CFD: Contract Types, Advantages, Disadvantages
CFD stands for “Contract for Difference,” and it allows you to benefit from price changes of an underlying asset without actually owning it. You can make gains or incur losses due to price movements in the underlying asset. CFDs are a cost-effective trading tool that offers high profits, leverage, and tax advantages.
When it comes to popular financial instruments, you probably won’t find a better solution than Contracts for Difference. CFDs, or Contracts for Difference, are essentially an agreement between a trader and a broker for the future price level of the underlying asset. If the asset is expected to grow, the investor will buy a CFD at the current price to sell it later at the price difference. This means that investors can speculate on price changes of almost any asset without physically owning it (as with stocks, futures, oil, and more).
How to trade CFDs?
Trading CFDs is not much different from trading currency pairs in Forex. Before investing in CFDs, you should research fundamental and technical analysis, as well as think through your trading strategy. If you open a buying position, it means you assume that the market has reached a support level and will start growing from that point. You sell when you assume that the market has reached a resistance level and will decline from that moment. The deal you make is just a type of contract you enter into with your broker. In this case, you’re not buying or selling physical assets, as is the case in the stock or commodity market. It’s simply an agreement on the price difference between opening and closing the position. And that’s a big advantage in CFD trading.
Unlike stocks and bonds in the stock market or foreign currencies in the exchange, where you can only play on the appreciation rate, in CFD trading you can make profits in both directions, whether for selling or buying. Profits from CFD trading are made from the difference between buying and selling prices.
Types of CFD contracts
Now, many brokers offer various contracts for price differences in addition to currency pairs. Since CFDs are a global tool, they can be used in any market. So, this is a great option for investors looking to diversify their investment portfolio.
Consider the most common types of CFD contracts:
Stock CFDs: Every trader wants to trade stocks, but to access the stock market, you have to go through a complex registration, find a broker on the exchange to act as an intermediary between you and the exchange, and also replenish your account with a certain amount. Not everyone will go for that. If you’re not familiar with stock trading features, we recommend paying attention to a tool like CFD for stocks. It’s almost indistinguishable from classic stock trading and has many advantages, such as leverage, trading in both directions, the usual MetaTrader 4 trading platform, and a minimum deposit. For example, the broker RoboForex offers over 9400 stock CFDs, leverage up to 1:20, a deposit from $10, and the ability to trade for advisors.
CFD Index: Another common area of CFD trading is indices, usually the most famous ones, like S&P 500 and Dow Jones. Some brokers even provide the opportunity to speculate on interest rates.
Commodity CFDs: From oil to gold and from grains to soybeans, the range of commodities is large, and investors can also trade in the commodity market using CFDs. Suppose coffee prices have risen by 5% due to stock concerns. You want to make money, so you buy a lot of coffee beans, but you need to pay for warehouse rental and transportation costs. However, you can also easily buy CFDs for coffee. Thus, you save in the sense that you don’t need to store actual coffee beans, and you’ll make more profits.
CFDs on cryptocurrencies: The popularity of Bitcoin and other currencies has led to the creation of tools like CFDs on cryptocurrency. Here, you get advantages like trading in both directions with fractions, ease of deposit and withdrawal of funds, and high leverage.
CFDs on ETFs: Exchange-traded funds are aggregated financial investment instruments in one group. A single ETF can consist of several assets – commodities, stocks, securities, and so on, so when you buy an ETF, you’re investing in an entire sector of the economy. Thus, you diversify your funds. If the value of one asset decreases, other assets can grow, providing you with profit.
Are dividends paid on CFD contracts for shares?
CFD contract holders differ from company stock owners and do not receive cash dividends themselves. However, during CFD trading, dividend adjustments are applied if there are open trades on the ex-dividend date – the date of the previous dividend. In addition, if you have an open long position, the amount is deducted, and if there is a short position, it is written off. Usually, the adjustment amount matches the actual profit size for one share. You will need to check with your broker for details.
Benefits of CFD Contracts:
- Leverage: The main advantage of CFD contracts is the use of leverage. It allows you, as an investor, to earn big profits in a very short time.
- Tax Efficiency: CFDs are more tax-efficient than investing in markets where you buy the underlying asset directly. Since you are not the owner of the stock or product, there is no need to pay taxes for what you do not own.
- Flexibility: CFDs are flexible instruments that allow traders to open trades in both directions of the transaction. If the stock market seems to be falling, you can immediately go to the selling side of the CFDs and make a quick profit.
- Low Commissions: In addition to the tax efficiency advantages discussed above, CFD brokers target much lower commissions than traditional brokers.
- No Expiry Date: CFD contracts do not have expiry dates like options. You can hold CFD contracts for as long as you need.
Disadvantages of CFD Contracts:
- Leverage: Leverage has its pros and cons. If you use leverage correctly, you will get huge benefits. But if you take too many risks and open large trades, you can lose everything. The key to success in CFD investment is the number of your positions, not their size. You can increase your profits by gradually opening trades and diversifying your portfolio in different markets.
- High Risks: Trading CFDs is risky due to the high rate of volatility in financial instruments. Therefore, you should have enough capital to cover potential risks and not trade with your last funds.
- Additional Fees: If you want to trade CFDs in the long term, additional fees will be charged in the form of a swap to transfer an open position to the next day. This may not be very beneficial for long-term investors. If you are trading within one day, there will be no deduction from the swap.
CFD contracts are an excellent opportunity to invest in various markets (stocks, commodities, raw materials, cryptocurrencies, and other assets). You can benefit from advantages such as using leverage, trading in both directions, low capital, etc. In addition, you can add a simple registration with a CFD broker and easy trading through the MetaTrader 4 trading platform. However, you should always remember that trading CFD contracts, in addition to other financial instruments, is associated with high risks, so it is recommended to monitor money management and stick to your trading strategy.
Hi, I am Nikesh Mehta, owner and writer of this site. I’m an analytics professional and also love writing on finance and related industry. I’ve done online course in Financial Markets and Investment Strategy from Indian School of Business. I can be reached at [email protected].