Published On: Sun, Mar 10th, 2013

5 Advantages to Trading CFDs over Stock

Over the last 20 years CFDs (Contracts for Differences) have become increasingly popular among traders in a long list of countries. There are good reasons for this state of affairs, a few of which are summarised below.

Leverage: If one reason has to be isolated why CFDs have become so popular, it probably has to be the fact that they are leveraged. This simply means the trader gets access to a much bigger amount of capital than the amount that he or she has available to trade with.

A CFD with a 5% margin rate allows a trader to control assets worth $100 000 with an investment of only $5 000. In a long position this means the trader could double his initial investment if the price of the underlying share goes up by a mere 5%.

What newbie traders sometimes forget is that this is a double-edged sword. An adverse movement of 5% will also wipe out the same trader’s initial investment.

This is why diversification is even more important with CFDs than with ordinary share trading. A trader whose trading account consists of only $5000 should never allocate this to a single share. A good rule of thumb is to allocate available funds to a portfolio consisting of at least 10 shares. This way a single bad trade cannot wipe out more than 10% of the trading account.

Lower transaction costs: With a $5000 trade on CFDs with a 20:1 leverage, one can control shares to the value of $100 000 – without having to pay the usual transaction costs on shares worth that amount. This is a major benefit of CFD trading.

Short trades: With ordinary share trading a trader can only benefit if the price of a stock goes up. With CFDs traders can also ‘go short’, i.e. benefit if the price of the underlying asset drops. The direction of the move has to be predicted correctly, however. It’s no use to go short just before a major increase in the price of the underlying asset.

Range of trading products: A CFD trader has at his disposal a much wider range of trading products than an ordinary stock trader. Although there aren’t CFDs available on all stocks, there are nowadays also CFDs available on currencies and commodities such as gold and oil.

Simpler than options or futures: Trading CFDs is much simpler than trading options or futures. The price of a CFD follows the price of the underlying asset on a 1:1 basis. No Options Greeks, volatility collapses or getting exercised here!

Hedging existing portfolio: Going short on CFDs is a popular and affordable way of hedging an existing (long) stock portfolio. This acts much like insurance: With a 5% short CFD one can fully hedge a share portfolio. Unlike when buying Put Options, however, this will also eliminate the possibility of benefiting from an increase in the price of the underlying asset since the short CFDs will deteriorate at the same rate at which the shares are gaining in value.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.