Contracts for Difference, or CFDs, can be a great financial instrument to trade given their unique properties and ease of execution. However, the same properties that make them appealing to seasoned traders can be tricky to navigate for novices. CFDs are complex products that carry a high-level of risk, and thus require a clear understanding on the part of traders in order to utilise their advantages correctly and avoid loss. Read on to learn more about this product.
What are CFDs?
In its essence, a Contract for Difference (CFD) is a form of over-the-counter (OTC) derivative trading which allows you to speculate on rising or falling prices of various instruments such as indices or commodities. A CFD is an agreement between a trader and a broker to exchange the difference in value of a financial product between the time the contract opens and closes. The trader never actually owns the underlying asset, but rather receives revenue based on the market changes of that asset.
In this scenario, if the trader has bought a CFD and the asset’s value rises the trader gains a profit. And conversely, again after buying a CFD, if the asset value decreases the trader makes a loss. Essentially the trader is predicting future price performance. CFDs allow you to take a position on the future value of an asset depending on whether you believe it is going to go up or down. Instead of you making a full purchase or sale of an asset, the contract mirrors the profit and loss of your intended purchase or sale.
How do CFDs Work?
For example, if you believe that the value of Brent Crude Oil (UKOIL) is going to rise, you enter into a contract with a CFD broker like this. You agree to buy 1 lot (equal to 10 barrels) at $70 a barrel. Using margin, this broker requires that you pay only 1% to enter the contract, so you pay $0.70 a barrel for a total of $7. If as you anticipated the commodity increases in value, on closing day of the contract you sell it and gain the difference in value as profit. Of course, if it decreases you are then at a loss.
The same mechanism works for selling shares if you believe the price will drop. You do this by opening your contract to go short (sell) rather than long (buy). If, as you expected the price moves downward, you can buy the instrument back at a lower price to make a profit on the price difference. If, however, your prediction is incorrect and the value rises, you will sustain a loss. As with all leveraged products, this loss can exceed your deposits.
Advantages and Disadvantages of CFDs
The advantages of CFDs include access to the underlying asset at a smaller financial commitment than buying it outright. CFDs also provide access to a variety of global indices and commodities. Lower fees, ease of execution and the ability to go long or short are some of the other attractive attributes that have quickly increased the popularity of CFD trading as a flexible alternative to traditional trading mechanisms.
On the other hand, disadvantages of CFDs include market risk which grows amid increasing volatility. And when entering a CFD the investor’s initial position is reduced by the size of the spread. CFDs are a leveraged product that allow you to put down a small deposit for a much larger market exposure. While this is a benefit that gives your smaller trading capital greater power, it also carries a significantly higher risk as you can lose more than you deposit.
What is the difference between CFDs and Forex?
The main differences between CFD trading and Forex trading is that the former involves different types of contracts covering a diverse set of markets and asset classes, such as indices and commodities, whereas Forex is purely currency trading. CFDs are mostly influenced by specific factors such as supply and demand whereas Forex is mainly driven by global events. This broker offers you both, in addition to precious metals trading.
What is the CFD financing cost?
The financing cost for your CFD trade is referred to as ‘rollover.’ This is the interest paid depending on the size of the position and for holding a position past 20:45 GMT on a daily basis. For Index CFDs, any dividend adjustments issued are included in the rollover amount as well. The formula for financing cost is as follows:
Closing Price of the Index * the interest rate / 100 / Number of Days +/- Dividends * Trade Size
On Fridays, if you hold a position over the weekend, rollover is charged 3 times as usual.
You can close your position before 20:45 GMT to avoid rollover and the charge will not apply.
Swaps on CFDs
For CFDs on a “spot” basis, when you roll an open position from Friday to Sunday, on a trade date basis, Monday of the following week becomes the new value date, not Saturday. Therefore, the rollover charge on a Friday evening will be three times the value indicated in the table.