Contract for difference (CFD) is a financial arrangement in which trades take place without ownership of the asset changing hands. Essentially, the buyer and seller participate in a transaction based only on the price movement of the share, not on the stock itself. If the price of the share increases during the course of the CFD, the seller pays the buyer the difference in price.
If, however, the price of the share is lower when the trade is closed, then the buyer must pay the seller the price difference. The share itself is not transferred during the trade, just the monetary change in value. The price of the CFD is the same as the price of the actual share, however.
In addition to this basic difference between CFD and stock trading, there are several other unique aspects of CFD trading that are important to understand when considering beginning this type of trading.
These financial details have their advantages and disadvantages. For example, greater potential gains come with greater potential losses, while the manner in which CFD brokers make a profit from CFD traders is different than for other types of trading.
Leverage and Margin
Compared to other types of trading, CFD trading typically has higher leverage and lower margin requirements. Leverage means, essentially, that the trader borrows money from the broker in order to trade more shares than would otherwise be possible with a given starting capital. This loan from the broker is the margin. For example, if a trader needs to provide 5% of the total value in order to make the trade and receives the rest as a loan from the broker, the leverage amount is 5:1 and the margin is 5%.
The standard margin requirement for CFD trading is 2%. The exact margin for a trade depends on the underlying asset, so the margin requirement for shares may be as high as 20%. Still, this margin is lower than the typical margin for trading shares through buying and selling of the actual shares.
A lower margin with CFD trading means that less start capital is required of the investor. Hence CFD trading offers greater potential returns with respect to the trader’s starting capital. Traders must be aware, however, that losses from CFD trading with a low margin can quickly amount to more than the starting capital that was invested in the trade.
It is therefore recommended to only risk a small percentage of the total trading capital in the brokerage account on any one trade. In addition, other protective measures can be taken, such as using stop loss orders or refraining from using the entire available margin for the account.
Last but not least, many CFD brokers provide new clients with extra funds just for opening an account. Using this cfd broker bonus to increase operational budget can be a smart move.
Rather than charging commissions or fees for CFD trades, most brokers require that the trader pay the spread. The spread is the difference between the bid price and the ask price. For CFD trades, the trader must buy at the ask price and sell at the bid price. Like the price of the asset, the size of the spread is determined by supply and demand. Usually, however, there is a fixed spread.
Paying the spread on entries and exits means that small price movements are not as lucrative for CFD as for stocks. Having to pay the spread results in a smaller return on successful trades as well as increased losses for unsuccessful trades compared to trading the stock directly. This is especially relevant for traders looking for smaller profits per trade that add up through frequent trading.
For example, a spread of $0.50 means that the trader only overcomes the cost of paying the spread on entry if there is more than a $0.50 move in the market in his favor. Paying the spread for CDF trades may end up costing more than paying commission on stock trades would.
On the other hand, the CFD market does not typically have short selling rules, and there is no shorting cost because the underlying asset does not change ownership. There may, however, be overnight financing fees if the position is held overnight. This overnight financing fee may either be set by the broker or based on the LIBOR or interbank lending rate.
Trading and Brokers
The markets for CFD trading are less regulated than the stock market. There are many CFD brokers available, for example CMC Markets. Most brokers provide access to all of the major markets from their online platform. There are many types of CFDs available, from stock and index to currency and commodity CFDs.