What are CFDs
CFD stands for Contract For Difference. This type of financial instrument allows you to trade an underlying index, share or commodity contract without actually having to own it. The CFD price is the price of the underlying asset. So if the price of the underlying asset, eg. Gold or Facebook Stock goes up, so will the price of the CFD. Similarly, if the price of the underlying asset goes down, so will the price of the CFD. It is important to emphasize that you don’t actually own the asset you trade
What is CFD Trading?
CFD trading is quite similar to forex trading. When trading on the platform, you select the instrument you wish to trade and enter your order. If you think the price of a certain instrument, e.g. crude oil, will increase, you’ll want to BUY the crude oil CFD. The same goes the other way – if you predict the value will go down, you short sell the CFD. Naturally, as with any type of trade or investment, wrong predictions can lead to the loss of money, and one should be aware of the risks involved in CFD trading before starting out.
How Much Will it Cost to Trade CFDs?
The spread is the difference between the BUY and SELL prices of a certain instrument. When calculating the cost for a position, you need to multiply the spread by the size of the position. For example, if the spread for crude oil trading is $0.03 USD, the cost for opening a 10 barrel-position is $0.03 X 10 barrels = $0.3 USD. Most of the CFD instruments are traded on market spreads, which means that the spreads are affected by the liquidity of the market. The more liquidity, the narrower the spread will get.
CFD Contract Rollover
Each index and commodity CFD is based on a contract defining its rates, charges, etc. Each of these specific CFD contracts has an expiry date, which is the date that the contract expires and automatically replaced by a new contract, just like the real market. In order not to disturb traders during market hours, the contract rollover takes place over the weekend. For more information, you are welcome to visit our CFD Rollover page.
Hedging with CFDs
Hedging is a risk management strategy that involves opening opposite or offsetting trades designed to practically mute the risk exposure of an open trade in the market. CFDs represent an ideal type of derivative to implement a hedging strategy effectively. To start with, they are low-cost and liquid. But they can also be customised (in terms of size and amount) to meet the specific hedging objectives any investor desires.
As an example, if you hold $10,000 worth of shares of Tesla in your portfolio, you could hedge the position by selling an equivalent or part amount of Tesla stock CFDs. In that way, if Tesla prices fall, the loss in value in your physical shares portfolio will be offset or cancelled by the profits gained by the CFD trade. You can then close out the CFD trade when the downward retracement comes to an end so as to lock in your profits and to give the value of your physical Tesla shares the chance to rise again.
CFD hedges are ideal when a market is moving against you (either due to sentiment or overall fundamental reasons) or when the market has moved so much in your favour that any extra gains are likely to be fractional. On the other hand, CFD hedges can be particularly riskier because of leverage; they are therefore not ideal when the underlying market is very volatile or when a retracement has been overextended.
Disadvantages of CFDs
Ironically, leverage is one of the biggest disadvantages of CFDs, just as much as it is one of its major appeals. Leverage boosts your profit potential, but when prices go against you, it can leave a devastating puncture in your trading capital. This is because losses are based on the leverage amount and not on your actual trading capital. CFD trading also comes with associated costs. When you open a CFD trade, you have to pay a spread fee which is the difference between the bid and ask prices of an asset. There are also additional costs in the form of rollover fees or swaps for positions held overnight. This is the cost applied for holding a leveraged position (which is essentially borrowed money) for an extended period of time.
Market volatility is another source of risk in CFD trading. Prices of financial assets are prone to random fluctuations and sometimes even choppy price action. There can also be price gaps that can occur during high-impact news releases or market openings after the weekends. This volatility can mean that you may miss your desired prices when entering trade positions, or your losses can be amplified when prices go against you. A final drawback for CFDs is that you do not own the underlying asset you are trading; you are simply speculating on its price changes. If you are trading a stock CFD, it means that you have no real shares, you do not hold any voting rights, and are not entitled to any dividends.