The contract for difference (CFD) offers European traders and investors an opportunity to profit from price movement without owning the underlying asset. It's a relatively simple security calculated by the asset's movement between trade entry and exit, computing only the price change without consideration of the asset's underlying value. This is accomplished through a contract between client and broker, and does not utilize any stock, forex, commodity or futures exchange. Trading CFDs offer several major advantages that have increased the instruments' enormous popularity in the past decade.
How a CFD Works
If a stock has an ask price of $25.26 and the trader buys 100 shares, the cost of the transaction is $2,526 plus commission and fees. This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account, while a CFD broker formerly required just a 5% margin, or $126.30. A CFD trade will show a loss equal to the size of the spread at the time of the transaction so, if the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the breakeven price. You'll see a 5-cent gain if you owned the stock outright but would have paid a commission and incurred a larger capital outlay.
If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1263=3.95% profit. However, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market. In this example, the CFD trader earns an estimated $48 or $48/$126.30=38% return on investment. The CFD broker may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn't include commissions or other fees, putting more money in the CFD trader's pocket.
CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market is subject to regulation. It once was as low as a 2% margin (50:1 leverage); but is now limited in a range of 3% (30:1 leverage) could go up to 50% (2:1 leverage). Lower margin requirements mean less capital outlay for the trader/investor, and greater potential returns. However, increased leverage can also magnify losses.
Global Market Access from One Platform
Many CFD brokers offer products in all the world's major markets, allowing around the clock access.
No Shorting Rules or Borrowing Stock
Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short or have different margin requirements for short and long positions. CFD instruments can be shorted at any time without borrowing costs because the trader doesn't own the underlying asset.
Professional Execution With No Fees
CFD brokers offer many of the same order types as traditional brokers including stops, limits and contingent orders like "One Cancels the Other" and "If Done." Some brokers offer guaranteed stops that charge a fee for the service or recoup costs in another way. Brokers make money when the trader pays the spread and most do not charge commissions or fees of any kind. To buy, a trader must pay the ask price, and to sell/short, the trader must pay the bid price. This spread may be small or large depending on volatility of the underlying asset and fixed spreads are often available.
- Traders Pay The Spread
While CFDs offer an attractive alternative to traditional markets, they also present potential pitfalls. For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves. The spread also decreases winning trades by a small amount compared to the underlying security and will increase losses by a small amount. So, while traditional markets expose the trader to fees, regulations, commissions and higher capital requirements, CFDs trims traders' profits through spread costs.
Weak Industry Regulation
Also note the CFD industry is not highly regulated and the broker's credibility is based on reputation, longevity, and financial position rather than government standing or liquidity. There are excellent CFD brokers, but it 's important to investigate a broker's background before opening an account.
Risks that you don’t have to consider when you invest in Cline Investment Firm
CFD trading is fast-moving and requires close monitoring. There are liquidity risks and margins you need to maintain; if you cannot cover reductions in values, your provider may close your position, and you'll have to meet the loss no matter what subsequently happens to the underlying asset. Leverage risks expose you to greater potential profits but also greater potential losses. While stop loss limits are available from many CFD providers, they can't guarantee you won't suffer losses, especially if there's a market closure or a sharp price movement. Execution risks also may occur due to lags in trades.
The Bottom Line
Advantages to CFD trading include lower margin requirements, easy access to global markets, no shorting or day trading rules and little or no fees. However, high leverage magnifies losses when they occur, and having to pay a spread to enter and exit positions can be costly when large price movements do not occur. Indeed, the European Securities and Markets Authority (ESMA) has placed restrictions on CFDs to protect retail investors.
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 5:1 (or 20%) leverage on Barclays shares, so you would only need to deposit an initial £5,600 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 £5,600, this CFD trade has made a profit of £2,800. That’s a 50% 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 fall 10% to 252p, the value of the position is now £25,200. So with an initial deposit of just £5,600, this CFD trade has made a loss of £2,800. That’s a -50% loss on your investment, compared to just a -10% loss if the shares were bought physically.
Markets that Cline Investment Firm Trade Finance invests in?
We offer contracts for difference on over 1500 global markets and multiple asset classes, all with the ability to utilize leverage and go both long or short including:
- Commodities (Gold, Oil and precious metals)
Cline Investment Firm 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.