A Detailed Look Into CFD Trading & The Best CFD Brokers
A Contract For Difference (CFD) is a financial derivatives product that allows investors to trade the price difference between an entry price and an exit price of a tradable asset. CFD trading is essentially a contract between a broker and a trader that facilitates the trading of an underlying financial instrument without actually owning it. In traditional stock markets, investors can either go long or short in the market by literally purchasing the underlying stock, commodity, currency pair, or ETF. However, in CFD Trading, a broker, and a trader agree to exchange an asset virtually, where profits and losses are determined by the magnitude of the movement of the instrument in real-time.
Why Is CFD Trading More Popular Than Traditional Forms Of Investing?
CFD is a leveraged product that does not require a trader to have substantial funds in order to invest in the financial markets. For example, one standard lot in the Forex market is 100,000 units of a base currency, which can be as much as $100,000 for the USD/JPY currency pair. In stock trading, holding 100 shares of a stock that are worth $100 per share will require a trader to invest $10,000 in real money. According to CFTC rules, Forex traders in the US are eligible for a maximum of 1:50 leverage, while stock traders can receive up to 1:10 in maximum leverage options.
However, in CFD trading, brokers offer a high amount of leverage and stipulate very low minimum margin requirements, which enable traders to control significant positions by using just a fraction of their trading capital. Therefore, with a 2% margin or 1:50 leverage, traders only need $20,000 per lot in FX-CFD trading and around $200 for share CFDs. CFDs are offered as minimum contract units that depend on the price of the underlying asset. CFDs are bought or sold in units of contracts, where the price of each unit is determined by the lot specifications, spreads, and the changes in the movements in the market.
CFD trading is also being widely adopted by traditional investors to hedge against unexpected market volatility and for short-term performance gains. Investing in conventional instruments requires a very large amount of capital outlay, and the break-even period is considered to be significantly higher than CFD trading. Therefore, long-term investors may use their spare trading capital to open long or short CFD positions to counter any negative results or any shortfalls in the value of their investment portfolio.
CFD covers a broad range of markets that offer more than 10,000 different instruments from leading financial markets across the world. CFD products are traded at the broker level; hence, brokers are not required to connect their traders to any interbank liquidity provider or a concerned stock exchange. Another significant advantage of CFD trading is that traders can invest in CFDs using a single platform, as almost all the different Contracts For Differences are offered by a broker using a standalone CFD terminal. There are absolutely no restrictions on CFD trading in most countries, and the brokers are free to implement their own trading conditions. CFD accounts start from as low as $1, although it is common for brokers to stipulate minimum deposit requirements starting from $100 and all the way up to $10,000.
CFD also enjoys several tax breaks and exemptions in countries such as the UK. CFD is entirely exempt from stamp duty in the UK but is not completely free from taxes on profits. On the other hand, spread betting enjoys the best tax-free status in the UK, but CFD does come a close second. Regardless, CFD might attract other taxes and fees in your local jurisdiction, which can only be determined by a professional tax or financial consultant.
CFD trading is an agreement between a broker and a trader, which has multiple levels of conflicts of interest, making it illegal in some parts of the world. Several regulatory agencies have several guidelines that prevent brokers from trading against their clients, but some markets such as the UK and EU have legalized the concept of CFD trading. In the US, there are several strict regulations that govern CFD trading, which might affect the freedom that one gets to enjoy at overseas CFD brokers. Nevertheless, CFD is an attractive way of trading that is actually more profitable than traditional forms of investing, albeit with several risks of trading.
The Risks Of CFD Trading
Leveraged financial products are considered to be significantly riskier than investing in conventional markets. Investing your money with a high amount of leverage means that you are exposing your trading capital to greater volatility in the markets. 1:100 leverage means that you are likelier to make or lose 10 times the amount of money than you would in a regular 1:10 leveraged account. Therefore, CFD is one of the riskiest forms of investing that should be treated with care and respect.
Although CFD trading helps in avoiding all the costs and fees of trading in regular stocks and the Forex markets, there are other associated costs of trading such as spreads and commissions that are considered to be far more expensive than the regular cost of trading. The significant amount of leverage also magnifies the cost of CFD trading, which can have adverse effects on the profits derived from CFD assets. Traders will also have to accommodate for larger fees and reduced market success due to massive intrusion from the broker or other intermediary third parties. Therefore, CFD trading cannot guarantee consistently successful trading results, even if a trader has developed a profitable trading strategy.
Unlike Forex and Share trading, CFDs are mainly non-regulated, even if brokers are required to adhere to the rules and regulations imposed by different regulatory organizations. CFD is usually provided as an alternate form of investment, and most CFD brokers are located in tax havens to enjoy lesser regulatory oversight. Nevertheless, some top CFD brokers adhere to the best guidelines in ensuring the best customer satisfaction that is devoid of any financial malpractices.
CFD Trading With Forex
The retail FX trading market is very similar to CFD trading, where the underlying contract is stipulated in units of currency pairs. Apart from the standard lots traded in regular Forex markets, some brokers that offer mini and micro FX lots may offer Forex pairs as CFD products, which work in the same manner as the regular Forex market. However, due to legal reasons and due to the amount of conflict of trading, several regulatory organizations from major financial markets have deemed it illegal for brokers to trade against their clients. Therefore CFD Forex brokers might move to relatively lesser-known jurisdictions to enjoy lenient regulatory guidelines and an attractive tax structure to improve their profits.
Some Basic Rules To Help You Find The Best CFD Brokers
• Choosing A CFD Broker According To Spread
Spread and cost of trading is an important aspect of CFD trading. The spread is termed as the difference between the ‘bid’ and ‘ask’ price of an asset, which can vary between 1 to 10 pips or its equivalent ni basis points. In share CFDs, the spreads may be denoted as cents or dollars, while in indices CFD trading, the spreads are usually indicated as points. Traders will have to let the market move in their direction to recover the spread and enjoy a profit, which makes it extremely imperative to select the top CFD brokers that offer the tightest spreads. On the downside, the spread will play a significant part in losing, since the leverage and unit size in CFD trading can result in dramatic losses with just a single point of movement away from a trader’s position.
• The Maximum Leverage On A CFD Account
Although we are apprehensive about the risks involved in trading on a high margin, CFD is a leveraged derivatives product that cannot be traded otherwise. Trading with lower margin requirements is a sure-fire way of losing money, but the main attraction of CFD trading is the ability to enjoy the higher leverage. A large number of the top CFD brokers are known to implement several conservative strategies to minimize the risk, but there is a huge amount of potential pitfalls with CFD trading that can result in a negative balance. Losses in CFD trading can result in losses that can be greater than your trading capital, which should be taken into account before opening a CFD trading account.
• The Number Of Instruments & Markets Offered
The best CFD brokers offer the most varied list of financial instruments to hedge your positions in any financial market. There are more than 10,000 popular assets in the market, which provides a massive database of financial instruments for the discerning investor. On the contrary, there are CFD companies that limit the number of financial assets to keep their services streamlined. Therefore, you should browse through different brokers to get a fair idea of all the instruments and financial markets covered by a particular broker.
• Reputation, Customer Services, & Testimonials
CFD is not as regulated as traditional stock markets or Forex trading. Still, CFD brokers may be regulated by some of the leading regulatory agencies such as the FCA and the CySEC. While browsing around for your CFD broker options, always take care to concentrate your efforts on investing with a highly reputed broker that has a stellar customer service history and an excellent reputation in the market. Brokers with excellent reputation and reliability will offer an overall better trading environment.
• Trading Platforms & Safety Of Funds
Your investment is only as safe as the security of funds and the reliability of your trading platform. CFD trading is a fast-paced trading product that magnifies the shortcomings in a trader’s strategy or an error in a platform by increasing the losses by many folds. A lackluster platform performance or reliability issues can make the difference between winning and losing, especially considering the amount of leverage on offer. Brokers should also provide a greater sense of security for your funds, which are protected by keeping them in segregated accounts and providing protection against broker insolvency issues. Ultimately, you should realize that you are pitting your strategies against a broker, and should always ensure that there are no other conflicts of interest with the company that you have chosen.
Learning CFD Trading Before Investing
CFD trading is not designed for beginner or amateur traders. The potential for losing in CFD is significantly higher than any other markets, and a trader can also fall in debt to his broker if he is not careful with his investments. The real danger of a negative balance is too high, even though modern CFD brokers try hard to implement filters to prevent any negative balance. Therefore, most companies resort to invoking margin calls, which will usually close all open positions if the equity in the account falls below a certain level. Most margin calls are activated at 100% of the account equity, while stop loss measures are put in place if the equity in the account falls below 20% or even 10%.
Apart from learning the dynamics of the financial markets, CFD traders must also be careful about the perils of using higher leverage, which requires a disciplined and methodical approach. Losses are a part of financial investments, but a trader should have the mental ability to deal with losses in a professional manner. The whole point of CFD trading is to hedge one’s investments in the market and to make a consistent amount of profits, which cannot be achieved without a proper trading strategy.
Demo CFD trading is vital in understanding the different rules of trading CFD products, as they provide an accurate representation of how your investments will pan out under real market conditions. By practicing in a demo account, you can not only learn about investing in the CFD markets, but it also offers you a risk-free environment to test out different strategies and find a winning combination that is guaranteed to improve your trading results.
CFD Trading can deliver consistent results over an extended period of time, but as an investor, you should weather out the lengthy drawdown periods and make your winning trades count. It is important not to fall into the urges of over-leveraging in the hopes of making millions of dollars in a single trade. You should also make it a priority to trade with the top CFD brokers in the market to increase the chances of your success. Try out different CFD products by opening a live account at some of the best CFD brokers from our recommended list, but always remember to practice before investing your real money in the markets.