'Contract for Difference' or CFD is a deal between 2 parties, to exchange the difference between opening and closing rate of an instrument. CFD trading enables you to take a position on the price of an instrument. It will be based on your prediction of a rise or fall in the instrument price.
Remember, you do not actually own the derivative product, thus you don’t have to incur stamp duty. Generally, you just trade on an asset’s underlying price movement.
Advantages of CFDs
- CFDs allow to maximize a trader's trading capital, because they are traded on margins
- No need to pay stamp duty, thus you save around 0.5% in comparison to traditional purchase of shares
- Trading short or long, allows you to gain from the rising or falling markets
- Traders can get access to a range of financial markets
- Stop loss & limit order features allows them to manage risks
Risks of CFDs
- Margin trading nature indicates magnified profits and losses. (Losses can be limited if you place a stop loss, as soon as you detect your position is moving against you)
- CFDs held for long term can increase the associated costs, so it is not suited for long term investors
- As an investor, you have no voting rights
Helpful features of CFDs
- Traded on margin - Traders just need to pay a small percentage while opening position (Initial margin). Margin allows leverage to access more shares.
- Trade in the rise and fall market environment - Traders can trade short or long. In long trade, you buy an asset because you feel the prices will rise. In short trade, you sell the asset after anticipating that the price will fall and purchase it back, at low prices. Thus, you can profit, even if prices fall with right prediction.
- No stamp duty - You don’t purchase the underlying shares physically, so no stamp duty.
- Overnight financing - Position that is held overnight will be subject to finance charges. Long positions are charged interest, whereas short positions are paid interest.
- Commission - Commission is calculated on the total position value, and not the margin price.
What markets allow CFD trading?
CMC Markets is the best CFD, Forex, and stock brokerage platform that deals with countless number of global markets and numerous asset classes. Traders can use leverage and participate in going long or short CFDs on assets like shares, indices, Forex, commodities and ETFs.
How CFDs work?
CFDs are leveraged products, which allow you to gain large market exposure with relatively smaller deposits. Let’s understand it with an example - You buy 10,000 shares of ABC Company at the rate of 270 cents per unit. It means your overall investment is $27,000, without including any broker’s charges for the transaction.
To open CFD trading position, you are given leverage ratio of 10:1. Thus you will need to deposit an initial amount of $2700.
Let’s suppose that the price rises to 10%, and then the position value will be $29,700 (27,000 + 2,700). Thus, with just Investing $2,700 in this CFD trade, you made a profit of $2,700. It means 100% ROI.
Similarly, if you made a loss, it could have exceeded your initial deposit. Therefore, it is vital to learn how to handle your risks too.