Advantages Of Trading CFDs
Although straight forward share dealing is the preferred choice for many investors, there are a number of reasons that make CFD Trading a superior alternative. This article will highlight the main features worth considering.
CFDs have been used by professional traders for over twenty years and emerged first in the over-the-counter (OTC) or equity SWAP market. Equity swaps were used by institutions to cost effectively hedge their equity exposure.
CFDs have become one of the most popular derivative products in global financial markets.
The popularity of CFDs has been driven by:
- Leverage: CFDs enable you to obtain full exposure to a share for a fraction of the price of buying the underlying instrument. CFDs require only a small initial margin as a trading deposit.
- The ability to go ‘short’: CFDs allow you to sell shares you don’t own. This enables you to profit from falling share prices.
- Lower transaction costs: CFD providers pass on volume discounts allowing you to benefit through lower transaction costs.
- Hedging: CFDs allow you to employ more advanced strategies such as hedging to protect your existing share portfolio.
- Simplicity: CFDs mirror the price of the underlying instrument: Unlike other forms of derivatives (i.e. futures and options).
- Dividends and Corporate actions: CFDs allow you to benefit from dividends or bonus issues which may occur in the underlying instrument on which the CFD is based.
Leverage, which is also known as trading on margin, is the ability to buy positions of considerable value, with relatively small sums of money. When opening a position using a CFD, the broker will only require a trader to pay a small percentage of its worth. This allows the benefit of being able to make much larger profits than you otherwise would be able to, with a straight forward share purchase (for example).
This feature isn’t something that will appeal to everyone but suits most traders and investors with a high risk reward appetite. If used properly, trading on margin isn’t actually any more risky than buying physical shares in a company although many people think it is.
Go Short or Go Long
CFDs are derived from the price of an underlying asset which means that rather than buying stock, a commodity etc. You are therefore essentially placing a bet on the direction of its price. For this reason, it is possible to open a position that is short or long. Going short means that you are expecting the price to go down while going long means you are backing an increase in its value.
No Stamp Duty
In the UK, whenever you buy something for investment purposes, you are required to pay stamp duty which is 0.5% of the total purchase price. Again, seeing a CFD is a derivative rather than an actual asset purchase, you are not required to pay this fee.
Trade on a Wide Variety of Different Markets
CFD trading accounts give access to a huge number of different tradable assets. Not only can you trade stocks and shares but things like energy prices, forex, commodities like coffee and wheat and much more.
Risk Management and Tools
CFD platforms provide tools to help you mitigate risk such as the stop loss and limit order. Most will also provide charting packages to help educate and inform you so that you can make better investment decisions.
What are the benefits of Contracts For Difference?
- Unlike traditional shares, initial payment on a contracts for difference is lower because you are not purchasing the share outright. The purchaser only needs to pay a percentage of the share price known as the ‘Initial Margin’. Trading on this margin allows a leverage to access a larger amount of shares than you would be able to if you were buying or selling them outright.
- As well as trading contracts for difference on UK equities, you can also trade on many world indices, including the FTSE 100, NASDAQ, Dow Jones, S&P, Dax, CAC, Nikkei and Hang Seng.
- There is no stamp duty as you do not actually own outright the share you are trading.
- The ability to go either Long (buy shares) or Short (sell shares).
- CFDs allow you to speculate on an upward as well as downward price movements. If you decide to go Short (sell your CFDs) in a falling market you will see your profits rise in accordance with the fall in price, so you can profit even when the market prices are falling.
- Transparency and clarity: CFD dealing directly mirrors the behaviour of the underlying stock market. If you already have good knowledge of the stock markets, then CFDs should be essentially easy to grasp and follow.
- Trading on a margin comes with greater risk. Although you can access a larger amount of shares, a higher leverage can result in losses that could exceed your initial deposit in order to cover the difference.
- Although there is no stamp duty of CFDs, you will have to pay capital gains tax on any profits that you make.