Beginners guide to CFD trading

Guide to CFD Trading

CFDs are popular for several reasons. They offer a more cost-effective, tax-efficient way to enter the financial markets and they allow traders to buy into the market at a much lower price point. Successful CFD trades can result in good profits for a nominal cost.

With CFDs, you can speculate and trade against share price movements without actually owning the underlying asset. CFDs are easy to access, quick to process and they remove the need to trade through a stock exchange. And because you are trading on margin, CFDs boost the risk/return on any capital investment.

 

What is CFD Trading?

CFD stands for the contract of differences. A CFD is a contract between two parties where one party is the buyer and the other party is the seller. A broker acts as the middleman.

A CFD is settled at the close of the contract which is either long or short, and any profit made is determined by the difference in price between the opening and closing position of the financial instrument.

If the closing trade price is higher than the opening position, the seller pays the buyer the difference and the buyer makes a profit. If the closing trade price is lower than the opening position, the seller makes a profit and the buyer loses on the CFD trade.

CFDs provide traders and investors with an opportunity to profit from price movements without owning the actual asset. Basically, the contract stipulates that the buyer will pay the seller the difference between the current value of an asset and its value at contract time. The financial asset never changes hands.

History of CFDs

CFDs were developed in the early 1990s in the United Kingdom, through the London Stock Exchange. They served as a contractual equity swap that was traded on margin. An equity swap is a financial derivative contract where a set of future cash flows are exchanged by agreement between two parties at set dates in the future.

The two cash flows are referred to as ‘legs’ and one of the legs is pegged to a floating rate. It’s also known as a floating leg. The other leg of the equity swap is based on the performance of either a share of stock or a stock market index. This leg is known as the equity leg.

Most equity swaps have a floating leg and an equity leg, although some exist with two equity legs. CFDs were developed along the same lines where one leg of the contract is pegged and the other is floating.

Why CFDs were developed

CFDs were initially used by hedge fund managers and institutional traders as they provided a cost-effective hedge when trading stocks on the stock exchange.

The main benefit derived from the CFD trading format is it requires only a small margin for trade. No physical shares change hands which also means no stamp duty is required on CFD trade deals.

What is a Contract of Differences (CFD)

A contract of differences is a contractual agreement between two parties that is made in financial derivatives trading. The difference in the settlement between the open trade price and the closing trade price is called ‘cash settled’. No physical goods or shares change hands with CFDs.

Cash settled is a method of settlement used in futures and options contracts. When the contract reaches its expiry date or is called in, the seller of the financial instrument transfers the difference related to the cash position. The seller retains ownership of the financial instrument.

Financial instruments are assets that can be traded or it may be capital that is traded. This might be cash, evidence of ownership of equity, or a contractual right to deliver or receive cash or equity.

CFDs are generally traded over short periods and are a popular format used by forex traders and commodity traders. Investors and traders are only required to trade a small amount of the contract’s notional amount. This amount is the nominal or face amount that is used to calculate payments made on a financial instrument. The amount does not change hands which is why it is termed notional.

What opportunities do CFDs offer investors?

CFDs provide traders and investors with an opportunity to speculate and trade in the price movement of securities and derivatives.

Trading securities are investments in debt or equity that businesses actively trade for profit. Securities are typically stocks or bonds made available for the market to purchase and sell to make money in the short term.

A trading derivative is a contract between two or more parties that is based on an underlying financial instrument (or set of assets). Derivatives are used by investors and traders to speculate on price movements of an underlying asset without having to purchase the asset itself to make a profit.

To put it simply, CFDs are a form of gambling in the financial world. Investors and traders use CFDs to bet on the movement of an asset’s price (or a set of assets) to make a profit. They place a price bet on the underlying asset decreasing or increasing in value and will either bet on its upward or downward movement.

If a trader expects an upward movement in an asset’s price, he or she will buy the CFD. If a trader expects a downward movement in price, he or she will sell an opening position.

If the trader has bought the CFD on a downward price movement and the asset’s price begins to rise, the individual will open a buy position. The net difference between the purchase price and the selling price is netted together. The difference is represented as a gain for loss and the difference is settled between the buyer and seller.

If the asset’s price starts to fall, a trader will open a sell position. To close the position, a trader must buy an offsetting trade. The net difference of the gain and loss is cash-settled through a trading account. An offsetting trade is when a trader closes a trade without acquiring consent from the participating parties.

How to trade CFDs

CFDs trade over-the-counter (OTC) through a network of investment brokers. The brokers are responsible for managing the market supply and demand for CFDs and set prices accordingly. CFDs are not traded through the major exchanges as you would forex and other financial instruments.

Instead, CFDs are negotiated contracts where a broker acts as a middleman between the buyer and seller. The net difference on a CFD trade is transferred to the relevant account when the CDF trade is concluded.

Let’s look at a typical example of how a CFD works:

If a trader anticipates the price of an asset will increase, he or she will open a buy position. This is known as ‘going long’.

IF a trader anticipates the price of an asset will fall, he or she will open a sell position. This is known as ‘going short’.

If you buy a CFD because you anticipate the price will rise, your profit increases the higher the price rises but your losses increase the lower the price drops.

Likewise, if you buy a CFD because you anticipate the asset’s price will fall, you’ll make money if the market price does drop but you’ll lose money if it rises.

Why trade CFDs?

CFDs are not traded through stock exchanges in a country, for example, the Johannesburg Stock Exchange (JSE) in South Africa). This means CFDs give traders immediate access to financial instruments.

CFD trading is speculative in nature and if you have an interest in a particular industry such as mining, energy, agriculture, commodities, and foreign currencies; you’ll appreciate the excitement of speculating on price movements coupled with your knowledge and insight into the industry.

CFDs allow you to trade with a low margin requirement which means you can trade with limited capital or cash in your account.

What is trading on margin?

Trading on margin means you borrow money from a broker to buy a financial asset. It’s more or less a loan from a stockbroker. Margin trading allows you to buy more stock of assets such as forex, futures, indices, shares, and commodities but the difference is you aren’t using your own capital, you borrow the money through a brokerage account.

Is margin trading safe? Well, that depends on whether you have a risk appetite. Basically, margin trading means you are betting on price movements with other people’s money.

If you don’t have the money to buy CFDs, you borrow it from a broker. When you close the position, you hope you’ve made a profit so you can pay back your loan to the broker. It’s like taking out a home loan and banking on the fact that the price of houses will go up by the time you sell and pay back your loan.

The difference with the simple home loan analogy is you generally have years to make a profit on a home and pay back your loan. With margin trading, you might have a few hours or even a few minutes.

When you trade on margin, you need to make a profit to pay back what you owe the broker. If the asset price falls, you no longer have enough collateral for the loan. The broker will then call your margin which means you have to put up the original stock as collateral or pay in more of your own cash. If the price continues to fall you can short the contract which means you end the contract at a cost to yourself.

Our advice is never to borrow more money on a trade deal than you can afford to lose. If you do trade on margin, keep it a low level and don’t let the margin run away from you.

What is leverage?

Leverage is a key component of CFD trading and is a powerful tool for any trader. Leverage is a facility made available by the stockbroker that allows you far greater exposure to the market you’re trading in than you would get on your own.

Leveraged products such as CFDs significantly boost your potential earnings but they also increase your potential losses.

Leverage allows you to take advantage of comparatively small price movements, helps you gear your investment portfolio for greater exposure, and makes your capital go further.

Leverage works where a deposit known as a margin is transferred to your trading account to increase your access to CFDs on a wider range of underlying assets. Basically, you put down a fraction of the full value of the CFD, and your stockbroker loans you the rest.

Leverage is like a traditional financial loan without a fixed interest rate. The stockbroker makes money off leveraged products on commissions and nominal transaction fees.

 

Advantages of CFDs

CFD trading offers investors the opportunity to profit from price movements in securities and derivatives without taking actual ownership of them.

CFDs are contractual agreements between buyers and sellers which are facilitated by brokers. They are not traded on the major stock exchanges in the world and as a result, there are fewer rules and regulations around CFDs. Hence, there is a lower barrier to entry on CFDs than other financial instruments.

CFDs require lower capital or cash amounts to set up a trading account. An investor can open an account to trade CFDs with as little as US$1 000.

CFDs are traded on margins. This is where a CFD broker permits an investor to borrow money to increase the leverage on a CFD trade or the size of the position the investor wants to take. All that is required from the broker is for the investor to keep a minimum amount of capital or cash in the account to facilitate the CFD transaction.

CFD trading generally requires lower margins which means less capital outlay and a greater return on the CFD trade. CFD margins provide higher leverage than traditional trading where standard leverage is anywhere from 2% to 20%.

An investor has the option of taking a long or short position on a buy or sell trade. The CFD has no rules regulating short sales and, since the investor does not take ownership of the asset, there are no borrowing or shorting costs.

Short selling is a trading strategy designed to profit on an anticipated decline in the price of a stock or share. A short seller typically buys low and sells high.

Lastly, CFD trading generally incurs low or no transaction fees. This is because brokers make money through the investor paying the spread. In other words, the investor pays the asking price when buying and takes the bid price when selling or shorting. The broker makes money by taking a portion of the spread on each bid and the asking price in the form of a commission.

Disadvantages of CFDs

The spread on a bid and ask price can be substantial when the asset experiences extreme price movement in a volatile trading period. When an investor pays a large spread on open and closing positions, it limits the profit that can be made on small price disparities. Large spreads decrease the number of successful trades and increase losses.

There is some benefit to the fact that the CFD market is not regulated but it does have its disadvantages. In fact, some countries actively discourage CFD trading or disallow it because of restrictions on over-the-counter security trading. For example, CFD trading is not permitted in the United States.

Leverage can augment gains but with CFDs, leverage can also exacerbate losses. Traders risk losing their entire investment if they hold a losing position and they get a margin call from their broker. They are then required to deposit additional funds into their trading account to balance out the losing position. If the investor has borrowed money from the brokerage, the individual will incur a daily interest fee.

 

Why are CFDs not permitted in the USA?

The reason why CFDs cannot be traded in the United States helps one understand how CFDs work. Contracts of differences are traded over-the-counter where the broker concludes a deal between two parties on open and closed positions. The broker makes money on the spread in the form of commission.

Over-the-counter trade deals on financial instruments are heavily regulated through legislation such as the Dodd-Frank Act and the regulations are strictly enforced by the Securities and Exchange Commission.

What is an example of an underlying asset in CFDs?

The most commonly used underlying assets in CFDs are:

Foreign currency (forex)

Forex stands for foreign exchange and is where one foreign currency is bought or sold in exchange for another currency. Forex is the most heavily-traded market in the world.

Cryptocurrency

Cryptocurrency is digital or virtual money. The most well-known example is Bitcoin. Cryptocurrencies serve as ordinary money, such as US Dollars, Pound Sterling, Euros, and the Yen.

The difference is cryptocurrencies only exist in an electronic form. You can’t touch or hand over a cryptocurrency note or coin to buy something.

Interest rates

An interest rate is a percentage a financial institution or private lender charges someone for the use of its money. If you borrow money from a bank to buy a car or home, the bank charges you a fee for borrowing the money. The longer you take to pay back the money, the more you will pay in interest.

The way interest trading works is one party pays a floating rate and the other party pays a fixed rate. You enter into a swap agreement to hedge your interest rate risk and pay a premium to fix the rate. You make money or lose money on the rate movement between the fixed and floating rate.

 

Bonds

A bond is a debt instrument that is issued and sold by the government, local authority, or a company to raise money. An investor who trades bonds on margin borrows funds from a broker for a pre-determined amount of time and hopes to make money on the price movement between the opening and closing position on the price of the bond.

Stocks

Stock is the total number of shares of a corporation owned by separate entities. A single share of the stock represents fractional ownership of the corporation which is calculated in proportion to the total number of shares. The collection of shares is known as stock.

Trading stock with CFDs means you buy or sell stock on contract but do not actually own the stock. You speculate on the price movement of stock and make money if the stock price moves in the direction you anticipated it would. You lose money if it moves in the opposite direction.

Futures

Futures is short for futures contracts. Futures allow traders to lock in a price of an underlying asset or commodity where the expiry date of the contract is fixed and the price is set upfront. Futures are identified by their expiry month. For example, a January gold futures contract expires in January.

Trading futures with CFDs means you enter into a futures contract but you do not own the underlying asset and, more than likely, you’ve borrowed the money from a broker to participate in the futures contract.

Commodities

The commodity market is a physical or virtual marketplace where you buy, sell, and trade raw or primary products. The virtual marketplace would be the stock exchange where products are traded without the physical product changing hands.

Soft commodities are typically manufactured products such as sugar, fruit, and cocoa. Hard commodities are typically mined products such as gold, diamonds, and crude oil.

Most commodity trading involves buying and selling futures contracts. Trading commodities with CFDs means you buy and sell the commodity or basket of commodities but you don’t take ownership of the commodity. In other words, you don’t own gold shares; rather you speculate on the price movement of gold shares owned by other investors.

 

Indices

Market indices are a measure of something (an index). In financial markets, stock and bond market indices consist of a hypothetical portfolio of securities that represent a particular market or a segment of the market.

For example, a stock market indices is an index that measures a stock market or a subset of the stock market. It helps investors compare current price levels with past prices to calculate market performance. Indices are computed from the prices of selected stocks.

Who owns the underlying asset in CFDs?

The broker retains contractual ownership of the underlying asset, although neither the investor nor the broker holds the rights associated with the asset. This includes voting rights.

The investor receives the full benefits of the underlying asset including capital growth and dividend income.

Dividend income is only earned on long positions. On a short position, the opposite applies. The investor pays out when the asset receives a dividend. CFDs are a derivative of the listed financial instrument.

Difference between CFDs and forex

CFD trading and forex trading are similar on the face of it but different when you compare the two. Both involve speculating on the price movement of an asset. For forex, this is on the price movement of a foreign currency. For CFDs, it’s on the price movement of a wider array of underlying assets.

Both CFDs and forex are transacted over-the-counter (OTC). OTC or off-exchange trading is done directly between two parties and by-passes a stock exchange. With OTC trading, you’re on your own whereas trading through the stock exchange, you benefit from its power to facilitate liquidity, maintain current market prices and provide transparency on trade deals.

CFDs and forex are processed electronically through a broker or financial institution. They incur similar costs because the broker or bank makes a commission from the trade and transaction fees are kept to a bare minimum.

CFDs and forex involve trading an underlying asset that you do not own. Whether you are trading US Dollar for Euro or speculating on the price movement of gold or mielies, you don’t own the currency or the product.

The big difference between CFDs and forex trading is CFDs cover a diverse range of markets. Forex is limited to price movement on the major currency pairs in the world (USD/EUR, USD/GBP). With CFDs, you can speculate on price movement on anything from futures and indices to stocks and commodities.

Is the CFD market regulated in South Africa?

CFDs are not traded through the four different stock exchanges in South Africa and therefore, CFDs are not strictly regulated. Stockbrokers are monitored by the Financial Services Board.

For this reason, it’s highly recommended that you trade in CFDs through a reputable financial service provider or broker. The two parties involved in a CFD trade are dependent on the skill and integrity of the broker, particularly when one party has traded on margin.

Is CFD trading safe?

CFD trading is considered to be riskier than other forms of trading largely because the CFD market is not well regulated, if at all.

The reason why the major stock exchanges discourage CFD trading is not that they are protecting investors or traders from great losses but because CFD trading is done over-the-counter which may as well be under-the-counter for the stock exchanges. Losses made on CFDs do not go back into the stock exchange’s pocket.

CFD trading is a spin-off of regular forms of trading that allows investors to trade in a wide range of markets on a global scale using a single account that has its own unique features. CFD trading aims to take calculated and controlled risks in much the same way you would trading forex and other financial instruments.

CFDs are leveraged products and this puts them on the riskier side of regular trading. You can leverage your account up to hundreds of times over what it is actually worth and if you get a margin call from your broker, you’ll have to keep topping it up. This is where CFDs can get away from you and you can lose a lot of money.

If you are new to CFD trading, it’s recommended that you trade in CFDs that are under the value of what funds you have in your account. This will do away with the temptation to use leverage for CFDs. If you make a loss on a position, you will not lose more than your initial investment. With leverage, you can make a lot of money but you can also lose a lot of money.

The contract of difference is ‘owned’ by the stockbroker between the period the position is opened and closed. You must trade CFDs using a reputable and professional broker who is registered with the Financial Services Board.

How much money can you make on CFD trading?

CFDs are a speculative form of trading and you can make a lot of money from CFDs if prices of instruments move in the direction you want them to go in your contract.

On the other hand, losses can be huge even though you are trading a geared asset. In some instances, if a broker makes a margin call, an investor has to transfer additional funds to top up the variation margin to keep the position open. If there is negative movement on a CFD, an investor has to top up often and will make a serious loss on the contract.

How much does CFD trading cost?

A broker charges a script lending fee when a trader shorts a CFD contract. This is because a broker needs to borrow the script (or shares) on behalf of the trader.

Otherwise, a stockbroker makes a commission on CFDs relative to the spreads quoted on each market. Basically, the broker makes money from a mark-up on the trade which is derived from the difference between the actual market price of an asset and the quoted price in the CFD.

Who can do CFD trading?

Anyone can do CFD trading but CFD trading is not the right financial instrument for everyone.

CFDs involve leverage which can result in huge losses if a trader exceeds his or her deposits. Like any speculative form of trading, proceed with caution and adopt a disciplined CFD trading strategy.

CFD trading for beginners

If you are new to online trading, CFDs allow you to access a wide array of financial markets without the need for a large amount of investment capital.

Other CFD benefits for beginners include:

  • You do not pay stamp duties
  • Brokers earn commission on CFDs so the transaction cost of CFD trading is relatively low
  • You only need a small deposit to set up a CFD trading account
  • CFDs are a great place to start learning to trade if you manage your leverage risk
  • CFDs expose you to different financial instruments ranging from forex and futures to indices, shares, and commodities while forex trading limits you to the foreign currency market

CFD trading for experienced traders

Experienced traders use CFDs to make their investment capital go further using leverage. They protect their physical portfolio by hedging.

CFD benefits for experienced traders include:

  • No stamp duties
  • Offset losses against future profits as a tax deduction
  • Make money using your knowledge and experience to anticipate price movements
  • Trade-in local and global assets without the risk of ownership
  • Protect your physical portfolio with short sells
  • Receive dividends from share CFDs

How to start trading CFDs

Getting started is simple. Register and open an account with a reputable CFD trading broker, deposit funds, set up your platform with your trading preferences, and start trading.

Before you apply for a CFD account

You must be 18 years and older to trade CFDs in South Africa.

Do your homework and decide if CFD trading is right for you. It’s important to understand how CFD trading works and understand the risks of trading a leveraged product.

CFDs involve over-the-counter transactions and the market is not regulated in South Africa, although stockbrokers are monitored by the Financial Services Board. Carefully select who you open a CFD trading account with because you will be dependent on their ethics and integrity.

After you apply for a CFD account

If your application to open a CFD trading account with a stockbroker is successful, you will be sent login details via email to access the trading platform.

Follow the easy instructions to set up your account. Your personal account manager will explain how the trading platform works and will help you place your first CFD trade.

Deposit funds into your CFD trading account, usually via a bank transfer.

Start with a demo account if you are new to CFD trading and learn everything there is to know about CFDs before you start trading with your own money.

Read as much as you can on price movements on the underlying assets that interest you. You can gain a wealth of knowledge and experience by watching video guides and following CFD traders on social media to learn how to trade CFDs.

When you are ready to start trading, set your preferences within the trading platform. You have access to advanced charting, reporting, and instrument tools to help you make careful and considerate CFD trades.

 

CONCLUSION

CFD trading has grown in popularity because it allows a broad range of traders accesses to a wide range of financial instruments.

Barriers to entry are low, largely because you don’t need a lot of investment capital to set up a trading account and CFDs involve over-the-counter trading and by-pass the stock exchanges. This means costs are reduced because you don’t pay stamp duties and the broker makes his money on commission rather than on transaction fees.

However, because CFD trading is a speculative form of trading, it does come with inherent risks. CFDs are leveraged products so while you can make money from CFDs, you can also lose a lot more than you have available in your account.

If you are new to CFD trading, align yourself with a reputable stockbroker you can trust to partner with you on your trading journey. Learn to trade CFDs with a demo account before you use your own investment capital. Over and above that, develop a disciplined trading strategy that is appropriate for your trading style and trade with care and caution.

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