Contracts for difference (CFDs) are financial instruments that allow an investor to speculate on the direction of an underlying asset without the need to purchase, own, or store the asset. CFD trading was initially introduced about 30 years ago, allowing hedge funds to use margin to enhance their gains on trades using these financial products.
One unique aspect of CFD trading is access to leverage. Leverage allows traders to improve their profits using a similar concept to borrowed capital. You can use CFDs to trade multiple markets, using several differential trading strategies.
Not only do CFDs provide access to Forex trading, but you can also trade commodities, indices, individual equities, as well as cryptocurrency. There are several pros and cons to trading CFDs, one of the most flexible trading instruments available to retail traders.
The History of CFDs
CFD trading initially came on the scene in the early 1990s as a swap to provide hedge funds with access to the London Stock Exchange without having to post significant margins. Following the introduction to retail traders later in the decade, CFD trading became popular with retail brokers who started to introduce them to their clients in the early 2000s.
As the new millennium started, traders realized that CFDs had the same financial payout as spread betting. At the time, spread betting had very favorable tax implications where the profits were exempt from capital gains taxes. CFDs started to apply in the early 2000s across Europe and Asia.
In June 2009, the UK government implemented a rule that allowed prosecutors to use CFDs as a metric to prove insider trading. This scenario followed several situations in which traders used CFDs to trade instead of the underlying stock to circumvent insider trades. In 2016 European authorities issued warnings on the risk related to CFDs as the marketing of these products exploded.
What Can You Trade When You Invest in CFDs?
CFDs provide traders with access to financial instruments that allow them to speculate on the price direction of an underlying asset. These assets include currency pairs, commodities, indices, shares, and cryptocurrency. Brokers have also introduced CFDs on exchange-traded funds (ETFs), baskets of stocks, or commodities that track underlying assets.
An ETF is a pooled investment security similar to a mutual fund. ETFs usually track a basket of stocks or indices. Some ETFs follow commodities and currency groups (like the dollar index). ETFs can also track stocks in a specific index, like the S&P 500. Additionally, some ETFs track particular sectors such as the technology, communications, and financial sectors. They also provide access to the utilities, energy, and industrial sectors.
The Pros of Trading CFDs
One of the benefits of trading CFDs is that you can trade several different instruments using leverage. Leverage is a concept that is similar to using borrowed capital to purchase an asset. For example, if you want to buy a house, you will go to a bank and apply for a mortgage.
A bank will check your credit background and determine if you qualify to borrow money to purchase a home. A bank will use the house your purchase as collateral, and if you default and cannot pay for the home, the bank will take your house as part of the agreement.
CFD leverage is similar to purchasing a home using a mortgage. A broker will ask you to apply for a margin account if you want to trade CFDs using leverage. You will need to apply for a margin account, and your broker will check your credit. The collateral, in this case, is the CFDs.
You will need to have enough money in your margin account to cover any losses that you could incur. Your broker uses an analytical program that is constantly running to ensure you have enough equity in your account to cover a loss if there is an outsized move in the CFDs you are trading.
Your CFD broker will not absorb your losses. If the equity in your margin account falls below a critical level, you will be asked to top it up. This situation is referred to as a margin call. If you cannot add equity to the account immediately, your broker will likely have the right to liquidate your positions.
Another advantage of CFD trading is that you have access to many assets. Your margining might allow you to net your positions, so the gains in one area could offset the losses. Portfolio margining is a concept that provides diversification and will enable you to enhance your CFD trades across many assets.
CFD trading also provides you with the ability to trade using many strategies. You can trade a buy and hold strategy, technical analysis strategies, fundamental stock strategies, and short-term scalping strategies. Additionally, you can also trade pair strategies. A pair trading strategy allows you to purchase one asset and simultaneously sell another.
The Cons of Trading CFDs
The most glaring issue is understanding the risks of CFD trading. Many investors do not understand CFDs and the leverage they provide. If you plan on trading CFDs simply to make money, you will likely find out how complex this process can be. In addition to a recommended trading strategy, it’s not advisable to trade CFDs without a sound risk management plan.
The Bottom Line
CFDs are financial instruments that track the movements of underlying assets. They were initially introduced in the early 1990s and quickly spread to the retail market by the beginning of the millennium. You can trade many assets using CFDs, including forex, commodities, indices, stocks, cryptocurrencies, and ETFs.
CFDs offer investors leverage that allows them to magnify their trading capital. However, leverage cuts both ways and can accelerate your losses. One of the cons of CFD trading is that novice traders sometimes do not understand a margin account and how it can impact your bottom line.
CFD trading also offers traders access to several trading strategies. You can buy and hold for long-term gains. You can pair trade and use technical and fundamental analysis to trade your portfolio.