CFD Trading – A Beginners Guide
What is CFD trading
Contract for difference or CFDs are a type of derivative trading, that is to say they derive their value from an underlying asset.
When you are buying a CFD you are taking a risk on the underlying asset increasing in price. You are not buying the asset itself but derivative of it that is linked to the price of the original asset.
For example if you are to buy a CFD in Apple you would be buying it at the current market price for an Apple Inc share. If the price changes in Apple Inc on the NASDAQ it will be reflected in your CFD.
Why Use CFDs
There are many advantages to CFD trading including:
1.It opens up potentially restricted markets to new audiences. Trading certain US company shares if you aren’t based in the US can be difficult.
2.Certain countries have specific tax advantages vs owning the shares outright. In the UK for example if you make money on the CFD it can count towards your capital gains allowance, however you don’t have to pay stamp duty when you buy and sell contracts for difference.
3.Owning partial shares. Unlike many online stock brokers with CFDs you can own a part of a share, meaning you can invest from as little as $50 with many brokers.
4.Many CFD brokers also offer leverage to their clients. This allows clients to take larger positions with a smaller initial investment. Leverage drastically increases the risks involved and isn’t something whichbroker.com recommends unless you fully understand the products.
5.CFDs allow you to have a short position, allowing you to bet on a drop in price in the underlying asset.
Problems with CFDs
With CFDs there are also a draft of disadvantages, some of which are listed below:
1.You do not own the underlying asset. This means you will not get any dividends or a right to vote on any of the companies share holder meetings.
2.Your contract is between yourself and your broker. This means if your broker becomes insolvent they may not be able to pay out on your position. It is very important to use a broker that is regulated in your market and not risk working with an unregulated broker. CySEC which regulates a large number of brokers in Europe offers protection of €20,000 or 90% of the claimed amount (whichever is lower).
3.Price transparency might be an issue with some brokers, as the prices are sourced from the market, making it unsuitable for high frequency trading.
Can I trust CFDs?
A big question we get at whichbroker.com is “Are CFDs safe?” And the answer isn’t a simple yes or no, but something fairly easy to answer.
Firstly, if you decide to use leverage you are making your investment contain more risk. Regulators around the world have begun to limit the larger amount of leverage some brokers offered. If you decide to leverage you CFD you are multiplying both your potential gains AND your potential losses. If your contract for difference in Apple drops 5% and you have leveraged your capital 1:10 you will have lost 50% of your capital.
It is also worth noting many CFD brokers charge for things like:
- Overnight Funding – this is a charge many brokers add or deduct from your account when holding a position after a specific period of time
- Currency conversion fees. If your account is in GBP but you want to buy a CFD in Apple, which is in USD$ and listed on the NASDAQ, some brokers will charge a currency conversion fee.
- Account inactivity fee. If your account isn’t used for a period of time the broker may charge a fee to keep the account open.
- guaranteed stop order. Brokers that offer this product allow you the manage your risks and close your position at a specific price, but often this comes at a cost.
Like many financial instruments – if you do not understand the risks you can get burnt. Familiarize yourself with the risks involved before committing real money.
Can I lose more than I deposited / more than I funded my account with?
This depends on which regulatory body your CFD broker is licensed by. Any EU regulated broker offers negative balance protection, which keeps you safe and prevents you from loosing more have invested in your account.
You can loose more than your initial commitment on a single trade if that trade has been leveraged. If that same CFD for Apple dropped 10% and you had leveraged 1:20 you would loose 200% of the capital investment which might eat into your deposited funds.
Can I make money when the share prices are falling?
Yes – with a CFD you can indeed profit from the shares in a company falling. Different to “Share Dealing”, you can open a contract for difference expecting the price of the underlying asset to fall over time. If/when the price of the underlying asset decreases the contract you have increases in price making your position more profitable.