CFDs, also known as contract for difference, can be fantastic financial trading instruments owing to their execution ease and unique properties. Even so, the same features that contribute to their appeal can, at times, be challenging to navigate, especially if you’re a novice trader.
CFDs are products that come with high-level risks, thus the need for traders to fully understand them. That way, they’ll be able to enjoy their advantages to avoid losses. CFDs can also be termed as being OTC (over-the-counter) derivative trading. This derivative trading makes it possible for you to speculate on the falling and rising prices of different instruments like commodities and indices. CFDs are also agreements between brokers and traders to exchange a financial product’s value difference-I.e. from when a contract opens to when it closes.
How they work
Here’s an example of how CFDs work.
If you have reason to believe that company A’s (which deals with oil) value will rise, you will make a contract with any CFD broker. You will agree to buy a single lot (about 10 barrels) at about $70 per barrel.
When using margin, you will have to pay 1% to be able to enter into the contract with the CFD broker. So, you make a payment of $0.70 per barrel for $7.Considering your commodity value increase anticipation, you sell on the day you were closing the contract; you will have gained profit from the value difference.
Pros and Cons of CFDs
- Access to underlying assets at cheaper rates than you would have gotten it from an outright purchase.
- Access to different global commodities and indices.
- Lower fees
- Easy to execute
- Ease of going short or long
- Putting down a small deposit for a more significant market share.
- Market risks brought about by increasing volatility in the market.
- Reduced initial investment by the spread size.
- Higher chances of losing more than what was deposited.
Is there a difference between Forex and CFDs?
Yes, there is a difference between Forex and CFDs. CFD majorly involves different contract types, covering various asset classes and markets. On the other hand, Forex only involves currency trading. CFDs are majorly influenced by some factors like demand and supply, whereas Forex is driven by events happening globally.
Contract for Difference Financing Cost
Also known as ‘rollover,’ this is the interest paid, and it depends on a position’s size and of a position is held past 8:45 GMT every day. Regarding index CFDs, if there is an issue of dividend adjustment, it will be included in that ‘rollover’ amount.
The financing cost formula:
Closing index price X interest rate ÷ 100 ÷ No. Of days +/- Dividends X Trade size
When it is a Friday, and you hold your position for the entire weekend, there will be a rollover charge up to 3 times.
- Assets ownership: When you trade CFDs or Forex, you’re not the owner of the underlying assets. For example, when a trader purchases EURGBP, s/he isn’t purchasing that actual currency. All the trader is doing is speculating exchange rates and CFDs are like that. For example, when buying a company’s CFD stock, you’re not the stock owner but rather a price movement speculator. So, it’s safe to say that Forex is also another CFD type.
- 2. Trade execution: Forex and CFD have similar processes of executing a trade. Trade is also OTC (Over-The-Counter), meaning decentralized transactions over a financial institution’s network.
- 3. Costs: The spread is the only trading cost for both Forex and CFD. When it comes to other investment types, traders are required to pay additional fees and commissions.
- Going short or long: Both markets make it possible for you to go short or long on positions. This is a key distinctive advantage to trading CFDs and Forex. Traders can speculate the movement of prices in any given direction. The markets are quite volatile, and the prices move up and down. So, if a financial asset is going well, you have the option of going long and vice versa.
- Leverage use: Both give you access to great liquidity via leverage and margin. As such, you’re able to open positions that cost more than what you have in the account.
Determining the assets you want to sell and buy isn’t easy. Trading Forex and stock are popular but have different types of traders. The one you choose solely depends on your preferred trade pace and personality type.