What is Contracts for Difference?

Explain what means Contracts for Difference or CFD

So what are Contracts for Difference?

Contract for Difference, or CFDs as they are commonly known, is a derivative product that derives its share price from the underlying stock or index that it is tracking.

For example if you are looking to trade National Australia Bank (NAB) and the current ASX stock price was $30 then the CFD would also be $30. The Contract for Difference or CFD will attempt to mirror the performance of the underlying stock at all times.

Contracts for difference are exactly like trading normal stocks except you need a small amount of money up front. There are some other subtle differences like CFD finance & CFD leverage and anyone looking to trade this product should certainly consider the CFD risks involved.

So who owns the stock?

When trading Contracts for Difference you don’t actually own the physical stock and you don’t get a contract note as you would with normal share trading. You are simply trading the difference in price between where you got in and where you got out.

Why do people trade contracts for difference (CFDs)?

There are 6 main reasons why people trade Contracts for Difference (CFDs).

  1. Take advantage of short term price swings or movements in the stock market.
  2. Take advantage of the incredible leverage CFDs offer
  3. To hedge existing share portfolio’s
  4. To access international stock markets through the one trading account
  5. To take advantage of lower commission rates or brokerage
  6. Profit from falling markets called short selling. See examples CFD trading portfolio

What are the differences of CFD trading to stock trading?

In fact CFD trading and stock trading are very similar but the 3 main differences are:

  1. You only put up a fraction of the total position as margin (from 1-50%)
  2. Commission rates are normally much lower (starting at $8 or 0.1%)
  3. You can profit when the market is falling by short selling CFDs

What are the differences of CFD trading to options trading?

The reason CFDs have grown in popularity so quickly is that they are very easy to understand. This is the single biggest benefit that CFD trading has over options trading. Options trading can be quite difficult to learn initially and many traders give up as a result.

The other benefits of CFD trading versus options trading are:

  • No time expiry;
  • No time decay;
  • You don’t have to choose a strike price;
  • When trading Direct Market Access (DMA) CFDs you are not competing against a professional market marker;
  • When trading Direct Market Access (DMA) CFDs the spread is exactly the same as the real market. Option spreads can get out to 7-10%; and
  • You don’t need to understand the ‘Greeks’ when CFD trading
  • Who can trade CFDs?

CFDs are generally available to anyone over the age of 18 years of age. Please keep in mind that when trading a leverage product like CFDs the risks can be more than what you initially start with so CFD trading is not for everyone. Please understand the CFD risks and read the relevant PDS and disclaimer of each company.

  • Having said that CFDs can be traded by…
  • Investors looking to hedge their existing share portfolio
  • Short term, medium term or long term traders
  • Intraday traders
  • Swing traders
  • Pretty much anyone looking to take advantage of a price movement, either long or short.

What are the risks of CFD trading?

Contracts for Difference or CFDs are a leveraged product which means you can access say $50,000 worth of stock even if you only have $5,000 in the account. CFD leverage is a double edged sword which means it’s great when you are winning and not so great when you are losing.

The greatest risk that CFDs pose is the fact that you can lose more money than what you start with.

Here are some of the other risks involved with CFD trading.

  • You can lose more money than what you have in your account
  • Short selling leaves you exposed to unlimited risk
  • CFDs tend to lend themselves to shorter time frame trading which is considered the toughest form of trading around
  • Current advertising seems to suggest that quick riches are easy with CFDs but this is not the case because
  • CFDs increase the size of your wins but also increase the size of your losses

What are the available methods to trade CFDs?

There are two main methods of accessing or trading CFDs which are:

  • Direct Market Access (DMA) or
  • the Market Maker model

There is no right way or best way as each has its own advantages and disadvantages. You are best off asking around and talking to other CFD traders to see what they prefer and their reasons for selecting one or the other.

It is very common for professional CFD traders to use both Direct Market Access (DMA) and Market Maker models together. In next part we talk why CFD trading is most popular instead forex in finance world.

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