How is a trader in a third world country able to buy and sell crude oil futures which are traded in London and United Kingdom? How are they able to invest in companies like Apple and Microsoft, which are listed in New York? What about coffee and cotton futures? What about currencies?
The answer to these questions is a financial instrument called Contracts for Differences (CFDs).
A Contract for Difference is a financial asset that helps traders gain access to popular assets like stocks and cryptocurrencies without having to own them directly. These assets are mostly popular in international forex brokers and are not offered in the United States.
In simple terms, they are financial instruments that allow traders to buy financial assets which are pegged to the real assets.
In this article, we will look at what this financial tools are, some of their types, and how to trade them.
What are CFDs
A CFD is a financial derivative made up of several parts. First, it is a derivative, meaning that holders don’t own the real asset. For example, if you buy a Bitcoin CFD, it means that you have gained exposure to BTC without owning it directly.
As such, you will benefit when its price rises and lose money when its price falls. At the same time, you can’t send your bitcoins to another person or use it to shop.
Second, as the name suggests, this is a contract that is made between a trader and a broker that lets you own an asset that you don’t own physically. It also allows you to either buy an asset which you believe will rise and short one that you expect will retreat.
Finally, a CFD is all about the open and closing price. When you are buying a CFD, you are simply hoping that the asset’s price will keep rising.
Contracts for difference are useful assets that have made it possible for people from around the world to take part in the financial market. For example, it is a bit hard for people in other countries to access American stocks since products like Schwab and Robinhood are not available there. Therefore, with CFDs, they are able to participate in all types of assets.
There are a few types of assets that are offered in form of CFDs. These include:
- Stocks - A stock is a small part of a company. For example, assume that a company is worth $1 million and you own $10,000 of it, it means that you own 1% of the firm. As such, when distributing its profits, you will be given 1% of it. Examples of popular stock CFDs are Netflix, Apple, and Nvidia.
- Cryptocurrencies - Cryptocurrency CFDs give you access to digital coins like Bitcoin and Ethereum without owning the real coins.
- Commodities - Commodities are physical products like crude oil and natural gas. When you own a crude oil CFD (or a gold contract for difference), it means that you benefit from the price movement of oil without owning it physically.
- Forex - These are currency pairs like EUR/USD and GBP/USD.
- ETFs - Exchange Traded Funds are financial assets that are created using multiple assets. For example, the Ark Innovation Fund tracks tens of high-growth companies.
- Indices - These are assets like the Dow Jones and Nasdaq 100 that track a wide variety of equities.
Why contracts for differences matters
In reality, without CFDs, it is impossible for people from the developing countries and some emerging markets to participate in the global financial markets. This is because, to participate in the business where you buy real stocks, you need to be an accredited investor and a citizen of the country.
Therefore, they play an important role in ensuring that people from around the world participate in the market.
How CFD works
CFDs are provided by forex brokers like IG Group, ATFX, and OctaFx. They are not provided by popular brokers like Robinhood and Schwab. The providers usually partner with companies and liquidity providers like Credit Suisse and Barclays.
These kind of contracts are offered in two prices known as bid and ask. Bid is the maximum price that a buyer is willing to pay for an asset while ask is what the seller wants to provide.
Most CFD brokers don’t charge a commission. Instead, they make their money through the difference (the spread) between the bid and ask prices.
Another key concept is known as the deal size. Unlike other assets, CFDs are usually traded in the form of standardised contracts known as lots. For example, silver is traded in lots of 5,000 troy ounces while stocks are offered individually.
Further, unlike futures derivatives, CFDs don’t have a fixed expiry period, meaning that you can open a trade right now and close it within minutes. The profit and loss is determined by the movement of the asset price.
Popular CFD trading and investing strategies
There is a difference between trading and investing. Traders generally bet on the short-term price action of assets like stocks and commodities. They are mostly not interested in long-term trends. Therefore, investors use several strategies like:
- Long-only - These are those who focus on buying stocks and other assets without shorting them.
- Short-only - These are people who focus on shorting stocks and hoping that their prices will fall.
- Hybrid - These are investors who combine the long and short strategies.
- ETF investors - This is a strategy that involves buying and holding diverse ETFs.
- Dollar-cost averaging - This is the process of buying a falling stock in smaller pieces.
Traders, on the other hand, use several strategies, including:
- Pairs trading - This is the process of buying and selling correlated or inversely correlated assets.
- Algorithmic trading - This is the approach of using robots or expert advisors to automate your trading.
- Scalping - A trading strategy that involves buying and selling of assets within a short period of time.
- Swing trading - It is different from scalping because people hold their holdings for a few days. In most cases, swing traders use charts that are less than 30 minutes.
- Price action - This is the process of using chart and candlestick pattern to open and close trades. Examples of patterns are triangles, head and shoulders, and wedges.
How to be a CFDs trader
To become a perfect CFDs trader, you need to understand a few things. First, you need to have a lot of interest on it. This will help you be able to spend tens of hours reading news and interpreting financial data.
Second, you need to have access to financial materials like books and videos. Finally, you need to spend hours reading and doing the research about the financial markets.
Benefits and cons on trading CFDs
Long and short bias
This comes with a number of benefits. For example, to trade in CFDs, you can buy or sell financial assets. By buying, you will benefit when the price of the price of the financial asset is moving higher.
If your thesis is that the financial asset will move lower, you place a sell order where you benefit from the downward movements. This makes it possible for you to make money regardless of the financial conditions.
No legal obligation
The second benefit about trading in CFDs is that you don’t have any legal obligation on a company. In the convectional investing, when you are a shareholder, it means that you can take part in the decision-making process.
You can participate in firing the board and the CEO and even influence the decision of the management of the firm. As such, when there is a financial issue in the firm, you can lose more.
As a contract for difference trader, when you sense that the stock is not doing well, you just respond by shorting it.
Third, with CFDs, there are thousands of financial assets you can trade in. If your expertise and experience is in the commodities market, there are tens of commodities to trade from.
If you are perfect at stocks, there are thousands of stocks to trade from. The same is true with indices and currencies. This also give people access to assets that are not offered in their country. For example, a person in Europe can easily buy and sell American stocks.
At Day Trade The World, we offer thousands of financial assets from tens of exchanges to choose from.
CFDs are offered using leverage, meaning that you can optimize your profitability. As such, you don’t need thousands of dollars to trade a stock going for $1,000.
Disadvantages of CFDs
There are a number of cons of trading contracts for difference, including:
- Higher risks - While leverage is a good thing, it can also be risky for investors since they can lose more money.
- Lack of ownership - When you own a stock CFD, it means that you don’t really own the stock, meaning that you cannot advocate for change.
- Overnight financing - Some CFD products have costs for overnight holdings known as swaps.
CFDs are important financial assets that have improved accessibility of the financial market. They can be seen as the foundation of modern trading, providing anyone in the world with the ability to trade assets in every part of the globe and of every type.
In this article, we have looked at how these assets work, some of the trading strategies, and their pros and cons.
External useful resources
- The role for contracts for difference in industry’s switch to cleantech - Pinsent Masons