A Contract for Difference (CFD) is a financial derivative that allows you to speculate on the potential fluctuation of thousands of different securities including indexes, commodities, bonds and even currencies.
Trading on CFDs enables individuals and institutional investors to benefit from potential increases or decreases in the market price of these securities without holding the actual asset, and the transaction is settled at the net result between the exit price and the entry price.
Now, why would someone invest in CFDs?
To answer that question, we will list 6 reasons why you should consider investing in CFDs:
An Easy Start.
Trading on CFDs doesn’t require much.
Here’s a breakdown of the requirements and benefits of each of these platforms:
- For UK customers, eToro requires a minimum opening balance of $50 USD.
- Provides CFDs for cryptocurrencies along with other securities. CFDs for Cryptocurrencies are not available for clients under FCA.
- Stop-loss orders can be placed.
- They offer an education center with tons of information for users.
- You can open a $50k or 40k Euros free demo trading account, once the balance of the demo account drops to 200 EUR (or an equivalent amount) or below, the initial demo amount will be automatically reinstated by the system.
- They offer 1:30 margin for CFD operations.
- You can start a real trading account with as little as $100.
- They don’t charge a percentage of commission on the operation, instead, they get paid on the spread.
They are Tax Efficient.
Given the fact that CFDs are basically a private contract established between you and your broker, the transaction is free of U.K. Stamp Duty.
This duty is commonly a 0.5% tax on the shares bought, but since you don’t actually hold the shares you are tying your CFD to, you will not be forced to pay a tax on it.
This is one of the most enticing benefits of trading on CFDs, as you will save 0.5% on your operation, compared to traditional trade.
Nevertheless, any profits made on the transaction are still affected by the Capital Gain Tax.
An Opportunity to Hedge.
CFDs provide the chance to hedge your investments in securities, as you can either sell or buy the CFD of the asset you hold, to offset any potential loses coming from an increase or decrease in its price.
The fact that you can do so through leverage, which is another benefit of trading in CFDs, allows you to hedge without having to commit your own money.
You can either fully or partially hedge, by employing the funding you obtain on margin, protecting yourself from big losses on your main trades.
Given the fact that CFDs don’t involve dealing with the actual security, they allow traders to short a considerable volume of the underlying security on margin.
This could be either employed to hedge a long position or also as a potential profit-seeking operation on failing markets, indexes and companies.
A trader that identifies an upcoming downward trend on given security can quickly short its CFD to make a profit on the difference.
For example, let’s say you are confident that an increase in interest rates will be announced by the Federal Reserve of the United States during their next meeting.
That announcement will probably drive down U.S. market indexes and you can benefit from this downturn by short-selling the S&P 500 or the Dow Jones Industrial Average.
On the other hand, let’s say you hold a long position on Google, yet you are worried that their next earning’s announcement will not meet the analyst’s expectations.
If that’s the case, you can short Google’s stock CFD and hedge your long position through this operation.
You Can Trade Them on Margin.
By using leverage, traders can enlarge their investment returns by accessing additional borrowed funds.
The margin ratio is often as low as 1:2 or as high as 1:300 depending on the broker, this means you can have access to a significant source of funding in order to employ your broker’s money to make your transactions.
This is particularly beneficial for short selling operations, as you can expand your profits by using the available margin on your account.
On the other hand, make sure you understand the terms and conditions of your margin account before you enter it, especially the minimum or maintenance margin required, so you can at all times make sure your positions are well funded to avoid a margin call.
That said, be aware that while trading on margin may expand your capacity and therefore, your profits, it can also expand your loses, which can go as far as to drain your entire invested funds.
An Alternative to Futures.
Futures are financial contracts that constitute an obligation to the holder to either buy or sell a particular asset at a pre-determined price at a given point in time.
Futures trading are mostly done through organized exchanges that demand a certain minimum amount to be put into each contract.
For this reason, futures are not commonly accessible for small traders.
In turn, CFDs provide an alternative, by allowing small traders to take long or short positions on certain assets without a predefined date or a predefined sell or buy price.
Given the fact that you can trade CFDs on margin, you can hold the CFDs for as long as you want, as long as you are covering the maintenance margin.
This makes them the perfect alternative for futures.
Let’s say you have a long position on Goldman Sach’s stock. Yet, you want to make sure you can exit your position within a certain price range in the next 3 to 5 days. In this case, you can short a certain percentage of your position through a CFD, ensuring that if a market downturn occurs, your net position is closed within the range you expect it to.
Since the CFD doesn’t have a predefined maturity date or a predefined exit price, you can either extend or shorten the period of time during which you hold it to suit your needs.