CFD Trading (Contracts For Difference), How It Works
CFD Trading (Contracts For Difference), How It Worksindependent2020-11-06T17:33:46+00:00
CFDs are a fantastic instrument to trade with, but only if you know what you’re doing. They are highly leveraged, cost-effective, tax-efficient instruments that let you trade flexibly across a range of different markets and asset classes. In fact, the numbers of professional traders and funds using CFDs as a substantial part of their portfolio is testament to the benefits CFD trading can bring to your account. The ins and outs of how CFDs work are not as simple as they might seem, however, and as we’ve seen over the course of the tutorial there is much to be understood firstly about how these complex financial instruments operate in real life market situations.
3 Pillars Of CFD Trading
Lots Of Markets
When it comes to soaringly popular financial instruments, you’d be hard pressed to find a more in-vogue instrument than the contract for difference. Contracts for difference, or CFDs, are essentially agreements between a trader and broker on the future price movement of an underlying asset. If an asset looks like it’s going to rise, a trader will buy a CFD based on today’s price, with a view to settling for the difference in price at a later date. Essentially, this means traders can speculate on prices more readily than with other instruments, and with a whole host of additional benefits that arise as a result of the structure of CFDs.
Consider the following basic example of a CFD transaction.
Following extensive research, you identify Company X as being a potential mover. Fundamentally strong performance with high growth might indicate that Company X’s share price has the potential to rise over the short to medium term, so you decide to buy CFDs based on today’s share price. After Company X shares increase in value, the trader can then settle the CFD position with the broker and bank the difference between the opening and closing prices, thus delivering the profit portion on the trade. Unlike futures, CFDs have no natural expiry date, so the position can be held as long as is necessary/practical in order to see the desired outcome.
Contracts for difference are fundamentally highly leveraged instruments, because they are traded on margin. This means that traders are required only to front a percentage of the total trade, with the remainder funded by the broker in the short term. This allows trades to be leveraged to the extent that minor market movements yield substantial returns, thus delivering higher profits over a shorter period of time. For traders conscious of maximising their return on capital, CFDs represent a cost-effective way to boost returns, and as a result they have become a staple investment style of institutional investors and trading funds alike.
CFDs are flexible instruments that can be used to speculate on a wide range of assets and markets, in much the same way as financial spread betting opens the parameters of what can be traded, and how. CFDs can be bought in support of a market or position, or sold depending on whether the market is forecast to rise or fall, with equal benefits on both sides of the transaction. This makes CFDs an ideal instrument for hedging risks, diversifying exposure to alternative markets, and generally rounding out a portfolio. With greater transparency requirements on institutional investors, CFDs were found to be traded extensively across a range of markets for this very reason of flexibility, while the substantial returns CFDs can provide can also help shore up the value of the overall trading portfolio.
The upsides of CFDs are unlimited, and with massive leverage coupled with volatile markets, traders can generate serious returns on their capital in a matter of minutes. However, correlatively CFDs are also extremely risky, and the downsides are as equally unlimited as the upsides. In fact, the risks of CFDs are so pertinent that some regulators and regional authorities are expressing concern over the frequency with which consumer investors are pouring their savings into CFDs without due consideration or care. As a result of these not-to-be-underestimated disadvantages, trading in CFDs is always a matter of balancing risks vs. rewards, and each individual trade must be considered firstly from the point of view of the risks posed to trading capital before gains can be taken into consideration.
If you’ve not yet started trading CFDs, the learning curve can be steep – especially if you start out losing money. CFDs are one of those instruments that are so unpredictable and so bulky that more trades than not will turn out to be unworkable. Even with the best logic in the world, calling the markets is in no way an easy task, and when a couple of points represents the difference between a clear profit and loss in a trade, the issue becomes how effectively losing trades can be mitigated while profitable trades are maximised. In effect, most CFD traders should strive to milk winning trades for every penny, while cutting out losing trades as quickly as possible to protect capital, in the hope that an aggregate profit can be delivered over time.
How CFDs Are Priced
CFD pricing is something that can vary from broker to broker . Understanding whether you’re getting a good deal isn’t easy, but knowing that there is sufficient transparency in the way prices are computed can at least offer some peace of mind, and for the most part that is the case with CFD trading. CFD prices track the base market, or the futures market depending on the circumstances, to give a roughly proximate link to ‘real world’ underlying prices. However, the CFD broker will usually also factor in a ‘fair value’ discretionary component, whereby the price can by weighted to even out anomalies in the underling market value.
What Determines CFD Pricing?
This then transpires to suggest that CFD pricing is determined by the underlying market for the particular asset or index concerned. The fair value component serves to act as a correcting mechanism through which the broker can compensate for factors not weighted in by the markets, effectively designed to serve as a handicap to the trader against dealing in the cash market directly. So, if the broker has reason to believe a position will rise, it might adjust the price of the CFD upwards relative to the underlying or futures market to account for this increased probability of outcome.
How Are CFDs Charged?
CFDs are charged by brokers in two main ways. Firstly, commission is set as a percentage of the total transaction size on both the opening and closing of each position. Expressed as a percentage, usually around 0.2% on each end of the transaction, the commission portion is charged on the total size of the position, although still remains proportionately lower than the fees charged in other areas of the brokerage sector. The second main way in which CFDs are charged is indirectly, as a result of overnight financing charges on leveraged positions. This is applied at usually around 0.03% on a daily basis, at the close of the market each day, and is notionally a charge to fund the leveraged portion of the trade.
CFDs can be invested for the long-term, or traded for the short term, although the latter is arguably a far easier goal to accomplish successfully because of the pricing structure of CFD financing. Trading CFDs over the course of one day is always a balancing act, and demands trades with the capacity for wider and more consistent price swings than the norm.
These price swings themselves will be dictated by a number of external factors, as part of the role of the market in facilitating CFD trading. Both in terms of providing an exchange for buyers and sellers to do their business and in performing its function as price setter, the market is central to everything financial and that’s no less true with CFDs. Understanding how the market works, how other traders shape its outcomes and how you can learn to better forecast those outcomes is the Holy Grail of successful investing, and those that dedicate the time, resources and energy into becoming true experts in these areas will forever stand the best chance of trading Contracts For Difference profitably.
CFDs trading can be highly profitable, but assuming they’re an easy route to financial freedom is incorrect. By using them in a rationed, reasoned way to trade logical, research-backed positions in markets you know inside out, you can optimise your chances of deliver a long-term return on your capital.