Benefits and risks of CFD trading compared to other trading types

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What Are CFDs (Contracts for Difference) and Why Do You Want to Trade Them?

CFD or Contract for Difference is a financial instrument that doesn’t involve the purchase of the underlying asset. The investor’s goal is to predict the direction of the future price movement and capitalize on the difference between current and future prices.

In general, CFD trading means you must close the deal in future to get either profit or loss in result. Forget about expiration time – you can close your deal at any time you want.

If the prediction is correct, the trader will earn a profit. The amount of it will depend on conditions of each particular deal. This makes difference between options and CFD trading, because while trading binary, classic or digital options you may just wait for expiration time and the deal will close automatically.

In CFD trading there is no expiration time. But you are able to set stop/loss and trigger a market order if the price gets a certain level.

CFD forex trading on IQ Option

Why to trade CFDs?

CFD is an alternative way of trading, which has its own advantages and disadvantages. When compared to more conservative trading tools, contracts for difference can boast the following benefits:

Margin trading. Contracts for difference offer the usage of a multiplier, an extremely powerful trading tool. With it, one can control the position that exceeds the amount of money invested in it.

When picking the 10:1 multiplier the trader gets an opportunity to open a $1000 deal with only $100 at hand. The other $900 would be automatically provided by the lender. What are the benefits and risks of trading on margin? The potential profitability (as well as risks) will also be magnified. Imagine investing $100 and getting the return that is comparable to a $1000 investment. That’s the opportunity a multiplier can offer. However, remember that the same goes with potential losses as these would be multiplied as well.

Fast trading. Trading on CFDs does not require massive time commitment and can be practiced both professionally and casually. Of course, for tangible results it is required not only to spend enough time on trading but also to undergo an in-depth training. Still there is a possibility of executing several deals spending less than 15 minutes a day, which certain traders will find beneficial.

Available CFD types

New CFD types, available in the IQ Option trading platform include CFD stocks, Forex and CFD cryptocurrencies.

Forex

The Forex market is the world’s largest and most liquid financial market. When performing the exchange of currencies, you’re expecting the price of a currency will grow and you’d be able to sell it back to make some profit off of that price difference. This kind of price speculation is the basic principle behind trading on the Forex market. For quite a while Forex trading was available solely to institutional investors such as banks, yet the development of the Internet let ordinary people join the international currency market.

Cryptocurrencies

The hottest trend of the trading season, cryptocurrencies drew the attention of both finance professionals and regular people. Now you also have a chance to capitalize on the movement of the six most popular cryptocurrencies.

Bitcoin has been growing against the USD, though with a series of downfalls, for years. Ethereum demonstrated an exponential growth pattern and grew from $15 to $371 in a matter of three and a half months. Fast-paced growth and speculative opportunities are not the only reasons why the financial community is paying close attention to cryptocurrencies. They are believed by some experts to change the world financial system forever.

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Etherium rise and fall

It is not necessary to invest in expensive hardware worth thousands of US dollars to mine cryptocurrencies on your own or deal with overcomplicated online exchange points. When trading with IQ Option, the process of trading the cryptocurrency of your liking is as smooth as any other trading operation. The world’s most popular cryptocurrencies are now close at hand.

CFD stocks

CFD stocks trading will be available on IQ Option platform in October.

When trading CFDs, instead of buying a share in a company and becoming one of its owner, you forecast the future direction of the price action and capitalize on the difference between the current and the forthcoming prices. Choose from the world’s largest and most known company. Follow corporate and industry news to capitalize on CFD stocks using fundamental analysis or apply your knowledge of technical analysis to trade existing market patterns.

The New York Stock Exchange is the largest stock market in the world that trades a daily volume of $22.4 billion. The FX market can boast $5.3 trillion of a daily volume traded. Forex, however, is not only 200 times bigger than the world’s largest stock exchange, it is also extremely volatile. Exchange rates constantly fluctuate, creating numerous speculative opportunities for traders willing to face the risks of high volatility.

Risks and multiplier

The risks associated with CFD trading mostly lie in the sphere of using a multiplier. A multiplier is a truly double-edged sword. When you get the forecast wrong, the losses your account will incur will also magnify. This is the main risk of using any amount of borrowed capital and especially high multiplier ratios, e. g. 100:1 and 1000:1.

If you are not being deliberate enough you can incur heave losses in a relatively short period of time. When you trade with a multiplier and the trend starts moving in the wrong direction, you will start losing the money to cover the losses in borrowed capital. Volatility spikes can therefore eliminate your entire margin in no time.

Certain Forex dealers would offer multipliers as high as 3000:1. Not only it is risky, the strategies involving extremely high multiplier ratios have little to no chances of providing positive returns in the long run. Knowing the risks of margin trading is essential to successfully utilizing this tactic in the Forex market.

NOTE: This article is not an investment advice. Any references to historical price movements or levels is informational and based on external analysis and we do not warranty that any such movements or levels are likely to reoccur in the future.
In accordance with European Securities and Markets Authority’s (ESMA) requirements, binary and digital options trading is only available to clients categorized as professional clients.

GENERAL RISK WARNING

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.
87% of retail investor accounts lose money when trading CFDs with this provider.
You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Why trade CFDs instead of Stocks?

Q: What is the difference between buying a share through a traditional broker versus trading it via a contract for difference?

The key difference between trading a CFD long and buying a security is due to the leverage that is employed. Contracts for difference are traded on margin which means that there is no need to tie up the full market value of purchasing the equivalent stock position. This also allows traders to open larger positions than their capital would otherwise allow.

There are a number of key differences between trading an underlying asset and a CFD -:

  1. As opposed to holding the underlying asset, a CFD is traded on margin which means that an initial deposit is lodged with the CFD broker which allows the investor to buy or sell a number of CFDs according to margin computations which allow extra leverage over the stock purchase itself.
  2. The investor doesn’t down own the underlying asset over which the CFD is based but enters a contractual agreement with the CFD broker to exchange the cash difference in price between the opening and closing prices of the contract.
  3. CFDs can be traded short or long and you are not required to deliver the underlying asset in the event of a short sale.
  4. Presently, CFDs are exempt from UK stamp duty of 0.5% although profits are subject to capital gains tax.

One CFD will usually be equivalent to one share, except that with a contracts for difference position your provider will usually only require you to put down 5% to 20% of the actual contract value in order to trade. On a share CFD with a 5% margin, you can gain exposure up to twenty times as many shares for the same capital outlay compared to an investor in physical shares. For instance, suppose you buy 5 shares of Google at $400, you would have to pay $2000 ($400 x 5). But if you bought 5 Google CFDs at $400, and the margin requirement was 10%, you would only be required to fork out $200 leaving you money to use on more trades. The net effect is a return (or loss) of 10+ times the amount using CFDs over shares due to the leverage that is employed. The fact that CFDs are traded on margin (which means that your broker is effectively lending you money) implies that a contracts for difference trade attracts finance charges while a position is held, while this does not apply to the share trade. The interest is charged on the full market value of the CFD position and the rate is set by your CFD provider, and again usually set with a spread around the base rate of the country within which the stocks are traded. So for shares traded on the London Stock Exchange, this would be LIBOR while for USA shares this would be the Fed Rate..etc.

The downside is that geared trading opens you up to the risk of losing more than your initial outlay – there is a risk that you would wipe out your account and end up owing more funds to your CFD provider. This cannot happen if you buy the physical shares. This could happen, for instance if you were to short shares and the market moved sharply against you. Of course, it is very difficult for retail investors to short shares in the physical market. It is also important to note that while the value of the CFD is derived from the value of the underlying asset, it may not mirror it exactly.

Lastly, and this is an important difference with CFDs you do you have the right to acquire the referenced shares, or benefit from any ownership rights, such as voting rights, in the underlying shares and therefore only have an economic interest in the share. So for instance if you trade a CFD on Apple or BP, you are in effect trading the price difference between your entry point and your exit point. You do not own the Apple or BP shares, you are only speculating on their price going up or down. CFDs are concerned ONLY with movements in price – nothing else. The contract is between you and your broker.

CFDs provide all the benefits of share trading combined with the added advantage of being able to utilise your unrealised profit, and only outlay part of the full notional value of your position.

Q: Do I get a share certificate when I trade a share CFD?

Q: Do CFDs have the 3 days settlement period like real shares?

Q: Why trade CFDs instead of stocks?

  1. Gearing i.e. the ability to leverage your capital. You are only required to provide only initial collateral at between 5 to 10% of the nominal value of the underlying share when the contract is opened. This allows you to trade up to 20 times (sometimes even more!) the value of your cash outlay – potentially benefiting from stock price movements without having to purchase that share outright. If you have $20,000 in a shares dealing account, then you would be able to buy shares for a total market value of $20,000. Once all your capital is ‘invested’ in positions you wouldn’t be able to take advantage of other trading opportunities unless you sold a portion of your stock portfolo. This is not so with a CFD brokerage account where if you put $20,000 in it – not only would you still be able to trade up to $20,000 but more importantly you will also be able to open extra positions should you notice other trading opportunities (without having to sell any of your existing holdings). This is leverage and is the greatest advantage of CFDs compared to traditional shares dealing.
  2. Ability to go short which allows you to take advantage of an overvalued stock – if you consider a share overvalued, you can short the stock using a CFD to benefit from a fall in its share price (with no extra costs).
  3. Avoidance of stamp duty in the UK and Ireland. In quite a few cases the half-percent saving from the stamp duty exemption will actually exceed the round trip commission costs for opening and closing the trade.
  4. Direct trading on live tradable prices – CFDs mirror the price of the underlying instrument and there’s no waiting for the execution of orders. Using DMA CFDs, every trade has a corresponding trade in the real market, so you are able to take part in the opening and closing price auctions.
  5. CFDs allow you to make use of more advanced strategies and tactics such as hedging your existing share portfolio.
  6. Dividends – When holding a long CFD position over the ex-dividend date, you will receive the dividend into your trading account immediately (usually on that same day).
  7. Minimum amount to start trading CFDs is usually $5,000 or less.
  8. Many international markets accessible from one CFD account – be it shares, forex pairs, indices, commodities, sectors..etc. This is another big advantage of utilising CFDs versus a traditional stock broker.

However, it is well worth noting -:

  1. CFDs are not standardised and every CFD provider has their own terms and conditions.
  2. Leverage means small market movements can have a big impact on the success of your trades..
  3. With CFDs the issue of counterparty risk crops up. Incidentally, since all you own is a contract with the CFD provider, you are also relying that the CFD provider is in a sound financial position and will be able to meet their obligations to you so it is wise to find a well-capitalised regulated provider.

In addition the evolution of the Internet and electronic trading platforms has reduced transaction costs involved in undertaking CFD transactions.

Most CFD traders want good leverage – paying small margins for potentially big pay outs. However it is important to have realistic margins. Too high and it’s not worth it, but too low and you just have too much rope to hang yourself by…

Q: If the CFD price moves like the stock price, why would you trade a CFD on IBM instead of just trading the IBM stock itself?

To see the effect of gearing, here is an example of a CFD trade compared to a traditional equity trade, where the investor uses the same amount required for a CFD deposit to buy ordinary shares instead.

Opening the Position
CFD Deal Equity Deal
Price of Company Z 112p 112p
Number of Shares 20,000 2,000
Value of Shares £22,400 £2,240
Commission £33.60 £17.50
Stamp Duty £0 £11.20
Total Value of Transaction £22,433.60 £2,268.70
Deposit Required £2,240 £0
Initial Cost £2,273.60 £2,268.70
Closing the Position
CFD Deal Equity Deal
Price of Company Z 115p 115p
Number of Shares 20,000 2,000
Value of Shares £23,000 £2,300
Commission £34.50 £17.50
Difference in share value £600 £60
Financing (3 days) £9.67 £0
Profit (difference – commission charges) £522.23 £13.80
Percentage ROI 23.32% 0.61%

As you can see for the same initial outlay you can control a much larger position with a contract for difference as the contract is traded on margin. This means that you can substantially increase the return on your investment – but you should note that any losses would be equally multiplied.

The main challenge is still in educating people about CFDs versus physical trading and spreadbetting and how to use leverage in a profitable way. I firmly believe that serious traders should use CFDs in terms of cost, execution and versatility. There is no stamp duty, no extra spread (so costs are transparent), no expiry period and you can go long or short and gain leverage easily. The challenge is to use these products correctly; limiting your downside, positioning yourself sensibly in the market and avoiding taking profits too early.

What is CFD trading?

A CFD stands for contract for difference. CFD trading allows you to take a position on the price of an instrument without actually owning the underlying asset. One of the most unique aspects of CFDs is that they enable you to profit from falling markets as well as rising ones.

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In this article, you’ll learn:

  • What CFDs are and the benefits and risks of trading them
  • What leverage is and how to use it in practice
  • What makes CFDs so popular

The term CFD stands for contracts for difference.

A contract for difference creates, as its name suggests, a contract between two parties on the movement of an asset price.

There are several key features of CFDs that make them a unique and exciting product:

  • CFDs are a derivatives product
  • CFDs are leveraged
  • You can profit and incur losses from both rising and falling prices
  • We offer contracts for differences on over 1500 global markets, including indices, shares, currencies, commodities, and ETFs

CFDs are a derivatives product

This means that you don’t actually own the underlying asset – you’re simply speculating on whether the price will rise or fall.

Let’s take stock investing as an example. You’d like to purchase 10,000 shares of Barclays and its share price is 280p, which means that the total investment would cost you £28,000 – not including the commission or other fees your broker would charge for the transaction. In exchange for this, you receive a stock certificate, legal documentation that certifies ownership of shares. In other words, you have something physical to hold in your hands until you decide to sell them, preferably for a profit.

With CFDs however, you don’t own those Barclays shares. You’re simply speculating, and potentially profiting, from the same movements in share price.

CFDs are leveraged

This means you gain a much larger market exposure for a relatively small initial deposit. In other words, your return on your investment is significantly larger than in other forms of trading.

Let’s go back to the Barclays example. Those 10,000 shares of Barclays are at 280p, costing you £28,000 and not including any additional fees or commissions.

With CFD trading however, you only need a small percentage of the total trade value to open the position and maintain the same level of exposure. Let’s suppose that XTB gives you 10:1 (or 10%) leverage on Barclays shares, so you would only need to deposit an initial £2,800 to trade the same amount.

If Barclays shares rise 10% to 308p, the value of the position is now £30,800. So with an initial deposit of just £2,800, this CFD trade has made a profit of £2,800. That’s a 100% return on your investment, compared to just a 10% return if the shares were bought physically.

The important thing to remember about leverage, however, is that while it can magnify your profits, your losses are also magnified in the same way. So if prices move against you, you may be closed out of your position by a margin call or have to top up your funds to keep it open – so it’s important to understand how to manage your risk.

If Barclays shares declines 10% to 252p, the value of the position is now £25,200. So with an initial deposit of just £2,800, this CFD trade has made a loss of £2,800. That’s a -100% return on your investment, compared to just a -10% return if the shares were bought physically.

What markets can you trade CFDs on?

We offer contracts for difference on over 1500 global markets and multiple asset classes, all with the ability to utilise leverage and go both long or short including:

You can profit from both rising and falling prices

If you believe the price of an asset is going to rise, you go long or ‘buy’ and you’ll profit from every increase in price.

If you believe the price of an asset is going to fall, you go short or ‘sell’ and you’ll profit from every fall in price. Of course, if the markets don’t move in the direction you expect, you’ll suffer a loss.

So, if you believe for example that Apple’s share price will fall in value, you simply go short on Apple share CFDs and your profits will rise in line with any fall in price below your opening level. However, should Apple’s share price actually rise, you would suffer a loss for every rise in price. How much you profit or lose will depend on your position size (lot size) and the size of the market price movement.

The ability to go long or short along with the fact that CFDs are a leveraged product makes it one of the most flexible and popular ways of trading short term movement in financial markets today.

The Complete Guide to CFD Trading

Last Updated on August 3, 2020

CFD trading is for retail traders.

You get access to markets usually reserved for institutional traders and you have a wide variety of markets to trade from.

But here’s the thing:

Just because you have more opportunities doesn’t mean you’ll make more money.

Because when it comes to CFD trading, you must open your eyes and know what you’re dealing with.

So in today’s post, I’m going all in on CFD trading (the good, the bad, and the ugly).

Let’s get started now…

CFD for beginners: What is it and how does it work?

CFD stands for Contract for Difference and it allows you to buy/sell financial instruments without owning the underlying asset.

Instead of buying Apple shares, you can buy the CFD on Apple.

You’re probably wondering:

“Why would I want to do that?”

You’ll discover the benefits of CFD trading later, but first…

To do so, you must have a CFD broker and here’s how they operate…

How a CFD broker works

Most CFD providers are the market maker.

This means they create a market by taking the opposite side of your trade.

You might be thinking:

“Isn’t this unethical?”

It’s just their business model.

Most retail traders buy/sell in small quantities, and it’s not large enough to be traded in the real market.

Thus, a Market Maker (MM) broker fills this demand by creating a synthetic market for smaller traders.

The benefits of CFD trading you’re probably unaware of

Unlike stock trading, CFD offers a number of benefits you can’t get elsewhere.

You can short a stock

Here’s the thing:

It’s difficult to short a stock outright due to regulations.

But with CFD, you can do it easily.

This means you can hedge your positions in bad times and even profit from the market collapse.

You don’t need huge trading capital

CFD is a leveraged instrument.

This means you can control a larger position size with small trading capital.

If a stock requires 10% margin and you have $1000 trading account, you can buy up to $10,000 worth of stock.

Note: Leverage is a double-edged sword. The returns are higher but so is the risk.

You’ve got access to many markets

CFD trading is a convenient one-stop shop for you.

Because you can access markets like…

  • Indices
  • Bonds
  • Agriculture
  • Commodities
  • Precious metals
  • Cryptocurrencies

All these different markets in one trading account.

How cool is that?

But wait, before you get started in CFD trading, you must know the risks that come with it…

CFD trading risks (this is important)

Compared to stocks, CFDs are riskier because it’s a leveraged instrument.

And here’s what you must know:

  • Counterparty risk
  • Risk of losing everything and more
  • Risk of margin top-up
  • Risk of getting stopped out (prematurely)

Counterparty risk

Unlike stocks which are traded on an exchange, CFDs are traded against the broker.

This means if your broker goes under, everything goes along with it.

You don’t get back your money, your stocks, or anything.

Now I don’t want to be a fear monger, but the possibility is there, albeit slim if you know how to find a good broker (more on that later).

Risk of losing everything and more

Your broker is not stupid.

It requires you to put up the margin to cover your potential losses.

However, there are times the market moves too fast and you lose all your capital — and more.

If that happens, you must repay back what you owe to your broker.

Note: This applies not only to CFD trading but to all leveraged products.

Risk of margin top up

You bought $10,000 worth of Crude Oil at a margin of 20%. So, you need at least $2,000 in your CFD account.

But during volatile periods, your broker might raise the margin to 40%.

This means you must inject more capital to hold the $10,000 position.

If not, your position will be closed out partially or fully (to meet the margin requirements).

Risk of getting stopped out (prematurely)

There might be price discrepancy when CFD trading, especially if your broker is a market maker.

The stock exchange might show $100 per share for Apple.

But the CFD broker would show $101 instead.

This means you might get stopped out on trades which wouldn’t be the case if it’s traded on an exchange.

You’ll discover the costs of CFD trading you’re probably not aware of.

The true cost of CFD trading you’re unaware of

These are the costs of CFD trading:

  • Commission
  • Spread
  • Holding costs
  • Market data

Commission

This is a fixed transaction cost that you have to pay for opening and/or closing your trade.

It’s usually a percentage of your trade or a minimum amount of money, perhaps $10 or $20.

Direct Market Access (DMA) CFD brokers tend to charge a slightly higher commission rate than Market Maker (MM) CFD brokers.

Spread

The spread is the difference between the bid and ask price — and that’s a cost.

For example, Apple has an ask price of $100 and a bid price of $99.

This means if you want to buy Apple right now, it cost you $100.

And if you want to sell it right now, you’ll get $99.

That’s a spread of $1 — which is a cost to you.

Pro Tip: Stay away from low liquidity markets as the spread tends to be large.

Holding costs

This is a financing charge to your account for each day you hold a position.

Here’s how it works…

Let’s say you $1,000 in your account and you borrow $9,000 from your broker so you can buy $10,000 worth of stock.

Interest is charged on the $9,000 you borrowed.

And the interest depends on 2 things…

  1. The financing rate
  2. The holding period

If you want to know the exact cost, go check with your CFD broker.

Market data fees

You’re charged a monthly fee for accessing price data (especially for international markets).

But if you trade often, your broker could waive the fee.

How much money do you need to start CFD trading?

I recommend you start with a minimum of $20,000.

Trading fees are about $20 per trade (including buy and sell).

If you think about it…

Your transaction cost is about 0.1% on every trade (20/20,000).

So, if you take 50 trades per year, you’re looking at a total transaction cost of 5% (0.01 * 50) a year.

This means if you want to breakeven, you must earn 5% a year.

And what if your account is smaller than $20,000?

On a $10,000 account, you need 10% to breakeven.

On a $5000 account, you need 20% to breakeven.

On a $2000 account, you need 50% to breakeven.

So if you want to give yourself the best chance of success, you must have a minimum account size of $20,000 (or more).

How to find a reliable CFD broker so can sleep soundly at night

I don’t want to openly recommend any brokers because I’ve no idea what goes on behind the scenes.

And I don’t want you to lose your hard earned money because I recommended the wrong thing.

Still, there are things to consider when choosing a CFD broker:

  1. Is it regulated?
  2. Is the support service good?
  3. Is withdrawal easy?
  4. Does it have the platform you want?
  5. Does it have the markets you want?

And now, the most important question to ask yourself…

Is CFD trading for you?

CFD trading is not for you if…

You’re a long-term investor

Most investors have a holding period of years.

But remember, CFD incurs a holding cost every day, and this eats into your return.

If your CFD trade turns out to be a bummer, you suffer even more losses.

You’re a newbie

CFD is a leveraged instrument and you could lose more than your deposit.

So for new traders, I recommend studying risk management first before anything else.

CFD trading is for you if…

You want to hedge your portfolio

You can take on the opposite side of your trades and thereby reduce the volatility of your portfolio.

You want to take short stocks

Unlike stocks, CFD allows you to short stocks with little to no restriction.

You want to trade a variety of markets

This is useful if you want to trade different types of markets like Futures, Forex, Stocks, etc.

Conclusion

In today’s article, you’ve learned:

  • CFD trading allows you to trade the markets without owning the underlying asset
  • CFD trading allows you to short a stock and access different markets (without huge capital)
  • The cost of CFD trading are commission, spread, holding costs and market data fees
  • I recommend starting a CFD account of least $20,000 with a CFD broker so your commission doesn’t “eat” a huge chunk of your returns
  • CFD trading is not for long-term investors and newbies

Now over to you…

What’s your take on CFD trading?

Leave a comment below and share your thoughts with me.

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