Contract for differences (CFDs) have gained popularity in recent years among active traders looking to capitalize on short-term market movements across a range of asset classes. By allowing participants to speculate on price direction without owning the underlying asset, CFDs open up trading opportunities across shares, commodities, currencies, and indices.
However, these advantages come with amplified risks that traders must actively manage. As with any leveraged instrument, losses can exceed deposits, especially for traders not adept at risk management.
So, are CFDs right for you? This article covers the key benefits and drawbacks you need to consider before trading.
What Exactly is CFD Trading?
So, what is CFD trading? It refers to leveraged derivatives contracts that allow traders to speculate on rising and falling prices of underlying assets. Unlike options or futures that expire, CFDs provide exposure based on regular market buy/sell positions and don’t involve acquiring the actual assets.
In CFD trading, traders enter long or short positions based on whether they expect the market price to rise or fall. They never physically own the asset itself, like shares or commodities. Instead, traders seek to profit from the price movements of the asset. They must also pay daily financing costs to maintain their CFD positions overnight.
The major appeal of CFD trading lies in gaining highly leveraged exposure to almost any global asset using only a small upfront margin.
Pros of CFD Trading
- Powerful leverage cuts both ways
The ability to trade on margin is a double-edged sword. CFD brokers allow leverage to reach 30:1, meaning traders can enter a USD$10,000 market position while only posting USD$333 themselves. This gives greater market exposure per dollar invested.
During winning trades, leverage boosts returns. A 2% underlying asset price move turns into a 60% profit on capital invested. However, the reverse also holds true—leverage will rapidly magnify losses on ill-timed trades.
Moreover, interest charges to hold leveraged positions can add up over time. For this reason, CFDs are generally suited to tactical trading strategies rather than passive buy-and-hold approaches.
- Access global markets with ease
CFDs provide exposure to thousands of international shares, indices, commodities, and currency pairs within a single account. This avoids the hassles of opening multiple brokerage accounts or complicated foreign exchange dealings.
You can trade market movements across leading Asian, European, and American stocks regardless of time zone or geographic location. The same holds for commodities like oil and gold or major currency crosses. Furthermore, global indices like the S&P 500 or FTSE 100 can be traded based on overall moves rather than picking individual stocks.
So, whether you have a view on Apple’s next earnings report or gold’s safe haven appeal, you can easily speculate on price direction without actually owning them. This flexibility and convenience are major advantages of CFD trading.
- Go long or short with ease
Whereas buy-and-hold investors can only profit from rising prices, CFD traders can also capitalize on market declines by short-selling. So, if you analyze that a stock is overvalued or that inflation risks will drag gold lower, CFDs allow benefiting from downward trajectories.
In fact, studies show most active CFD traders tend to favor short positions. This flexibility caters to opportunistic traders aiming to profit across diverse market conditions, both in rising and falling environments.
- Lower costs than other instruments
Entering CFD trades avoids exchange fees and transfer taxes associated with buying real assets. This keeps commission costs relatively low, especially for short-term trades held intraday or a few days.
Brokers also allow trading fractional shares, meaning you can take a view on Apple or Tesla without paying their hefty per-share prices. This facilitates better risk management by diversifying across more positions.
Of course, trading costs still apply in the form of spreads and financing charges for leveraged exposure. Costs can also grow substantially for traders making several intraday transactions over longer holding periods. But overall, costs are less than trading the actual assets in most cases.
Cons of CFD Trading
- Risk management is paramount
While CFDs carry many advantages for strategic traders, their inherent leverage also amplifies downside risks. Because market exposure exceeds invested capital, it becomes critical to utilize stop losses and discipline around position sizing.
For example, you have USD$2,000 in your account and enter a USD$10,000 position in the S&P 500 with 1:5 leverage, risking 50% of capital. A sudden 2% market drop would translate to a USD$200 loss, wiping out 10% of your equity despite using stop losses.
This example illustrates how quickly losses accumulate. Formulating trading plans defining maximum risk-per-trade and risking only 1-5% capital is vital. Compulsively overleveraging leads to margin calls and wiped-out accounts. Risk management separates successful traders from gamblers.
- Mind financing costs overnight
Unlike traditional securities, CFD trades held overnight accrue financing charges. This compensates providers for granting leveraged access and mirrors money market rates.
Long trades typically pay financing costs, while short trades receive them. Under normal yield curves, short financing rates exceed long rates. So, while going short may seem intuitively safer, financing expenses could erode positive returns.
Therefore, keeping positions intraday or only a few days optimizes total financing costs. This favors nimble day traders over long-term investors.
- Execution uncertainty
Entering stop or limit orders on CFD trades doesn’t guarantee execution at those exact levels when volatile price swings strike. Gaps between the market opening and previous closing can jump straight through entry or exit points before participants can react.
Similarly, fast-moving assets may gap down and hit stop levels prematurely, even using guaranteed stops that ensure exiting at specified prices. These risks mean your realized entries and exits could deviate considerably from initial plans.
Moreover, spreads and execution quality vary substantially between retail CFD brokers. Market makers can widen spreads during news events and volatile periods when favorable pricing is most crucial.
Analyzing brokers’ spreads, liquidity depth, price aggregation, and order execution is vital. Retail traders are price takers, so execution certainty and transparency are frequently overlooked CFD trading challenges.
- Complex tax considerations
Tax rules regarding capital gains, income, and withholding taxes differ across jurisdictions. Many countries like the UK deem proceeds from active CFD trading as taxable income rather than the more favorable capital gains categories from passive investing.
Short-term trading gains could, therefore, face income tax rates approaching 50% in some countries. On the other hand, losses may not qualify as deductible, skewing the system against traders. Reporting requirements also typically view profits withdrawn from CFD accounts as taxable events.
Navigating these complex rules requires planning and skilled financial advice. The administrative hassles and tax burdens can accumulate.
CFDs carry major opportunities but also unique risks requiring active mitigation. Offering easy market access and the ability to profit across diverse market conditions, they remain appealing for tactical traders comfortable with leverage.
Specifically, intraday and short-term traders stand to benefit most from CFDs, while longer-term investors face compounding financing and tax costs. Because losses can mathematically exceed deposits, strict risk management is mandatory, not optional.
Understanding these cons while intelligently wielding the pros allows skillful traders to target short-term gains from market swings. Overall, the huge flexibility and leverage explaining CFD trading’s popularity outweigh the risks if utilized prudently. Then again, reckless overtrading inevitably proves costly in such an environment.