What are CFDs?
Contract for Differences are a way that European and Asian traders are able to speculate on price movements in assets without actually owning the underlying assets. More commonly referred to as CFDs, these derivative securities are a simple construction that mirrors the price movement of underlying assets, with a small offset the account for the spread between the bid and ask prices.
The CFD is a contract between the trader and the broker they are working with. The purchase of a CFD does not confer any ownership rights over the underlying asset. CFDs have become increasingly popular over the past decade thanks to the several major advantages offered by the trading instrument.
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Introduction to CFDs
- A Contract for Differences (CFD) represents an agreement between a trader and a broker to exchange the difference in the value of a financial asset contract between the opening and closing of that contract.
- There is no asset ownership conveyed by a CFD. Trader’s profits and losses are based strictly on the price change of the underlying asset.
- CFDs have advantages such as the ability to go long or short, ease of execution, and higher leverage.
- Some disadvantages of CFDs include the spreads, a lack of strong regulation, and the risks created by leverage.
Short and Long CFD Trading
One of the advantages of CFD trading is the ability to speculate on price movements in either direction. This means you can match a traditional long trade in which an asset is purchased, and you can also match a short position that profits when the price of the underlying asset falls.
As an example, if you believe the price of gold is going to fall you could sell a CFD based on gold. If the price of gold falls you will profit when you close the short position, but if gold rises you’ll suffer a loss when closing the short position.
Regardless of whether your position is long or short the profit or loss is only realized when the position is closed.
Leverage in CFD Trading
When trading CFDs you are trading using leverage, which means it is possible to control a large position in an asset without offering up the full cost of that position. Let’s say you want to open a trade on 500 shares of Tesla. In a standard trade to purchase these shares you would have to pay the full cost for the shares. However if you are trading using a CFD you might only need to put up 5% of the full amount of the trade.
This leverage allows you to spread your capital out and employ it more efficiently, but don’t forget that the total profits and losses are still calculated based on the full position size. In our example with Tesla shares that means your profit or loss is still 500 times the difference between the price when you open the trade and the price when you close the trade. This can magnify profits and losses substantially, and it is possible to suffer a loss that’s greater than your full deposits. This makes it crucial for traders to fully understand leverage and to keep a close eye on any trade using leverage to ensure it doesn’t get out of control.
Another way trading with leverage is explained is by calling it “trading on margin”. This phrase is used because the small deposit needed to open the larger position is referred to as the margin.
In CFD trading there are two kinds of margin. In order to open a position a deposit margin is necessary, and once the trade is open there is a maintenance margin amount that is required to ensure that the position never goes below what the funds in your account can cover. If your loss does get larger than your deposited amount you will receive a margin call from the broker asking you to make an additional deposit to cover the potential loss. If you fail to meet this margin call by depositing additional funds the broker can close your position and any losses will then be realized.
Hedging with CFDs
One of the less used applications for CFDs is in hedging existing positions to manage risk. An example of this might be if you already own Apple shares but think the stock is due to pull back because of adverse market conditions, or a disappointing quarterly earnings report. In an effort to protect yourself from the drop in the share price you could go short with Apple CFDs. If the price does drop as you believe it will the gains made on the CFDs will offset any unrealized losses in the actual shares.
How to Trade CFDs
Choose your instrument – The first step in trading CFDs is to decide which asset you’ll be trading. At AvaTrade you can choose from forex, commodities, stocks and indices, or cryptocurrencies. If you aren’t sure which asset class to choose, why not take a look at our Education Center in the section entitled “Trading for Beginners.” As an alternative you could look at our economic calendar or earnings releases to see which assets might soon be moving.
Each CFD type has its own specifications regarding the spread, available leverage, and margin requirements which can be seen on our contract specifications page. This information can help you plan your trade and trading costs.
Choose your position – After you’ve chosen the asset you’re going to trade the next thing to decide is your position in that asset. Basically you’re deciding if you want to go long (buy the CFD) or go short (sell the CFD) based on whether you believe the price of the asset is going to rise or fall. In order to make this decision you can use either fundamental or technical analysis methods.
Finally you’ll decide on the size of your position. The unit value of the CFD being traded will depend on the asset, so you should attempt to calculate the optimal number of CFD units that will work best with your account balance and trading strategy.
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CFD Trading Strategies
You can follow several kinds of trading strategies when you are trading CFDs. Consider some of the following:
Day trading strategy – As you might have guessed from the name, day trading consists of opening and closing a trade on the same day. Day traders might hold a position for the whole session, or they might only hold a trade open for an hour. Day trading avoids the risks and costs of holding a CFD position open overnight.
Swing trading strategy – Swing trading is similar to day trading because it looks to profit from short term changes or “swings” in price. The main difference is that a swing trading strategy is more flexible, and traders will sometimes hold their positions overnight despite the added costs and risks.
Scalping trading strategy – A scalping strategy goes in the other direction from day trading. That is, scalpers open many extremely short term positions, some lasting as little as seconds. The scalper attempts to make many small profits throughout the day by capitalizing on the prevailing trend or momentum in an asset.
Advantages of CFDs
Higher Leverage – With CFDs traders are able to access much greater leverage than with traditional trading methods. The European Union has regulated the use of leverage and it is now limited to 30:1 for retail traders. However those who qualify as professional traders can get access to leverage that’s as great as 500:1. Remember that increased leverage has the potential to magnify both gains and losses.
Complete Market Access – Because AvaTrade offers CFDs on all the major asset types a trader can get complete market access from one platform, saving them the headaches of managing multiple brokerage accounts.
No Shorting Rules or Borrowing Stock – There are some markets that prohibit shorting or have regulations the limit the ability of a trader to short the asset. Some require that the trader own or borrow the asset before they can short it, and some have different margin requirements for short positions. With a CFD a trader can short any asset offered at any time because the trader isn’t actually buying the underlying asset.
Professional Execution with No Fees – When trading CFDs at AvaTrade you’ll be able to use all the same order types you’re used to from traditional trading, such as stops, limits, and contingent orders like One Cancels the Other. Unlike traditional brokers who often make money off commissions tied to different order types, AvaTrade only makes money from the spread. There are no commissions or trading fees of any kind. Spreads can be smaller or larger depending on market conditions, but they are the same spreads that professional traders have access to.
No Day Trading Requirements – In some markets there are minimum capital requirements or limits on the number of trades that can be made in certain accounts for day traders. But CFD trading has none of these requirements or restrictions. Traders are able to day trade as little or as much as they like. The same is true for scalping.
Variety of Trading Opportunities – At AvaTrade you have access to forex, commodities, stocks, indices, and cryptocurrencies. This allows you to diversify and to move on trending markets quickly and easily.
Disadvantages of CFDs
Traders Pay the Spread – Because of the spread that exists it is impossible to profit from very small price moves when trading CFDs. The spread also decreases profits on winning trades by a small amount and increases losses on losing trades by a small amount. While these are disadvantages they are often preferable to the fees, commissions, regulations, and increased capital requirements of traditional markets and brokers.
Weak Industry Regulation – This has often been cited as a disadvantage to trading CFDs, however as each year passes it becomes less and less true. Regulation is now widespread and greatly improved over where it was just a few years prior. Long-standing CFD brokers like AvaTrade have also become self-regulating to some extent, realizing that they can thrive when providing clients with transparency and fair trading conditions.
Risks – It’s well known that CFD trading presents risks due to the fast-moving nature of many of the markets offered. There are also risks posed by the large leverage offered by CFD brokers. Traders face margin risks and liquidity risks as well. Finally, execution risks are present due to lags in internet connectivity. Yet many of these are the same risks present in traditional markets as well.
Is CFD Trading Legal In The USA?
CFD trading has unfortunately been banned in the USA and citizens are unable to take advantage of this excellent trading opportunity. Both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have prohibited U.S. citizens from opening CFD accounts domestically and on foreign platforms.
Both regulatory bodies have deemed CFDs to be illegal in the U.S. in part because they are considered over-the-counter (OTC) products that don’t pass through regulated exchanges. U.S. regulatory agencies are also worried about excessive losses due to the use of leverage in CFD products. Interestingly European regulators have tackled this issue by limiting CFD brokers to offering leverage no greater than 30:1 unless a trader has been approved as a professional trader.
The Bottom Line
It’s no wonder that CFDs have continued growing in popularity over the past decade. These unique financial instruments have several advantages over traditional markets such as lower margin requirements, greater access to leverage, no commissions or fees, the ability to go long or short, no day trading or scalping rules, and easy access to a wide range of global assets from a single account. There are some disadvantages such as the potentially large spreads and the chance of large leverage causing costly losses, but the advantage outweigh the disadvantages of CFDs by far.
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Main CFD FAQ for Expert Traders
How long can I hold a CFD?
CFDs do not have an actual expiry date and can remain open as long as possible. However, keeping the position open after the market close can incur fees known as a rollover in CFDs or swaps in Forex currency pairs. Therefore, it would be in your best interest to calculate possible swaps in advance and project it onto your expected return.
Is CFD trading taxable?
CFD trading, in general, is a taxable income and subject to capital gains tax within EEA. However, UK residents can take advantage of Spread Betting, which is exempt from both stamp duty and taxation.
Does CFD expire?
CFDs are not traded in a regular stock exchange, and therefore don’t have expiration dates that would require buying or selling the underlying asset at a certain price.
What is the difference between CFD and futures?
CFDs and futures contracts are similar derivatives, and they both offer leveraged trading; however, futures contracts are traded in the stock exchanges, and CFDs are traded between traders and brokers. Thus, CFDs has more flexible trading requirements, such as higher leverage, lower capital, and flexible contract sizes. Moreover, futures contracts have expiration dates and are exercised on expiry, while CFDs can remain open until the trader decides to exit it.
Is Forex a CFD?
The term Forex itself means foreign exchange; in other words, trading currencies against each other. In online Forex brokers, Forex trading is virtually conducted as a CFD, and the currency pairs serve as underlying assets in the contracts. Similar to stock, commodity, and index CFDs, where the underlying asset is traded against a currency and form a pair like XAU/USD (Gold), in Forex trading the base currency (e.g., EUR) serves as the underlying asset that is traded against another currency (e.g., USD) and form a pair like EUR/USD.
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