What is CFD?
CFD stands for Contract For Difference and is a type of security that allows two parties to exchange between themselves the difference in opening and closing prices of any contract. A CFD trading allows a trader to speculate based on the rise or fall in prices of global financial markets, such as Forex, indices, commodities, shares, and treasuries. The contract is settled using cash, instead of physical goods or securities and this is an easier approach to settlement, which brings favorable tax conditions and the ability to speculate on declining prices.
CFDs are offered in numerous nations such as Australia, Canada, Cyprus, France, Germany, Hong Kong, Ireland, Japan, Singapore, South Africa, Spain, Sweden, Switzerland, United Kingdom, and New Zealand. They are not permitted in some other countries, like, most notably the United States, where retail investors can not trade CFDs due to rules about over the counter products, unless on a regulated exchange but there are no exchanges in the US that offer to trade CFDs. Instead, U.S. traders are forced to trade the futures markets, where the margin requirements to open a position are much higher and unattainable for the average investor.
Benefits of Trading CFDs
Below are listed the benefits that a trader can have from trading in CFDs vs. conventional means of trading:
- Trade on leverage
- Low Fees
- No Stamp Duty
- 24/5.5 Markets
Trade on leverage
CFD contracts provide access to leverage, and this allows investors to generate high returns with a small initial deposit. However, leverage can also generate losses that exceed deposits. The typical leverage is 25 times the deposited amount, and this means that a trader that hold a position for 100 000 only needs to deposit 4000 to their CFD trading account.
CFD trading offers lower fees than traditional investing or trading as the investor is not buying the actual underlying financial asset, rather the investor is speculating on the price change. This means that in general only the spread is paid to transact. The spread of a CFD is the difference between the buy-price and the sell-price, and it is derived from the underlying market, and most CFD brokers add a markup to the spread.
No Stamp Duty
Trading in CFDs does not include any stamp duty since these types of contracts are a replica of the underlying product such as a futures contract or a share. Therefore, investors who choose to trade in CFDs will avoid the tax liability that they would incur by trading in the underlying instrument.
Last but not the least, trading in CFDs takes place 24 hours a day, five and a half days a week. Even if the underlying market remains closed, a trader can sometimes still trade CFDs.
Risks of Trading CFDs:
While CFDs offer market participants a lot of benefits, it does not come without risks for holding the security. The access to margin trading (leverage) is something that is not suitable for all type of trader and investors.
Lack of Ownership
As the trader does not own the underlying product that he is trading, say, for instance, a share, then he does not possess the right to vote at a shareholders’ meeting. However, he will receive any dividend paid by the underlying company, and he has to pay the dividend if he is short of the CFD.
Cost of Overnight Financing
As CFD trading is done on margin, the trader is effectively borrowing money from their broker to trade, and for this service, the trader needs to pay an interest rate to the broker. This means that holding a CFD position for a long time could dent any returns made on the price change of the CFD.
In case of clients holding a long position on the ex-dividend date, they are entitled to receive a cash-adjustment form of dividend.
In case of clients holding a short position on the ex-dividend date, they are chargeable for a cash-adjustment form of dividend.
Another risk of trading in CFDs is the counterparty risk, a very familiar concept in most of the over-the-counter (OTC) traded derivatives. It is defined as the risk associated with the counterparty’s financial stability. Regarding CFD contracts, if the counterparty, e.g., your broker, is not able to meet the required financial obligations set by the trade, then there is no value associated with the CFD, regardless of the underlying instrument. In other words, if you bought Apple Shares at 50 dollars a share and two years later the share price is at $250, and your broker goes bankrupt before you book profits and withdraw your money then you could have lost your profit.
However, CFD providers over the OTC desks are required to segregate the client funds to protect client balances in the event of a company default. However, cases such as that of MF Global remind us that guarantees can also be broken.