Light and informative stories from LCG and the world of online trading.
What are CFDs?
CFDs – short for ‘Contract For Difference’ are a popular form of derivatives trading. The word ‘derivatives’ can have some spooky connotations – weren’t they what caused the financial crisis in 2008? Yes and No. Complicated structured products like Mortgage-Backed Securities (MBS) ran into problems but not simple derivatives like vanilla options or CFDs.
A CFD means a client enters into a contract with a broker (like LCG) to trade the difference between market prices of an underlying asset at different points in time. The client can realise profits or losses when the underlying market moves, but the client never owns the underlying asset.
Why even use a derivative instead of just the underlying asset you might ask? There are number of advantages to CFDs that has meant a huge surge in their use and popularity.
How does it work?
Let’s go over a quick example trade.
A trader buys 50 CFDs of Facebook when the share price is $170. Each CFD is worth 1 share so the size of your position is $8,500. If the price rises 20 dollars and you close out your position, you would make a $1000 profit. If the price of Facebook shares falls 20 points, once your position is closed, you would lose $1000.
With a traditional stockbroker, the client would need all the funds or, using a 50% margin, the trade would require $4,250 in the account. A CFD broker might only require a 5% margin so this trade can be entered using of only $425. Read more about LCG’s margin here.
Whatever trading account you use, there is always a bid/ask spread – the difference between the price you can buy and sell at. Traditional trading accounts charge a commission on top, perhaps $10 each way. CFD brokers do not typically charge commissions but widen the bid/ask spread, perhaps by 0.1% each way.
You sell 0.5 CFDs of the ‘Germany 30’ index at €12,000. Each CFD is worth 10 times the index price so the size of your trade is €60,000. If the price falls €100 to €11,900, and you close the trade, you make €500 in profit. If however, you sell 5 CFDs of ‘Germany 30’ at €12,000 and the price rises by 100 points, once you close the trade, you would lose €500.
The advantages & disadvantages
Trade on rising and falling markets.
If you think the market is going up then ‘go long’ or if you think it will fall then ‘go short’. The cost and the ease of placing the trade is the same whether going long or short.
Trade 24 hours a day.
Trading CFDs is not confined to exchange hours, which are typically also working hours. Out-of-hours markets allow trading at a time that suits your schedule.
CFDs provide much higher leverage than traditional trading. Leverage (or margin) helps reduce the barrier to entry to new traders with less capital available for trading. Using margin allows you to place bigger trades using less capital so it amplifies potential profits and losses and can result in losses that exceed your initial deposit.
Trade multiple markets.
Only one account is needed to trade all the major asset classes including shares, stock indices, forex, bond, commodities and ETFs. LCG offer products in all the world's major markets with over 7,000 different securities.
CFD brokers offer many of the same order types as traditional brokers. These include stops, limits and contingent orders such as "One Cancels the Other" and "If Done". LCG even offer guaranteed stops for a slightly wider spread.
No day Trading requirements.
Certain markets require minimum amounts of capital to day trade. The CFD market is not bound by these restrictions, and LCG do not require a minimum deposit. Capital to cover the margin is the only requirement.
CFDs avoid the headache of keep certificates of ownership. Because you don’t own the securities, you have no voting rights or influence over the assets you are trading. You still earn dividends when trading shares CFDs, but only when you are ‘long’ i.e. buying.
CFD trading offers a number of unique qualities that differentiates it from traditional investing accounts. Depending on your investing style and tolerance for risk, trading CFDs can be a very flexible and economical solution.
CFD trading carries a high level of risk to your capital and can result in losses that exceed your initial deposit. They may not be suitable for everyone, so please ensure that you fully understand the risks involved. You should seek independent financial advice, if you feel it is necessary or appropriate.