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What is CFD trading and is it suitable for you?

Over the past decade, CFDs (Contracts for Difference) have become one of the most popular ways for investors to trade commodities, indices and currencies online. Although they have grown rapidly and many online brokers now offer them to traders, CFDs are risky and certainly not suitable for everyone. Understanding the volume of potential gains and losses is just one important consideration in deciding whether CFDs are right for you.

CFDs may look attractive because if you do not have the money to buy the underlying assets you can still take a share in the potential gains in the value of those assets using leverage, but the biggest risk with leverage is that it eventually makes you exposed to losing much more than you put in. Thus any large gains can be offset with large losses. Learn what it means to trade on leverage and margin before using CFDs.

What are CFDs?

CFDs can be traded on a variety of financial instruments such as stocks, indices, commodities or currencies. The profit in CFDs depends on the change in the value of the underlying asset over time. In both cases you can get the difference between the closing price and the opening price of the contract. It works as an agreement between two parties to exchange the difference in the price of the asset. This means that you do not have the asset in real terms.

Learn more about what are Contracts for Difference and how they work

How do CFDs work?

CFD trading is similar to investing in any other financial market. For example, if the price of a commodity rises by 10% then you have earned the same percentage. If the commodity falls by 10% then you will lose the same 10% value. The main difference between the actual investment in financial assets and investment in CFDs is that the contract gives you more flexibility and you can also apply leverage that maximizes profits. You can also use stop loss orders and choose when you will take your earnings, loss ratio and closing time of the transaction.

Do you profit only when prices rise?

One of the big advantages of CFDs compared to other financial instruments is that you can take advantage of price declines as well. Remember that CFDs are all about the difference in price, where you can invest in high or low prices according to what you think is more likely to happen.

Is CFD trading more risky than traditional investments?

Any financial investment involves risk and CFDs are not exempt from that rule. In fact, they can carry substantially more risk when using leverage, which increases your exposure to the markets. Leverage increases your profits but also increases your exposure to losses.

Why do traders prefer CFDs?

Apart from the ability to borrow and take advantage of leverage, there are several good reasons why many traders prefer CFDs:

  1. No fees are paid for trading contracts apart from the spread (see this brokers’s CFD pricing).
  2. You can access a large segment of markets including commodities, indices and others.
  3. You can access all the markets from a single trading platform.
  4. Trading is possible when the market is closed due to 24-hour trading.

If any of this appeals to you or you would like to learn more, get in touch with us below and we’ll take you through the entire process step by step. And remember, a risk-free demo account is a great way to try things out before committing any actual money.

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CFDs 101 – What are Contracts for Difference and How Do They Work?

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.

This* is a CFD execution-only broker that offers CFD products in over a dozen commodities and global stock indices.

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.

Learn more about this broker’s attractive CFD pricing and contract specifications.

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A Brief History of CFDs

Since their introduction almost thirty years ago, CFDs have grown hugely in popularity and availability, and now include more asset classes and instruments than ever. Their unique advantages make them a favourite among many traders today, but CFDs haven’t always been so readily available to retail traders. The origins of CFDs date back to their use by hedge funds, but the immense trading possibilities they offered quickly made their way to the average trader. Here’s when, how, and why.

CFD History

Beginnings

Early 1990s, London – CFDs are developed as a type of equity swap that utilises margin for trading it. The credit for this market-changing invention is generally given to Brian Keelan and Jon Wood, who were both at UBS Warburg at the time.

Given that they are securities and financial instruments with low costs, CFD contracts are originally used by hedge funds to cover financial positions in the London Stock Exchange, especially since they required relatively little margin and also bypassed the UK transaction tax (or stamp duty) since no actual physical shares were exchanged.

Entry into Retail

Late 1990s, UK – CFDs first become available to retail clients through a number of innovative UK-based brokers. Online trading platforms made it easy to get real-time price quotes and place immediate trades, and as technology advances so does the proliferation of CFDs.

The first company to offer CFDs to the public is GNI Touch, which is subsequently acquired by MF Global (now defunct). This is soon followed by others and by the year 2000 CFDs become known by the average trader.

Growth Phase

2000 – 2001 – Retail markets come to realise that the real advantage of CFDs is not just the exemption from the transaction tax, but the possibility to leverage many underlying instruments. CFDs enter their big growth phase.

CFDs offerings quickly expand to include indices, global stocks, currencies, commodities, and more. Index CFDs based on major global indexes such as the Dow Jones, DAX, CAC and others become the most popular CFD type, still retaining their popularity till today.

Within a short time, the London Stock Exchange no longer only covered stocks, but started trading CFDs, which achieved annual growth of more than 100% in volume.

Global Expansion

2002 – CFDs begin to expand out of their UK home as providers enter overseas markets, with Australia being the first. CFDs have since been introduced into dozens of other countries and different jurisdictions, including throughout the Euro Zone. The United States is a notable absentee where CFD trading still remains restricted to retail traders due to rules regarding over the counter products and the lack of registered exchanges in the US that offer CFDs.

Regulatory Arena

2009 – UK’s Financial Services Authority (FSA) develops a general regulatory framework for CFD trading, specifically to prevent the use of internal corporate information in CFD trades, following a number of high-profile cases of abuse.

2013 – LCH.Clearnet, Cantor Fitzgerald, ING Bank and Commerzbank launch Europe’s first central clearing of OTC CFDs, in line with EU financial regulations, while working to improve CFD coverage.

2016 – The European Securities and Markets Authority (ESMA) issues a warning regarding the sale of speculative products such as CFDs to retail investors, after an increase in misleading marketing and unscrupulous brokers, many of them registered in Cyprus. European financial regulators respond with new rules on CFD trading.

2018 – The European Securities and Markets Authority (ESMA) agrees to set strict regulations on trading CFDs for the public. A leverage cap is being established along with margin limitations. Licenses are only granted to existing companies that are known and able to cover all obligations for the managing, issuance and distribution of CFDs.

CFDs have come a long way but they show no signs of slowing down. And with increased regulation and a more informed public, trading CFDs with a trusted broker makes managing the associated risks all up to the individual trader’s own discretion.

You can trade CFDs for commodities like oil and natural gas, index CFDs for some of the world’s biggest benchmark indexes, and more with the best brokers. See our attractive transparent pricing for CFDs and talk to one of our knowledgeable reps by opening a free demo account with no obligation.