A contract for difference (CFD) is a popular type of financial derivative in trading. It is an arrangement of formed in a futures contract, whereby differences in settlement are done via cash payments, rather than through delivery of physical goods or securities.
CFDs can be used to trade in various financial markets, such as forex, commodities, indices, and bonds, where you can speculate on the rising or falling prices of a particular market or instrument.
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If you are looking to diversify your investment portfolio, a CFD is one tool you could use, given the advantages it offers. Still, like most tradable tools, a CFD have its own disadvantages that you must watch out for.
This article sets out to discuss about CFD and identify its advantages and disadvantages to help you better understand this financial instrument.
CFD Relationship between Margin and Leverage
Given that CFDs are leveraged products, you only need to deposit a portion of the overall value of a security to open a position. The deposit is called, ‘margin’.
Still, while trading on a margin raises your returns, your losses will increase as well, since they are based on the total value of the position. This means that you might lose more than any capital deposited.
CFD Trading Costs
When trading CFDs, you must pay for the difference between the buy and sell price, which is the spread. This represents your transaction cost, as the difference between the bid and ask prices are subtracted from the total profit, or added to the overall loss.
If you enter a buy trade, that means you have to pay the higher ask price, and when selling, you must accept the lower bid price. The smaller the spread, the less the price has to move to your advantage or against you, before you receive profit or experience a loss.
Holding costs are charges that can either be positive or negative depending on the movement of the spread. Any positions open in your account by the end of each trading day are charged with a holding cost.
Market Data Fees
These are charges for exposure to CFD trading services and are broker-related costs as well.
A commission is usually charged by CFD brokers for trading shares. CFD trades incur a commission when the trade is open and when it is closed.
Advantages of CFD
One of the perks of trading CFD is its ability to offer higher leverage than traditional trading. Leverage in the CFD market usually starts as low as a 2 percent margin and can climb as high as 20 percent. This means that you will have a small capital outlay and big potential for returns.
As a CFD holder, you are able to benefit from dividend payments and other corporate developments at a fractional rate.
That is why, it is vital to ensure that you factor in future dividend announcements, especially when you are going short, as it could have an effect on the value of your CFD positions and the amount of profit you are able to acquire from a certain transaction.
Global Market Access
Investing in CFD should not come as a challenge to you, as CFD is available and traded globally.
Since it trades on financial markets worldwide, a CFD also provides what is called Direct Market Access (DMA), which gives you the opportunity to trade globally.
Shorting in the CFD market is doable, as this market does not exactly have rules that prohibit short-selling.
CFD instruments can be shorted at any time without borrowing or shorting costs, since you, the trader, do not have ownership of the underlying security.
Investors at times hedged positions to curb any potential risk. Let’s say you have a long position on a stock that is experiencing losses and you want to balance these losses. This can be done by opening a position in the opposite position using a short CFD.
The short position will start to generate gains, provided the prices continued to drop. This hedge therefore, enables you to reduce risk and prevent future losses.
Know also about the Strategies Used in Hedge Funds before you put your money to any hedge fund.
Disadvantages of CFD
The potential for huge losses is by far the primary and most significant downside in trading a CFD.
Leverage can be an excellent instrument when things are going your way, but it could spell serious consequences once the markets move against you. Keep in mind that leveraged positions rise and fall, and that your whole deposit balance is exposed to margin call.
If you are trading with margined products, it is important to work with tight stops to protect your bank balance from getting wiped out by runaway positions.
Some traders see CFDs as a less robust investment opportunity due to their lack of ownership. Buying one offers no underlying ownership of anything other than the contract relative to the index price of the security.
A CFD does not have an asset that provides a periodic yield in the form of a dividend that you can keep for the long term, nor does it have an intrinsic value lying aside from its current market price.
While traditional markets expose you to fees, rules, commissions, and high capital requirements, a CFD reduces your returns through spread costs.
Your chances to generate profit from small moves diminish when you pay the spread on entries and exits. Paying the spread also slightly reduce winning trades and raise losses a bit over the underlying asset.
Since the CFD industry does not get the same regulation treatment as the other industries, the credibility of the CFD brokers are more based on reputation than life span and financial position.
So before you decide to open an account, be sure that you have look into the broker’s background. There are many excellent CFD brokers in the world of investing, but it is still better to do your research before you seek the help of a certain CFD broker.
As CFDs offer high leverage, it is crucial that you take extreme care when using it. Too much of anything is bad and that also goes for the excessive application of leverage.
Use it too much and you will find yourself overtrading, and in a position where your account balance is vulnerable to huge losses.
Landing on overtrading territory is easily done when trading is notionally cheap. However, once several positions head south, your money could follow as well, if you adopted a less cautious approach.
Such problems can be prevented by using a reliable and well-tested risk and money management strategy that can guarantee the safety of your equity from high levels of risk.
Learn the right way of handling potential risks on Powerful Risk Management Strategies for Traders and Businesses.
Generally, a CFD presents you a great method to trade in financial markets, given the advantages they offer. Still, keep in mind that you must have a professional trading attitude to protect you and your money from the risks involved.
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