A CFD (Contract for Differences) is a tradable contract between yourself and a counterparty. The valuation is based on the value of an underlying asset and gives a participant the possibility to benefit from the change of the asset value. Investors refer to these types of contracts, which base their value on an underlying asset, as derivatives.
These derivatives can benefit an investor by fluctuations in the value of an asset without requiring any ownership of the underlying asset. Essentially, CFDs are bets on whether on the price of an asset rises or falls. If the investor expects the value of an asset to rise, the trader can buy the CFD and sell it later. If an investor expects the value of the CFD to lower, the investor can sell an opening position for the CFD to whoever may be interested.
Advantages
The details of these contracts can be tricky, so brokers are usually relied on to arrange them. Their commission rates are also not too high (0.1% would not be an unusual figure) if trading in stocks. The benefit of dealing with brokers also means that your personal understanding of the underlying systems of trading does not need to be very deep to invest successfully. The price of the investment can be small, as little as $1,000.
CFDs tend to be traded on margin, meaning by using borrowed money or leverage. This also means that you do not have to possess a great amount of personal funds to invest in it. In fact, the personal funds invested in a CFD may start from as low as 2% but can rise up to 20%.
Another benefit of investing in CFDs is that most of them do not have a fixed expiration date. This means that you can make your decisions on when to sell them depending on the current state of the market, rather than having to depend on some hypothetical future price.
The use of a broker, combined with the low investment price, is why we recommend investing in CFDs for traders who are only just beginning; so that they can lightly dip their toes into the deep ocean that is trading, and acquire a basic understanding of how trading works in the real world.
Disadvantages
There are, however, several disadvantages to trading in CFDs. The earlier mentioned reliance on leverage can be a double-edged sword, as it can amplify your profits and losses. The broker handling your case can request a margin call for additional payments if your investment accrues losses, and they are uncertain about the future of your investment. The CFD market can indeed generally be highly volatile and fast, and thus requires close analysis.
If things go south and you can no longer cover the necessary fees, the broker may terminate the contract. You should also consider that even though the commissions on CFDs can be low, the payment for the spread when trading in areas such as the forex market can be much greater. This ‘spread’ is the difference in bid price a broker will give an investor for a CFD, which will be higher than the underlying value, and the asking price they will give an investor for a CFD, which will be lower than the underlying value. This can make trading on low stakes unprofitable, as the brokers share can eat heavily into whatever profits you may have made if you do not choose your investment wisely. This is especially true if there has been a great amount of volatility in the value of the asset.
It is usually the brokers themselves who regulate the CFDs, and no other centralized institution regulates them. This is unlike how the markets would deal with forex trading, for example. This means an investor will have to take their time to carefully evaluate how trustworthy a broker may be.
You should also finally note that these contracts are not permitted in the USA. It is mostly investors throughout Europe who use them much more frequently.
Conclusion
Despite our recommendation that new traders attempt investing CFD as a sort of simple litmus test for trading, we caution them that they may have to take into account the volatility of the market and the associated costs this may bring.