Advantages And Disadvantages Of Trading CFDs
Traders interested in trading CFDs must be aware of the advantages and disadvantages of trading CFDs.
By knowing them, they can fully utilize the features CFDs provide and avoid taking unnecessary risks.
The ultimate goal of trading is to earn profits. But purely focusing on profits will take you nowhere.
Ask any experienced successful trader and he will tell you trading when equipped with a proper strategy and knowledge will result in more success.
This article’s objective is to educate you on the various pros and cons of CFD trading.
What are CFDs? What are its features? Let us understand the basics first.
What Are CFDs?
CFDs stand for Contracts for Difference. So as the name suggests, they are contracts which are formed between a buyer and a seller.
CFDs are traded OTC (Over the Counter), meaning the trading is done off-exchange and there is no centralized exchange for it.
CFDs are leveraged financial derivatives. This means you don’t own the CFD assets and its value is derived from the value of another asset.
They are leveraged assets which mean you can invest only a fraction of the value of the total trade to open your position. This is also called marginalized trading.
If your margin is 5%, that means you are covering the rest of the 95% with this amount.
With such a potential for high profits, CFD’s attract all kinds of traders. Let’s take a look the features of CFDs.
What Are The Features Of CFDs?
Trading CFDs is different from investing in shares. Here is a quick look at the features of CFDs:
- Lack of ownership of assets: You don’t own CFD assets. You only speculate on their price movements. Likewise, you don’t get to enjoy the ownership benefits of the asset.
- Going both directions: You can go both long or short on CFD assets depending on the market conditions. If you want to sell, you have to go short on these assets, and if you want to buy, then open a long position. If the market moves against your position, you lose money and vice versa. This is a big advantage of trading CFDs.
- Leverage and Margin: As discussed above, CFDs are leveraged financial products. You pay only a marginal amount to open your position which worth a lot more than what you paid. This is both advantageous and disadvantageous as we will see in the next section.
- Lack of expiry date: CFDs don’t have any expiry on them. They last as long as you continue them. However, there is an overnight charge for continuing your position to the next day. Certain CFD assets such as commodities have a fixed expiry, however.
- Risk management facilities: You can utilize various risk management tools that CFD trading provides. Stop loss orders and limit order helps to reduce your losses in case the market moves swiftly against you. You can also use hedging as a security measure and protect your profits.
Advantages And Disadvantages Of Trading CFDs
Now that we know what CFD trading is and what its features are, we can take a look at its advantages and its disadvantages.
The Advantages of Trading CFDs
Marginal Investment
Let’s explain the concept of margin and leverage with the help of an example. A CFD trader wishes to purchase shares of Netflix as CFDs.
The selling price is set at $303.30 and the buying price is set at $303.60. The difference of $0.3 is known as the spread. The trade thinks the price of Netflix shares will drop.
Therefore, he wishes to open 10 contracts and take a sell position. His total transaction value excluding fees amounts to $3033.
Now our trader is a small-time trader. He doesn’t want to invest a large portion of his capital.
The margin for this instrument is 5%. This means he only has to pay 5% of the total cost ($3033) which amounts to only $151.65. So by investing only this marginal payment, he is able to trade 10 shares of Netflix. Therefore marginal trading can be extremely beneficial for small traders to make big profits.
No stamp fees
As there is no ownership of assets in CFDs, traders are also not required to pay any stamp fee on them.
There are no hidden fees in CFD trading. This reduces the cost to a great extent.
Unlike shares, you won’t be charged any stamp duty on any CFD asset that you trade.
Flexibility in trade duration
As we discussed above, there is no expiry on CFDs. You can keep your position open as long as you desire.
Both day traders and long-term traders can trade CFDs. This flexibility in duration attracts all kinds of traders to trade CFDs.
Positions that are held for too long are subject to daily overnight fees.
Multiple trading instruments
When trading CFDs, you are not limited to one or two asset types. You can trade from shares, indices, currencies, commodities, and even cryptos.
With so many options, you can diversify your portfolio and minimize your risk.
You also get to try out different assets and increase your trading experience.
Trade both ways
With CFDs, you have the option of going both long and short. When you anticipate a price rise, you can go long and open a buy position.
What if the markets are collapsing? With CFDs, you can take advantage of falling prices as well. When prices are falling, go short and make money off that.
With CFDs, you have many options, so much versatility, and far too many benefits for traders to ignore.
But that’s not to say it doesn’t have its fair share of disadvantages. We will see some of the risks of trading CFDs down below
The Disadvantages of Trading CFDs
Leverage carries great risk
Under the advantages section, we praised margin and leverage for bringing in big profits using small investments.
But the same leverage becomes the villain when your prediction goes wrong. You will losses that are far greater than your investment.
Just like profits, losses are magnified when trading with margin and leverage. So keep that in mind before you go crazy over some asset that carries a high leverage ratio of 400:1 or higher.
Not ideal for long-term traders
Even though long-term traders can trade CFDs, it is recommended that they don’t. This is because of overnight financing.
At the end of each trading day, an overnight fee is charged against your account.
If you think long-term, even a few days of keeping your position open will get very expensive. The cost may even outweigh your profit margins.
No ownership benefits
When you own shares, you own a percentage of that company. You have direct involvement with the company.
You can even take part in shareholder’s meeting and influence company decisions. But none of that applies to CFDs.
You don’t own assets, rather speculate on the price changes. Hence, you get any ownership benefits.
Not for emotional traders
CFD trading isn’t meant for traders who trade by emotion. It is not meant for traders who can’t control their emotions such as greed, or lack patience.
You are guaranteed to lose money in CFD trading if you let emotion get the better of you.
Practicing on a demo account helps with the strategies and experience but remember that in a demo account, you can’t lose real money. Hence these things must come within you.
Overtrading can be a problem
Ease of access, low trading fees, marginal investment. All these reasons contribute to overtrading.
Beginner traders are under the illusion that by overtrading, they can learn quickly and make more profits. In reality, all they do is waste their capital and face losses.
Conclusion
In reality, no trading system is perfect. Each one comes with its pros and cons. The same applies in the case of CFDs.
It is us, as traders that we have to be aware of the pros and cons that the trading method provides and adjust our trading plan accordingly.
It is important to realize the advantages and disadvantages of trading CFDs or any trading system for that matter.
This was the purpose of the article and we hope you have benefited from this. Good luck in your trading endeavors.
