CFDs or contracts for difference are a trading vehicle popular with retail traders in mainly the UK, Europe, and Australia. They are the perfect way to start, being both simple and requiring minimal start-up capital.
A brief history of CFDs
They began in the City of London during the early 1990s and were known as ‘equity swaps’. UBS Warburg was the first financial firm to offer them to clients for hedging.
With hedging, it also becomes possible for directional shorting. Traded on margin, with no stamp duty payable plus the possibility of dividend like payouts, CFDs experienced a boom among the professional trader class.
With the end of the '90s was a move to electronic trading platforms.
Financial spread-betting and CFD brokers were among the first financial institutions to embrace the internet and developed sophisticated trading platforms which allowed retail traders to access markets from the comfort of their own home.
Nowadays CFDs have gone global; Germany, Holland, France, Australia, Singapore and Malaysia are all countries with a large retail trading community.
Contracts for Differences are not legal in the US due to the lobbying efforts of the futures and options industry, who view them as competition.
However, retail FX trading is legal, having many similarities to CFD trading. Also the largest US Forex broker, FXCM offers a range of contracts for difference for none US clients.
CFDs are over-the-counter derivative products
This means they are a transaction between two parties, the provider/broker and the client. They are not exchange-traded in the way stocks or futures are.
CFDs are a ‘derivative’ because they follow the price of an underlying market and are not a market in and of themselves. For example, shares in Apple are a real market. An Apple CFD, on the other hand, is a synthetic market that mimics the real Apple share price.
A CFD provider makes a market for clients, allowing them to effectively bet on the price of a financial asset be it stock, index, commodity or FX pair.
These contracts are traded on the broker's trading platform. The broker agrees to pay the client the 'difference' between the price when the client opens the contract and when he or she closes it.
Or, if the client loses, the client agrees to pay the broker that amount. This is all done automatically from the client's account.
Trading on margin.
You could choose to purchase 100 shares in a stock like Apple at $25 per share, for a total of $25,000.
Alternatively, you could use a CFD and deposit a fraction of that amount, with a broker, and still participate in the share movement of Apple as if you have purchased that full amount.
This is what is known as margin trading and it is a more efficient allocation of capital than stocks that offer no leverage.
Margin is a great way for small traders to make large gains with small amounts of capital. And in all honesty, is the main reason why retail traders have embraced both CFDs and Forex so readily.
But margin trading is not without problems. Inexperienced traders often have issues with it, choosing to leverage up trading positions far beyond what is reasonable for their account size.
This has caused concerns from financial regulators who have now reduced margin levels for non-experienced traders, and have imposed other regulations on brokers using questionable marketing tactics.
Range of markets
Traditional stockbrokers specialise in stocks and maybe stock options; futures brokers offer futures only, and forex brokers specialise in the currency markets. But CFD and financial spread betting firms offer the ability to speculate on most of the those (except for options). All from the one account.
Individual company shares, stock indexes, commodities, foreign exchange, and interest rates and now even Bitcoin are all traded.
Everyone has heard the term ‘don’t sell yourself short’, but few know where the term originates. Selling short is actually the name given to the activity of speculating on a falling market.
Yes, people do actually hope markets fall in the hope of profiting from them.
It is actually one of the main reasons why stock traders gravitate to CFDs; because shorting stocks is a difficult process, for retail traders at least.
Fear is a more intense emotion than greed, and markets tend to decline quicker than they rise. With the ability to short on margin there is the chance for large gains very quickly when shorting the market.
While stock options and futures make shorting easy, they are not the best entry-level instruments for new traders.
Holding a stock CFD before the ex-dividend date will not make you rich, it is a nice little bonus when trading CFDs. If you're holding a stock or index CFD; the value of the contracts held is used to calculate a payout designed to be the same as that of real stockholders.
If you are short before ex-dividend day the opposite is true, you have that amount deducted from your account instead.
When you hold a long CFD position overnight, a small interest payment accrues. If you hold a trade for too long this charge can be excessive. At a certain point in time CFDs are no longer cost-effective.
The interest rate used is usually 2-3% above the overnight base lending rate and will be calculated on the total value of the contracts you hold.
If you are short a CFD the opposite is true, you'll be paid interest instead.
Free from Stamp duty
Stamp duty is a small tax placed on the ownership of assets when they are sold.
However, CFDs are excluded from it as no actual ownership takes place. You're merely entering an agreement to exchange the difference in open and closing price.
Why CFDs are suitable for new traders
Trading is not easy. It takes time to learn the ropes and develop the talent needed to make money consistently.
But it can be done. Despite the gloomy failure rate of traders (roughly 85%), it still means there are around 15% of traders that are profitable.
CFDs are a great way to refine your skillset to become a great trader.
Financial barriers to entry are low. An account can be set up with minimal funds.
This means even if you do blow up your first account you haven't lost a fortune. The same cannot always be said when you go into another type of business.
It is not recommended that you use a lot of capital for trading when you begin.
Many CFD providers even offer micro contracts. These accounts use minuscule sized contracts that can be traded with small accounts of £300 or so.
Some CFD traders may never wish to gravitate to more 'respectable' forms of trading such as futures or stocks.
But, if your wish is to eventually have a large enough trading stake to trade real stocks, then CFD trading is a way to build up that capital and experience at the same time.
Whether you plan to move up the trading food chain or not, contracts for difference provide one of the best entry-level products for beginners there is.