A contract for difference is a financial product that allows you to trade a specific market without owning the underlying instrument. CFDs were developed in the early 1990s in London by Brian Keelan and Jon Wood, originally as an equity derivative product. Most brokers offer leverage on CFDs using a margin account. CFDs where introduced to the retail trading markets in the late 1990s and began to expand in the early 2000s as a replacement for spread betting in the UK. There are several benefits to trading CFDs, which include level, enhanced returns and minimal costs.
What is a CFD?
A contract for differences, is a financial security that allows you to speculate on an underlying instrument. Brokers will offer CFDs on forex, commodities, indices, shares, and crypto currencies. If you purchase a CFD, you are entitled to the difference between where you purchased the CFD and where you sell the CFD. You are not entitled to the ownership benefits of owning a currency, commodity or share. CFD’s are regulated around the globe. CySEC, the Cyprus financial regulator, increased the regulations on CFDs capping leverage at 50:1 as well prohibiting the paying of bonuses in November 2016. This was followed by the UK Financial Conduct Authority which followed suit in December 6, 2016.
What are the Pros of Trading CFDs?
There are several benefits related to trading CFDs. The first is leverage. Your broker will allow you to open a margin account, which provides you with borrowed capital to trade. This can enhance your returns significantly. Obviously, leverage cuts both ways, which means that you can enhance your losses if you are not careful.
You can bet on long and short positions. If you think a stock or a currency pair is going to move lower you can sell a CFD.
The spreads and commissions are a lot smaller when you trade CFDs relative to futures and shares. A stock broker will charge a minimum of $7 per side when you make a trade. This means that you are paying $14 round trip to get in and out of a stock. You also dealing with a bid/offer spread. When you trade futures, you are also paying a commission in addition to the spread. When you trade CFDs, your broker is unlikely to charge you a commission, and you will only be trading with a spread. This can cut down on your costs of trading.
What are the Cons of Trading CFDs?
If you hold a CFD position overnight, your broker will charge you a financing fee. They are just passing on the cost of lending your money as part of the leverage you have with owning a CFD. If you buy a CFD on shares in a stock, you don’t actually own the stock which means that you are not entitled to receive a dividend.
There are several pros and cons to trading a CFD. You can use leverage to enhance your returns and reduce the costs of trading different financial instruments. The downside is that you will be charged for holding leveraged positions overnight and you are not entitled to benefit from a dividend if one is paid.