In the recent years one type of instrument has not received the attention it deserves. The CFD, short for “contract for difference” is a relatively new addition to the traders’ toolkit. But what are CFDs and how to start using them?
The contract for difference, as the name suggest, is a contract usually between to broker and trader. As is the case with many other financial instruments like options, the contract is not necessarily written and signed on paper; it is enough to click the “buy” or “sell” button on the trading platform. The contract essentially means that each party will pay the difference in price at the time of closing the position compared to the entry price. In case the trader wins on the trade, then the broker is obliged to pay, and in the unfortunate circumstance that the trade went bad and the trader lost, then the traders account will take the hit and the deduction.
A key benefit of CFD trading compared to stocks is that while stocks can be leveraged, there are sometimes rules and regulations, and even limits to the maximum leverage available. For example the US has strict laws regarding account sizes below USD $2,000 and trading on margin, or day trading below the account balance of USD $25,000. Since CFDs are not the instrument themselves but a contract between two parties these rules don’t apply, even if the underlying instrument is a stock from a US stock exchange. This means that even the smallest account can benefit from market movements of the underlying instrument, and there are no limits how often the trade can be entered or exited. This creates perfect conditions for day trading and swing trading alike, from virtually any account size.
CFDs are usually a leveraged product. This means that the trader has to pay financing when they go long in an instrument, and can receive financing in case of a short trade. Although the latter is relatively seldom in the current economic climate, since most of the financing at brokerages is linked to some sort of interest rate, like the LIBOR. As the rates went lower and lower the financing received dropped to zero and even went negative – meaning that the trader has to pay to keep a short position.
In case the underlying of a CFD is an equity which pays dividends then the investor who went long the CFD is eligible to receive the dividends, just like it would be the case when owning the stock itself. Brokerages tend to keep a small part of the dividend sometimes, to cover costs of handling the corporate event. Conversely the short trader of the CFD has to pay the equivalent of the dividend from his own account. The same goes for any other type of CFDs, as the products offered can range from bonds, stocks or commodities to even forex pairs.
Another common attribute of CFDs are that they offer no voting or ownership rights of the underlying instrument. This means that in case the brokerage goes bust the trader does not own the physical underlying instrument itself, only a claim to a certain amount of money from the brokerage. If the trader wants to get an invite to the next shareholder meeting, then he is better off to buy the underlying equity itself.
CFD trading therefore is just about the same as trading the underlying itself. Combined with the benefits of leverage, favorable treatment in case of regulations and ease of access it might be a good choice for those who seek to benefit from market movements in short or medium term trading.