For many, the concept of CFD is a very difficult concept to grasp. What are CFDs? How are they different from stocks and other instruments? Contracts for Difference, CFDs, are over-the-counter financial instruments. CFDs do not trade on any particular exchange, but through brokers who take the other side of the transaction. This means that instead of your order being routed to an exchange, the brokerage firm who warehouses your account takes the opposite side of the trade.
The Benefit of CFD’s Include:
- Enhanced Leverage: All exchange traded products have established margin/leverage requirements for any given instrument. CFDs circumvent these limits as exchange rules do not apply to them. Leverage is determined by the broker who takes the principal position of the trade. For example, to trade oil on the New York Mercantile Exchange, NYMEX, a trader is typically required to put up 8% (approx. 12:1) of the notional amount of the trade. Most CFD brokers only require 1% (100:1) of the notional amount of the trade for oil contracts. Thus, a trader may enter into positions with less money, allowing him greater exposure to the market. Greater leverage also allows the trader to diversify his account equity as the trader is able to open more trades in different instruments with the same amount of money.
- Greater Flexibility in Position Sizes: For most commodities that trade as futures contracts, position sizes are governed by the contract specifications as determined by the exchange. CFDs offer a fully customized position as determined by the minimum increment offered by the broker. Using the same example as above, the NYMEX contact specifications for oil is 1,000 US barrels. Another exchange offers E-mini contracts in US Crude, but those contracts are set at 500 US barrels. When trading in US Oil CFDs, the typical minimum order is 10 US barrels and anything above this minimum is fully bespoke. A trader can enter into a 1200 US barrel contract where if the trade bought oil futures, he would need to either place 2 to 3 E-mini contracts (between 1000-1500 US Barrels) or 1 to 2 regular US Oil Contracts (1,000-2,000 US Barrels).
- Available on Almost Any Financial Instrument: As CFDs are OTC products, they are available in any form, denomination, and on any financial instrument your broker
chooses to offer. CFDs are generally available in metals, energies, commodities, debt, and shares. This is especially convenient for countries where equity and futures positions must be held in different accounts.
- No Shorting or Exchange Rules: If trading CFD stocks or shares, most exchanges a litany of rules on how and when stocks may be traded. Some exchanges restrict the ability to short stocks if that stock is under pressure. Other exchanges have day trading rules. With CFDs, as they are not traded on an exchange, they are not subject to exchange rules.
- No Broker Commission, pay only the spread: When trading a financial instrument such as oil or gold, you must pay a commission to the broker, pay the spread to the market maker, and the pay other fees such as exchange or regulatory fees. With CFDs, the only charge is the spread when entering and exiting the trade.
- Tax Benefits. Typically this applies to UK residents. The Stamp Tax does not apply to CFDs.
Some CFD Disadvantages Include:
- Counter-party risk: This is the risk of the opposing party to the trade, typically your broker, going bankrupt or is otherwise unable to perform on the trade, you will lose any profit and potentially all of your investment. This is a serious risk and you need to do your homework prior to choosing your broker.
- Excessively wide spreads: Yes, we know – no commissions and low cost. Many firms advertise these features as a value proposition to their product offering. Some CFD brokers charge excessive spreads that may actually be more expensive than buying a future or other instrument. The excessive spread makes it harder to turn a profit as a trade is only profitable when it crosses the spread. Do your research and choose your broker carefully.
- Not as regulated as exchange traded products. Although the brokers themselves may be regulated, the execution or the trading product may not. CFDs are contracts in their very nature. The terms of the CFD are the terms you agree to when you establish your trading relationship with your broker. Make sure you read the Terms and Conditions of your trading account prior to executing any trades.
CFDs are versatile, low cost and a very attractive trading product. CFDs allow small, retail traders to enter the market at substantial less up front capital. However, CFDs do have their risks. One thing is certain, never trade with money that you cannot afford to lose.