A contract for difference (CFD) is an over the counter (OTC) derivative since you don’t trade it through an exchange (like shares), but through a bank or company who provide CFD trading.
When you trade a CFD, you agree to exchange the difference between the open and close price of the contract with the market maker (the bank or CFD trading company).
There are numerous reasons why investors chose to CFDs, explains Viv Govender, analyst of Index Trader
Why you should trade CFDs
Here are five benefits of trading CFDs…
#1. Magnified returns
CFDs are a leveraged (geared
) product. This means you gain exposure to the price movements of the underlying asset without having to pay the full price.
Gearing is essentially the borrowing of funds to purchase a financial instrument. CFDs give you a magnified return from this small deposit or margin.
You need to maintain the margin
and are on average ten times geared.
By trading CFDs you benefit from the full movement of the underlying asset for a fraction of the capital.
#2. Make money even when markets go down – a world of short selling profits
A traditional stock market investor who invests in equities can only make money when shares go up.
With CFDs and other derivative instruments like futures, you can profit from the market regardless of the direction it’s moving in.
If you think the market is going up – you can buy into a position. This is ‘going long’.
If you think the market is going to go down – you can sell the position. This is ‘going short’ or ‘shorting’.
#3. Low trading costs
You’ll spend a fraction of the normal commission and brokerage when entering a CFD trade versus a normal equity trade.
There‘s no stamp duty, VAT (depending on who you trade through), STT (securities transfer tax) or STRATE fees.
And there’s no delivery of the physical asset.
#4. No expiry date
In general, CFDs don’t have an expiry date.
This is the key difference between CFDs and futures, which expire every three months.
With a future you have to either exit your trade at expiry or roll over into the next quarter but this involves extra charges.
Although you can hold a CFD indefinitely, financing costs add up over time. The CFD company charges you daily financing costs.
#5. More benefits of trading CFDs
CFDs offer all the benefits of the underlying share without actually owning it.
The CFD company usually alter cash positions in your CFD account to reflect corporate action such as dividend payments, rights issues, warrants, stock splits, etc.
If you trade the CFD you’re replicating exactly the same action as if you owned the underlying asset.
So if you’re long a CFD trade and a dividend is declared, you’ll receive the dividend payment.
The opposite is true if you are short the CFD – you may be liable to pay out.
There you have it, the benefits of trading CFDs.