Contracts For Difference, also known as CFDs, is an investment instrument that allows traders to participate in price movements of securities, indices and even commodities without taking full ownership of the underlying asset.
CFD enables traders to realise profit from falling markets as well as rising markets due to the ability to trade both sides of the market.
So what are the benefits of CFDs vs physical share trading?
CFDs enable investors to leverage an investment up to 20 times under normal conditions based on equities and share indices.
The ability to leverage the investment is a principal benefit of this product. There are a number of reasons why investors and traders choose CFDs over physical shares. In practical terms, investing in stock through CFDs offer similar profit and loss opportunities as when trading stocks in the traditional manner.
One of the benefits of CFDs is leverage. It enables the trader to take positions that are larger than his or her initial deposit on their account, and thus being able to trade on smaller market movements.
Another benefit is that of short selling, where the investor or trader benefits from falling stock prices. Short positions may even earn interest, although indexed CFDs do not earn interest.
And there’s no interest to pay when trading CFDs in today, as long as they’re closed on the same day as they are open. That makes CFDs a very attractive proposition to intra-day traders.
So what separates CFD trading from share trading?
For one, the CFD trader does not have any shareholder rights. There are no voting rights and you cannot attend annual general meetings. When you trade CFDs with one broker, it has to be closed with the same broker.
Furthermore, CFDs are traded on margin and you will pay interest to carry a position from one trading day to the next.
If you’re going to short a CFD, you will receive interest, except if it carries a negative interest. Short positions will require you to pay the dividend but if you have a long position in a CFD, you will receive the dividend.
The essence of CFD trading is as follows:
When you are CFD trading you are trading at the underlying market prices.
When you are trading CFDs you will pay to enter and exit the market via commission.
And finally, you also have the ability to trade the market, not only from the long side, but also from the short side, capitalising from falling prices.
When we’re talking about leverage, we’re really talking about margin. When the margin is low, it can be 10% or less.
CFDs are available on stocks, stock indices, and commodities.
For educational purposes only, with no mention of real profits earned, let’s take a trading example. Let’s say you think a given company will rise from its current share price of £6.10 and you buy 1000 CFDs at that price.
Assume it rises to £7.00 where you then sell your 1000 CFDs that you purchased earlier. You have now realised a profit of £900, excluding any commissions that are yet to be paid.
Say you think a given company will fall from its current share price of £6.10, and you sell 1000 CFDs at that particular price. Assume it falls to £5.50, which is when you close your CFD position by buying back the 1000 CFDs.
What is your profit?
The profit is the difference between where you sold it short and where you bought it back. In this case you would make £600 excluding any commissions due.
How does margin work when we’re trading shares on CFDs
Again, for educational purposes only, with no mention of real profits earned, let’s say you buy 1000 CFDs at a given company, which incidentally is the same as buying 1000 physical shares, thinking it will rise from its current price of £6.10.
This makes the value of your investment £6100 – your nominal position. But your margin requirement for this CFD purchase is 10% of the value of your investment.
In other words, you will be asked to deposit at least £610 on your trading account in order to control this position. This is known as your initial margin.
Imagine you expect the price of this same investment to fall. Now the share is trading at £7 and your holding is worth £7000. So far you made £900 profit which is a return on investment of 14.75% in this hypothetical scenario.
As you can see there are many options when working with CFDs. All you need to do is choose the right platform, such as CMC Markets and start trading.
Tarik Pierce is the founder of InvestorTrip.com and regularly contributes articles to this website.
While living overseas, he uses PureVPN for a low cost VPN service.
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While his background is mostly related to trading stocks, he recently gained interest in real estate crowdfunding with Fundrise.