CFD Trading

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CFD Trading

With the world economy in recovery mode, people are increasingly finding themselves in a situation where they have a little bit more money in their pockets. Consequently, many will be asking themselves what to do with their extra capital. Should they expand their existing shares portfolio, or should they look at new markets?

Given that the blame for the recent economic crisis can be at least partially attributed to the banks, a lot of people are considering how to invest their money independently. Contracts for Difference, or CFDs as they are better known, can offer just such an opportunity.

CFD trading has a wide range of benefits over other forms of investments, however it also has its risks. It is important that any potential investor should note that there is a negative side: you can in fact lose more than your initial investment when investing in CFDs.

CFD Brokers

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Why CFD Trading?

So what exactly are the benefits of CFD trading?

Trade on a Wide Variety of Financial Markets

You can trade on a wide variety of financial markets with contracts for difference; CFD trading companies often offer thousands of markets to speculate on. From the leading stock market indices such as the FTSE 100 and the Dow Jones, to the forex rates such as USD/JPY or EUR/GBP, to the prices of commodities such as gold, oil or even sugar.

Long or Short; Speculate on Markets to go Up or Down

CFD trading allows you to speculate on markets to both rise and fall. Think the FTSE is about to rally? Speculate on the index to go up. Think gold is over priced and about to drop in value? Trade on it to fall.

No Exchange of Assets Means Quicker Trades

When investors trade CFDs, they are speculating on the future price and do not actually take ownership of any assets. Consequently, investors can usually trade CFDs far quicker than traditional share trading.

24 Hour CFD Trading

Just because the FTSE has closed for the day does not necessarily mean that you have to stop trading. Certain CFD trading companies offer investors the opportunity to trade 24 hours a day, five days a week, meaning no more waiting for the stock markets to open.

No Stamp Duty on CFD Trading*

Another advantage that CFD trading offers over more traditional forms of share trading is that in the UK it is exempt from stamp duty*. This can help lower your trading costs.

Part Close Your CFD Trade

When you are trading CFDs, you can part close a winning trade and bank a profit, however you can also part close a losing trade in order to limit your loss.

Part closing a CFD trade essentially means that you close one portion of your trade, however keep the rest of it open. This can be used to help lock in profits and restrict losses.

Place Stop Losses/Guaranteed Stop Losses on your CFD Trades

Utilising stops losses is an important element in any trader’s risk management strategy. A stop loss is an automated request to close your trade if the market on which you are speculating moves against you.

You should however note that whilst a stop loss is not guaranteed, they can still help reduce losses. Be aware that, in particularly illiquid markets, certain financial instruments may ‘gap’, ie jump between two prices. If the market gaps then your stop loss order will be activated at the next traded price.

A guaranteed stop loss works in a similar way a stop loss. However, should a market gap, your trade will still be closed at the price which you specified.

CFD Trading

The term CFD stands for ‘contract for difference’, a mechanism whereby you purchase exposure to a specific trading asset, such as a currency, equity or commodity, at one price, the ‘offer price’, and sell it at another, the ‘bid price’.

The price of a CFD is based on that of the underlying asset. For example, if you think the value of the sterling v US dollar will increase you could buy £1,000 worth of CFDs. A CFD broker will give you a quote based on the value of £1,000 at that moment eg you might get a quote of $1.5833 - $1.5836. Where $1.5833 is the bid price and $1.5836 is the offer price.

If you were to sell immediately afterwards, you would make a loss, since the bid price at which you sell is a little lower than the offer price. This is, in fact, the commission or profit involved for the market maker.

If you are correct, however, and the price of the sterling/dollar rate increases during the day, the bid price could move above the offer price that you initially paid. If you were to close the trade at that point, the difference would be your profit. It has to be remembered that if the price were to go down instead of up, you would make a loss.

Leverage is primarily what distinguishes CFD trading from trading in the actual financial instrument. If you want to trade in CFDs to the value of £1,000, you do not need £1,000 GBP; instead, you only need a deposit, which for most CFD brokers varies between 14% and 35% of the actual value of the underlying asset.

You could therefore trade in CFDs to the value of £1,000 by depositing £140. If the value of the sterling/dollar rate should increase by 1% during the trading period, you would make a £10 profit on your initial deposit, which is significantly more than 1%.

The other side of this coin is that if the price were to move against you by 1%, you would lose £10 on the same investment, which means your loss percentage will also be multiplied by the leverage principle.

CFD Trading - Interest and Dividends

Daily markets are often the most popular CFD markets and, on a long position, you have to pay interest if you roll the position over from one day to the next. If you close it before the end of trading on a specific day, you will not be charged interest for that day. This is why CFDs are so popular with day traders.

If you trade in equities, you receive the full dividend on the particular shares if it were to be declared while you were in the trade.

The reverse is true for short positions; you actually receive interest on the value of your open positions at the end of each day, but have to pay the value of any dividends declared while you are in the trade.

CFD Trading - Pros and Cons

The leverage factor of CFD trading is a double-edged sword. If the price of the underlying asset goes the way you expect, you could potentially double your actual investment in a relatively short time. However, if it goes against you, you could lose everything you deposited (or more), with just one trade.

In short, CFDs involve a high degree of risk and it is possible to incur losses that exceed your investment. This is why it is important that you only speculate with funds you can afford to lose and never to risk all of your money on a single trade. You should also use a stop loss to minimise the amount you stand to lose.

As mentioned, there are risks associated with CFD trading. It is important that you realise that Contracts for Difference (CFD) and Financial Spread Trading carry a high level of risk to your capital and you can lose more than your initial investment. They may not be suitable for all investors, ensure you fully understand the risks involved and seek independent advice if necessary.

Contracts for difference (CFDs), Spread Trading and Margined Forex carry a high level of risk to your capital. You can lose more than your initial deposit. These products may not be suitable for all investors. Ensure you fully understand the risks involved and seek independent advice if necessary.

* Based on current UK tax law. This may change or differ depending on your personal circumstances.