Contracts for Difference were developed in the early 90s in London. The invention of CFD belongs to the financiers Brian Keelan and Jonathan Wood. The Contracts for Difference were first used in hedge funds with institutional trading. It was a cost effective way to hedge the positions of your shares on the London Stock Exchange. The effectiveness of CFD is high due to the low margins and lack of need for the payment of tax collection, and at the same time, the physical shares don’t migrate in other hands.
The CFDs are a flexible method to trade on the price movements of products and instruments such as indices, shares, commodities, currencies or treasuries. In comparison to purchasing shares, when you trade CFDs, you don’t actually, or more precisely said, physically own the product, so you don’t have to pay the relevant fees of ownership like management fees and stamp duty. You can also sell the product and buy it back at a later stage.
For instance, there is an important company on the market which has just anticipated a record profit and you believe the price will go up. You decide to buy 10 000 units at 20 $. If the price moves up, like from 20 $ to 21 $, you will get a profit of 1 dollar. Considering all the units, that will be equal with 10 000 dollars. However, if the price goes down with 1 dollar, you will lose this amount of money. It is a much simpler way of settlement because losses and profits are paid in cash. You can use CFDs to speculate on the future movement of the market prices regardless of whether these go up or down. You can go short (which means to sell), allowing you to get profits from falling prices or can buy more units if you feel that the price goes up.
The CFDs were first introduced for retail traders in 1990s, as mentioned above. These became more popular due to a number of British companies whose proposals were generally characterized by innovative online trading platforms that enable to track the prices and trade in real time. The first company in this area was GNI. Soon, the GNI joined IG and CMC Markets, which began to popularize the product in 2000. Now, the retail traders have realized the real benefits that you can get with this method, and it is not about exemption of tax collection, but the ability to trade with leverage on any underlying instrument. This was the beginning of the growth phase in the use of CFDs.
The pros and cons of CFD
Now that you have some general ideas about the purpose and the history of the Contract for Difference, here are some advantages and disadvantages that you get with this trading method. Let’s start with the pros:
- Low margin requirements – the required deposit is only 10 % of the real value of the contract.
- Universality and ubiquity – trading operations are available from anywhere in the world where you can get the access to the internet.
- Guaranteed orders – the possibility of setting orders of any kind and any price movements in the market.
- Low commissions – the proportional size of the charged fees for operations is 0.05 %.
- Diversification – generally the traders can have the access to a wide range of financial instruments. There are stock, index, treasury, currency and commodity CFDs.
- The possibility to trade on forex market and CFD with the same trading account.
- The possibility to get profits from both growing and falling market.
- With CFD, there is no stamp duty, as is the case with British shares.
- Low requirements for positions through trade with leverage.
- No day trading requirements – some markets require a minimum amount of capital to day trade, or place limits that should not be exceeded during a day. The CFD market has not these restrictions and you can trade whenever you want.
Even if the CFDs appear to be attractive and profitable, they also have some potential pitfalls. Here are few of these:
- You have to pay the spread on entries and exits and this can eliminate the potential profit from small moves. The spread will also decrease winning trades by a small amount (over the actual stock) and will increase losses by a small amount. So even if the CFDs have not commissions and duties, the larger spreads can influence the profits.
#ava300x250#- The higher leverage in trading can lead to increased amounts of losses, as well as profits, like in forex market.
- There are some high risks which are linked with the margin trading.
The risks of the CFDs
The Market risks – this represents the main risk as the contract is meant to cover the difference between the opening price and the closing price of the underlying asset. As mentioned in the list of disadvantages, CFD trading on margin increases the risk significantly. Another aspect of CFD is that small changes in the market can have a big impact on returns.
Liquidation risk – if the prices move against your CFD position, additional variation margin will be needed to maintain the level. This can lead to the situation in which the holder of an existing contract would be required to take less than optional profits or cover any losses incurred by the CFD provider.
Counterparty risk – it is a factor in most OTC traded derivatives. It is associated with the financial stability or solvency of the counterparty to a contract. In terms of CFD, if the counterparty fails to meet the financial obligations, the CFD may have no value regardless of the underlying instrument, even if it moves in the desired direction.
The CFD deservedly enjoys high popularity in Europe due to simplicity, low cost and greater flexibility compared to other alternatives. CFD suits most trading strategies, including algorithmic, and can be a good addition to your existing investment models. It is a derivative financial instrument that allows you to profit from changes in the price of the underlying asset without significant capital costs.