i. CFD stands for Contract For Difference and it is a financial product that is traded on listed over the counter markets.
ii. It is a contractual agreement between the buyer and seller in which the buyer must pay the seller the difference between the current value of the asset and its value at that time.
iii. According to laws in USA, CFD trading is illegal.
What is CFD?
CFD stands for Contract For Difference. CFDs are financial instruments or assets that are traded on listed over-the-counter markets.
CFDs are contractual agreements between a buyer and seller that stipulate that the former i.e. the buyer, must pay the seller the difference between the current value of the asset and its value at the time.
The CFDs are based on an already existing financial product like a stock, bond, commodity, etc., but ownership of a CFD does not mean ownership of the underlying asset.
The change in price or value of the underlying asset will reflect on the price of the CFDs.
CFDs can be traded only through listed over-the-counter markets. CFDs cannot be traded in the US as their laws do not support it, but they can be traded in other major countries like France, Canada, UK, Germany, New Zealand, and Switzerland, etc.
If a trader has a bullish bias on a particular financial asset, he can look to buy the CFD of that particular asset. If he is bearish on the asset then he can initiate a sell position on the CFD of that particular asset.
In CFD trading there is no requirement of borrowings in case of short positions, as there is no ownership of the underlying asset.
It is seen as a basic sell position that is to be squared off and the trader receives the difference according to the price of the asset at the time of buying back the CFD.
The same is the case with a buy position. The trader gets the difference between the buy price and the sell price of the CFD. It could be a profit or even a loss.
CFDs and Futures
Individuals that come across this concept of CFDs may think that CFDs are just like the futures contracts that are traded on the exchanges and markets of the various financial assets.
Unlike futures, CFDs do not have any expiration date. In futures, traders may have to take ownership of the underlying asset at the time of settlement if they wish to, in CFDs, there is no scope of ownership.
Futures contracts are traded on government-regulated exchanges, while CFDs are traded on over-the-counter markets.
The price of the futures contracts is not always equal to the price of the underlying asset, there is a calculation involved in determining the actual futures price. The prices of CFDs reflect price movements of underlying assets.
Advantages and disadvantages of CFD trading
Now that you know what CFDs are and how they work, let’s look into the advantages and disadvantages associated with CFD trading. This will help you decide if you should participate in this market or not.
One of the main advantages of CFD trading is that traders can avail leverage. Margin trading or leverage is not provided everywhere but in CFD traders can trade with less amount and take up big positions.
Leverage can also be a disadvantage as higher leverage means higher exposure in the market and every price move will affect the CFD position drastically.
Traders often become greedy on seeing leverages and they max out their account on the positions. This only leads to a blowout in the end. So it is important to manage risk properly.
Like mentioned earlier, traders can take short positions in CFDs. In this, there is no requirement of borrowings on the broker’s side as there is no actual ownership of the underlying asset involved.
Almost every kind of financial asset has its CFDs that are traded and traders can always look to capitalize on price movements in the financial markets through the CFDs.
One major disadvantage of CFD trading is the spread that is involved. Traders often have to bear the cost of the spreads on the trade, which eats up their profits.
The other disadvantage of CFD trading is that it is not highly regulated by laws. I have already mentioned that the laws in the USA do not allow CFD trading.
Some of the major countries do allow CFD trading but the laws regarding it are comparatively weak.
The CFDs are traded on a network provided by forex brokers, hence it is important to find the right broker to gain access to this market.
Since CFDs as simply derivatives of an underlying financial asset that are traded by traders around the world, they have risks associated with it.
Traders can anytime lose money and incur losses while they trade these CFDs. So it is important that they identify risks and manage them properly.
How to start trading CFDs?
The first step to begin CFD trading is to find a good reliable and regulated broker that provides access to the CFD trading market.
The next step is to take a directional bias in any of the financial assets that are underlying the CFDs. You will take your trades based on this bias, whether to buy or sell the CFD.
CFD trading is just like trading any other derivative or financial asset and everything that applies to the latter is to be applied to the former.
Should you trade CFDs?
CFD trading is not free. It has some costs associated with them. These are costs that traders must take into consideration before they decide to trade them.
Traders not only have to pay spreads but also brokerage charged by brokers. Brokers also charge a fee for trades that are held for more than a day.
If you are someone that’s thinking about trading CFDs over other products then you should take this decision only after understanding everything i.e. take an informed decision.
It should be noted that CFDs are not suitable for long-term trades or investing, but are purely for short-term trades.
Like I mentioned earlier, CFDs have the benefit of leverage and wherever leverage is involved, there is risk involved too.
Hence, I would sincerely suggest that you trade CFDs only after you know what you are getting into, know the risks you will be exposed too and that you manage the risks properly.
Have you traded CFDs?
If you have traded the CFDs or have participated in this market then do let me know your experiences about the same. Anything that you share could help someone out.
I urge you to share this blog post with anyone you know that is looking to enter this market, it will allow them to understand what exactly they will be getting into.
Feel free to share your thoughts or ask questions in the comments section below and I will get back to it as soon as possible.