefore, knowing your technical indicators and graph analysis act as foundational skills when investing in this type of asset.
Different CFD platforms
1) XTB has very good overall rating, fees, speed, and margins allow great flexibility for the trader.
2) eToro ranks second. The reason for this is that the social trading platform of Etoro offers opportunities for information sharing. Investors can subscribe to follow a trader for a certain fee, and subsequently copy the experienced investor’s positions.
3) IG gets the third place, as if an investor wishes to trade FX, this platform provides the best infrastructure.