Choosing to invest in a Contract for Difference (commonly called a CFD) can be a great opportunity for some investors, but the first thing a trader should decide is whether CFDs are suitable for their needs. Trading CFDs have numerous advantages, and spending time to research and understand these advantages can help traders comprehend the real nature of trading CFDs.

First determine whether a CFD is a good option based on the advantages.

Trading on Margin

CFDs are traded on leverage, so that traders can fully utilize their trading capital. Each trader deposits a small percentage of the trade’s whole value to open a position, instead of the traditional method of paying each trade at full value. This is known as “margin” trading, and means that traders have the opportunity to produce bigger returns on their investments with less initial deposit.

For example, the typical share margin of the FTSE 100 starts at 1.5%. Assuming that the trader wants to purchase 10,000 shares, and the current value of each share is 260p, the average trader historically would have to pay the total share value of £26,000 (£2.60 x 10,000). With CFDs, traders need only deposit £390 (10,000 x £2.60 x 1.5%), plus commission on the trade, to gain the total value of £26,000. In this situation, if the share price of the FTSE 100 rallies to 10% in favor of the trader, the trader would have a total profit of £2,600. This creates an 85 % return on investment (ROI).

You can maximize your return on investment as much as 10 times greater than the initial deposit. However, if the market moves against you, your losses are magnified in exactly the same manner as your gains. Your total loss could amount to more than your initial deposit.

With a smaller investment, you could maximize your profits by trading on leverage with CFDs. However, you could also increase your losses if the market turns sour.

Stamp Duty and Other Tax Surcharges

Stamp duty is a type tax charged for asset transfers in the United Kingdom. For a modern share trade, stamp duty is calculated at 0.5% of the instrument’s value. Because CFDs are derivative products, the trader does not physically own the underlying shares being bought or sold. Therefore, stamp duty is not charged for CFD trades, saving the trader 0.5% on each trade.

However, tax laws differ in each country, and there may still be tax surcharges added for trades conducted in/with other nations. For instance, Ireland charges 1% stamp duty for CFD trading, and Spain also has a tax surcharge added for this type of trade. CFDs are not allowed to be traded in the United States.

For trading in the UK, stamp duty can be avoided when trading CFDs. In most other countries, taxes and other restrictions may apply.

Trade Long or Short with Equal Ease

One of the biggest advantages of trading CFDs lies in the lack of ownership because CFD trading is the theory of a financial instrument’s price movement without indicating the instrument’s physical ownership. This makes a difference for both long and short trades. Short trade transactions occur when a trader sells an asset anticipating a fall in value with the intention of buying it back at a lower price. Conversely, a long trade occurs when a trader purchases an asset anticipating a rise in value with the intention of selling later at a higher price.

Before the introduction of CFDs, share sales were based mostly on ownership. Selling an ordinary share meant borrowing the instrument from the stockbroker before selling it. The stockbroker charged additional fees for the transaction, in addition to the average brokerage, share price. However, with CFDs, traders can use long or short trading methods without having physical ownership of the share.

Take advantage of long or short trading positions when utilizing CFD trading since ownership is not an issue.

Simplicity

Simplicity is another reason that so many traders are turning to CFD trading. CFDs are easier to trade and understand compared to other derivative products, such as options, warrants, and futures. Options, futures, and warrants can be great products, but the learning curve for each of these products is very steep and can be especially challenging for beginner traders.

So long as the trader has a basic working knowledge of share trading, CFD trading is simple to learn and master in relatively no time. It is exactly the same as trading shares and indices; wherein 1 share is equivalent to 1 CFD. The main differences between the two come in the amount of initial deposit and physical ownership. In addition, due to the high risk involved in trading on margin, many CFD providers offer far more sophisticated stop loss and limit orders so traders can effectively manage their risks in fast-moving, liquid markets.

The ease of trading is the main advantage when it comes to CFDs. With a short learning curve and sophisticated stop loss and limit orders, when compared to other trading products.

Hedging

Hedging is a common trading technique in the financial markets, and many traders use CFDs to hedge a large investment portfolio and minimize the risks involved for each trade. It can almost eliminate some of the risks involved by taking an equal but opposite side. For example, a trader who holds a long position in the FTSE 100 can hedge long exposure by opening a short FTSE 100 position simultaneously. If the price of FTSE 100 falls, the trader will not suffer as much loss, since that loss is compensated by the other open but opposite sell position.

It is important to note that options and warrants do not work well with hedging techniques because they are greatly limited by costs and expiry dates. Most of these transactions are restricted to multiples of 1000 units for each trade, meaning very limited flexibility when it comes to exact share amount trades. In other words, if a trader has 1560 shares, the transaction only incorporates 1000 shares unless that trader can afford to increase the trade to 2000 shares. With CFDs, the trader can hedge the exact same number of shares since the contract is flexible and based on the actual number of shares instead of a rigid number of units.

When hedging, CFDs provides greater flexibility to cover exact number of shares.

No Fixed Contract Size or Expiry Date

CFD providers allow traders to do business with smaller contract sizes. They can trade any number of financial instruments using the contract size of choice instead of being forced into larger trading positions.

All CFD contracts, with the exception of Energy, Copper, and Treasury CFDs, have no expiry date. In the Forex market, they are treated the same as cash products. Energy CFDs, which include UK and US Oil and NGAS, expire monthly. Treasury CFDs, like Bonds, expire quarterly. Copper, the only metal with an expiry date, expires every two months.

Without a fixed contract size or expiry date, trade using parameters that work better for your portfolio.

Liquidity

Actively-traded CFDs provide the trader with high liquidity and competitive prices, retaining one of the highest popularity spots in the financial industry, followed by FX, indices, and commodities. That said; prices may vary from the actual market price, so it is extremely important to trade only with a large and established broker that can offer lower counterparty risk and competitive terms.

While CFDs are very popular, trade only with established brokerage firms.

Ability to Trade Extended Hours

Although CFDs also has a designated trading time, some markets, such as the FTSE 100 and Dow Jones Industrial Average (DJIA, often known as the Dow), allow ptraders to utilize CFDs even after the market has closed for the day. The exclusion is during weekends and bank holidays, where traders are unable to place trades, though limit and stop loss orders can be adjusted.

Gain trading hour flexibility when utilizing CFDs.

Overnight Financing

Overnight CFD positions incur overnight interest adjustments, representing the financing fees required to maintain open positions. Overnight long positions are generally charged interest, and overnight short positions are paid interest (depending on the holding rate used for the calculation). In other words, traders receive interest on overnight short positions but pay interest on overnight long positions. Interest rates are calculated daily and can vary with each broker.

Keeping long or short positions open overnight can have consequences—some that pay, some that cost.

Overall Transaction Fees

CFDs have lower overall transaction costs and are considerably cheaper when compared to buying shares through a traditional stockbroker. Some CFDs charge as little as £10 for trades up to £5,000, however prices are subject to change and may be different in each country. Any trade valued greater than £5,000 is usually charged 0.01% of the total trade amount.

Another great benefit of trading CFDs is the savings seen through transaction costs alone.

Regulated Industry

Trading CFDs does have a form of regulation, since these trades are strictly mandated by the Financial Conduct Authority (FCA) in some countries, though other regulatory agencies rule in other countries. A regulated CFD provider must abide by the strict rules and regulations of FCA or face penalties, fines, and even revocation of CFD trading privileges.

Traders are still protected by regulatory agencies when they trade CFDs.

Bottom Line

There are many great reasons to choose to trade CFDs over other common trading derivatives. From lower transactions costs to lesser taxes, the savings alone is a great advantage for any trader. For traders with far less investment capital, lower initial investment costs are a great benefit, allowing more flexibility for future trading. Flexibility regarding contracts and trading hours are a benefit for part-time traders and beginners, but something even the most experienced trader can enjoy. Finally, traders do not have to worry about unscrupulous trading since there are still regulatory agencies that monitor CFD trading.

Summary


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With a smaller investment, you could maximize your profits by trading on leverage with CFDs. However, you could also increase your losses if the market turns sour.


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For trading in the UK, stamp duty can be avoided when trading CFDs. In most other countries, taxes and other restrictions may apply.


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Take advantage of long or short trading positions when utilizing CFD trading since ownership is not an issue.


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The ease of trading is the main advantage when it comes to CFDs. With a short learning curve and sophisticated stop loss and limit orders, when compared to other trading products.


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When hedging, CFDs provides greater flexibility to cover exact number of shares.


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Without a fixed contract size or expiry date, trade using parameters that work better for your portfolio.


P

While CFDs are very popular, trade only with established brokerage firms.


P

Gain trading hour flexibility when utilizing CFDs.


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Keeping long or short positions open overnight can have consequences—some that pay, some that cost.


P

Another great benefit of trading CFDs is the savings seen through transaction costs alone.


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Traders are still protected by regulatory agencies when they trade CFDs.


 

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Comments

 forextester
# forextester
Saturday, July 26, 2014 4:05 PM
I love trading cfds :)

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