CFD, or Contract for Difference is a form of derivatives trading that offers certain distinct advantages compared to trading the security directly. Most notably, CFD trading is more commonly used for Stocks and commodities rather than spot forex. If you are considering trading CFD’s then here are 5 things to bear in mind before you short or long that contract.
But before we get into the details, a little bit about CFD’s. Contracts for Difference or CFD for short is a contract that is agreed upon between the buyer and the seller. In most cases, the broker with whom you trade CFD’s is the seller of the contract. During the term of the contract, if the value of the security increases, the seller pays you the difference and if the value of the security decreases, you end up paying the seller the difference. Besides this basic definition, trading CFD’s is almost the same as you would trade forex or equity markets, but there are some finer details where Contract for Difference (CFD) trading varies. Here are 3 things to keep in mind when trading CFDs.
CFD’s are financial derivatives
Derivatives are a form of financial products that are derived from the actual underlying markets. Therefore, when you want to buy or buy a company’s stock, you are simply paper trading. In other words, you don’t hold any ownership in that particular stock you are buying. This derivative nature is both a blessing and a curse. It is advantageous because unlike traditional stock investment, you wouldn’t be able to buy just 1 share, but rather in a bundle, which requires higher investment. Likewise, if a stock’s price is falling, the best you can do is to sell your shares and get out of the market.
With CFD’s you can make money either ways. By going long (or buying) when the share price starts rising or you could very well short (or sell) if the share price starts to drop.
Mind the Spread
Because CFD’s are derivatives, the contract is offered by the broker who is a market maker. Thus, when you Buy or Sell (short) a CFD contract, you are in effect trading against the broker. Because of this, the broker usually adds a mark up to the spread. So, if for example AAPL’s stock was actually trading on NASDAQ at $500, then your broker would charge you a bid price of $501, with a markup of $1, or offer you $499 if you want to short the stock. Spreads are important or can be ignored depending on your trading style. If your trading strategy requires you to hold on to a stock over a period of weeks, spread don’t really matter. But if you were an intra-day trader off to make a few pips/points the spreads definitely matter.
Swaps & Dividends
Although CFD’s are derivatives, when you buy or sell and hold on to the position overnight, you are charged an extra fee. This overnight fee is called the rollover fee or swap and varies from one CFD trading broker to another. However, in most cases, you get positive swaps if you sell or short a CFD and you are charged a negative swap if you Buy or go long on a CFD. The reason why you get +ve swaps when you short is because, in essence, you borrow the CFD from your broker, short or sell it at a higher price and when you close that short position (which is in effect a buy), you return that CFD back to your broker a better price.
Swaps are something to take into account if you want to improve your odds of successfully trading CFD’s. Depending on your position size, the swaps vary. And if the CFD that you buy doesn’t move much over a period of days, the negative swaps will start eating up your equity, to the point that you would require the CFD to move 10 points instead of 8 points just to break even.
On the other hand, when you buy CFD’s and hold them before a dividend period, you are credited the dividend based on the number of shares that you buy. This can be important and is a good way to offset any losses caused by overnight swaps. In the event that you were short on a CFD ahead of dividend date, then the amount is debited from you, which results in a negative dividend. Again, depending on your position size, it is possible for the +ve swaps to offset the negative dividend but not all the time.
CFD trading offers investors and traders alike a different market scenario which can be interesting at times, especially when trading CFD stocks which allows you to short a position which is unlikely in traditional stock investing where you can either Buy and hold or sell your shares and get out. By keeping in mind the above important elements of CFD trading, traders can fine tune their trading strategy accordingly to reap more benefits from trading CFD’s.