CFDs - An Introduction
Introduced to the market during the 1990s, the CFD (Contract For Difference) is an increasingly popular derivative within the retail sector. It is very similar in principle to spread betting but is more accessible globally, mainly due to the stigma attached to the word betting in some countries.
A Contract For Difference is simply an agreement between two parties where one pays the other the difference between the current price of an asset and its price at a specified time in the future.
One of the similarities with spread betting is that although there is an expiry date of the contract, it can be closed early by either party - the private trader or CFD broker. The broker will usually only close a contract in the event that the traders' account balance falls below the margin required on open trades. The trader will close out their position in the event that they want to take the profit they have made from a trade or in the event that they want to limit a loss.
The benefits of CFDs over more traditional methods of investing are numerous. We will discuss each of these in turn:
Minimal margin requirements. CFD brokers, like spread betting companies, offer their clients the ability to trade using leverage. When they open contracts, the trader is only required to fund a small percentage of the contract's value in the form of a deposit. Being able to trade on margin means the trader can open positions that are worth considerably more than their account balance meaning resulting in larger gains.
Although it is a highly beneficial aspect of the CFD trading with leverage is particularly risky and should be headed with caution. This is why we would advise anyone starting out in CFDs to begin by opening a demo account first to familiarize themselves with how it effects trades and also the risk management tools that can be used to offset this risk. Most of the leading brokers will offer a practice account and they are free to open.
Market choice. The number of different tradable markets within a CFD account are simply breath-taking. Most brokers will provide access to the following and more:
Individual stocks and shares
Short and Long. The Contract For Difference is a derivative which means its value is taken from the price of an underlying asset and ownership of that asset never rests in the hands of the trader. For this reason, it is possible to speculate on prices going down as well as up which is of great benefit during bear markets.
Tax advantages. Depending on what country you live in, you might find there are tax advantages to trading CFDs rather than buying actual assets. For example, in the UK, CFDs are exempt of stamp duty unlike share purchases which brings about a saving of 0.5% of the trade value. 0.5% might not sounds like a massive saving but if you are looking to trade large contracts or even do so regularly, this 0.5% can quickly add up.
Although it can be beneficial to trade CFDs or even use them as an investment vehicle, they are harder for the novice investor to pick up and get into. Although the principles are very similar to normal investing, there are things you need to be aware of such as understanding leverage as you can lose large sums of money very quickly. It is therefore important to take advantage of stop losses, limit orders, and other risk management tools to ensure you are always in control of your trades.
This article was published courtesy of Marcus Holland, editor of the website FinancialTrading.com. Check out the site to compare CFD Brokers and learn more about the subject of Contracts For Difference.