CFD (Contract for Difference) trading is basically a type of forex trading that gives a trader, individual or investor the ability to take a position on the price of any financial trading asset without actually owning the asset. The CFD is usually a contract between the forex trader and the CFD broker who are exchanging the difference in the current value of an asset (be it shares, commodities, indexes or currencies) and its value at the end of the contract.
In CFD trading, most contracts are similar to future contracts whereby the differences in a settlement between two parties are made solely through financial payments, no physical assets are actually getting delivered. Forex traders who trade CFDs are provided with all the benefits and risks attached to owning an asset/security without actually owning it. In CFD trading, market participants trade assets on a margin. This simply means that he/she can either sell an asset if its price decreases (going short) or buy an underlying asset if the price increases (going long) by means of speculations.
Characteristics of CFD trading
Contracts for difference are derivative products
CFDs provide a means whereby forex traders make profits and returns from price fluctuations without actually owning the financial asset. CFDs are derivatives, meaning the underlying asset can’t be owned, bought or sold by the trader. The trader in question can only buy or sell a number of units for a specific financial asset depending on a speculation on an increase or decrease in the price. For every point the price of a trading asset moves in a trader’s advantage, he/she gains multiple of the number of Contract for Difference units purchased or sold. However, for every point the price of a trading instrument moves against a trader, loses are encountered.
CFDs are leveraged in nature
CFD trading provides higher leverages. This simply means that a CFD trader can gain a large marker exposure for a reasonably small amount of initial deposit. CFD trading tends to make more profits for an investor when compared to other forms of trading. When trading CFD, the basic requirement for opening a trade position and maintain the exact level of market exposure is only a small percentage of the total trade value.
Advantages of CFD trading
Higher leverage
The trade of CFDs provides forex traders with a higher percentage of leverage than other traditional trading. The standard leverage provided to forex traders when trading CFDs starts with a low of two percent in a margin trading account and can increase up to 20 percent. With this borrowed funds, CFD traders stand a higher chance of taking advantage of all trading opportunity that comes their way. A lower margin requirement in CFD trading entails less capital layout with larger profits and returns. However, a high level of leverage in CFD trading can magnify losses.
Ability to access the forex market from a single platform
There are a lot of forex brokers who offer the trade of CFD in the forex market. These CFD brokerage firms offer products and assets in the world's market. Hence, CFD trading takes place at all trading hours of the day from reliable trading platforms.
No rules on shorting and stock borrowing
There are a lot of traditional markets that bans shorting from their trading environment. This act requires forex traders to borrow the financial asset before selling short and have a series of margin requirement before a trader can engage in a long or short trade position. Unlike these markets, CFD assets can be shorted at any point in time without a need to borrow the underlying asset first and without any cost. This is made possible because the trader doesn’t own the physical/underlying asset.
Professional execution of trades without fees
Just like other forex trading brokers, CFD brokers offer traders the ability to trade with a good number of order types like stop-loss order, limit order, and contingent order. However, unlike the regular brokerage firms that attach different fees to own trading services, CDF brokers don’t charge any fees of such. CFD brokers generate money when traders pay the spreads on entries and exits or, in case it's the ECN type of account, they charge an additional commission on each opened or closed trade.
No requirements on day trading
Certain market or financial trading environment require a certain amount of capital from traders before they carry out a day trade. Someplace limits the total number of day trades that a forex trader can execute within a specific amount. Unlike these markets, the CFD market doesn’t abide by the above regulation and restrictions and gives traders the ability to day trade as they please. CFD traders can trade with a minimum amount as little as one thousand dollars although it places two thousand and five thousand dollars as minimum deposit requirements.
Trading opportunities on a variety of assets
In CFD trading, forex traders are given the opportunity of trading varying assets like indexes, currencies, cryptocurrencies, commodities (metals, energies, agricultures), stocks, ETFs, bonds and notes.
Disadvantages of CFD trading
CFD traders pay higher spreads
Although CFD trading is regarded as an attractive trading option when compared to other traditional markets, it also has its drawdowns. The trade of CFDs entails that a trader pay required spreads on each trade entry and exit. This singular requirement often eliminates a trader’s ability to make profits from small market moves. The spreads also have a great ability to reduce the percentage of winning trades by a small amount and heightens losses by a small amount. Therefore, as various traditional markets place various trading requirements like fees, regulations and greater capital requirement, the CFD market cuts down a trader's profit via higher spreads (or higher commission on each opened or closed trade).
Weak broker regulations
Most CFD brokerage firms and industries are not highly regulated. CFD brokers function based on reputation, financial positions, and trading lifespan. They are not backed up by government stability and liquidity. In trading CFDs, it is very important to conduct a research on the background of a brokerage company before opening a trading account with it.
In conclusion, CFD trading is a trade venture that capitalizes in providing leverages on margin accounts. However, these leverages can turn out to be a double-edged sword. These volumes of leverages amplifies losses when they occur.