If you regularly follow a financial news channel, chances are you’ll often hear stock market pundits talking about stocks, bonds, or commodities like gold or oil. These are tools that are common and familiar to most investors. However, the reality is that there are still other financial products that are less well known and investors do not know enough about them.
One of these is CFD (Contracts for Difference). This is a derivative product that is becoming increasingly popular and offered by many online exchanges.
How does CFD trading work?
To understand how CFDs work, we will first need to describe to you some of the concepts that include derivatives.
What is a derivative?
The first thing you need to understand about CFDs is that they are derivatives. It means that the product you are trading has no value on its own but will derive its value from another asset. Instead of owning assets, you speculate on the price of an underlying asset.
The most commonly traded types of derivatives include:
- Futures contract (forward contract)
- Swap contract
- Option contract
The most common underlying assets are commodities, stocks, bonds, interest rates, and currencies.
Derivatives are very attractive to professional traders who use them for diversification or hedging. In fact, the derivatives market is very large and its value is estimated to be around $640 trillion (VND 14 million 720 trillion) in 2019. To appreciate its true value, the market’s value The global stock market is only approaching $90 trillion, according to CNBC.
However, according to a report by Bank for International Settlements (BIS), the value of this market is only $12 trillion (VND 276,000 trillion)!
A product with leverage
Imagine you buy a CFD contract from an exchange for an order of 1,000 barrels of crude oil. The current price of a barrel of oil is about $40 (920,000 VND), which means you will need $40,000 (920 million VND) to buy the whole thing.
With CFDs, you don’t actually buy oil and won’t need to pay the full amount through leverage. The broker will require you to have a margin amount depending on the leverage offered. For example, with a margin requirement of 10%, you will only have to invest $4,000. In this case, the theoretical value of this contract would be $40,000 (VND 920 million) while the deposit amount is only $4,000 (VND 92 million).
The role of the exchange
You may see some differences depending on the market in which you trade derivatives. In general, derivatives markets are centralized. They can also be OTC or Over The Counter.
In the first case, the derivatives will be traded on an exchange, for example, the Chicago Mercantile Exchange (CME). The difference of OTC markets is that they do not have a so-called centralized market and this is where exchanges are needed.
The Forex market is the largest market globally with $6.6 trillion (151,800 trillion dong) traded daily. However, this is an unlisted share market, which means that the entire market is not supervised by any one exchange in the world. To solve this problem, retail brokers found that they could partner with the key players in the forex market, namely the big banks. Through these partnerships, retailers can receive market quotes on exchange rates and make them available to their customers.
After that, brokers realized they could offer more currency pairs using the same system and started offering other assets like stocks, commodities, indices and cryptocurrencies. All an exchange needs to do is partner with liquidity providers and create synthetic contracts based on market prices.
Retail traders, therefore, have the opportunity to buy contracts based on the market price of the instruments. When the price changes, the trader can have a profit or loss on the difference between the bid price and the current market price and hence it is known as a Contract for Difference (CFD). For the trader, he can make a profit by applying the market spread he gets from the liquidity providers. This spread allows traders to make profits even if their trades are profitable or not.
Since traders will create their own CFDs, care should be taken to choose the correct one. Cases of price manipulation among unregulated exchanges also occur in a few places. It is for this reason that we recommend choosing only CFD brokers that are regulated by market regulators. The presence of financial regulators is essential to ensure that CFD brokers honor the contracts they create.
What is leverage?
Similar to other derivatives exchanges, CFD brokers do not require traders to pay the full value of the trade. In fact, exchanges require a lot less capital to create contracts. This is due to the leverage effect.
Exchanges that offer CFDs usually only require a small amount of money to execute an order. This amount is considered a security deposit and is the same as the name deposit in insurance.
Leverage allows you to access the markets easily with only a small amount of money. Some CFD brokers have the ability to offer leverage up to 1:1000 on their platforms. This means you will only need 0.1% margin to open a position (1/1000 x 100).
What financial products can be traded as CFDs?
CFDs can be traded with all types of financial instruments.
There are no restrictions on the products that can be traded as CFDs as long as there exists a market for that product. In fact, CFDs are so simple that you can create contracts from any listed asset.
However, the most traded CFDs are usually still in stocks, stock indices and metals. US stocks in particular, especially technology stocks like Amazon, Facebook and Google are becoming increasingly attractive thanks to the growth of this sector. Metals (gold, silver) and petroleum are also very popular.
Since the bubble in the crypto market, CFD exchanges have also started offering virtual currency pairs. This gives a huge advantage allowing speculators to take advantage of their volatility without setting up a cryptocurrency wallet.
Since all of these securities are traded on global stock markets, CFD exchanges can easily partner with liquidity providers to provide quotes. In addition, these markets are also highly liquid which allows traders to access assets at attractive prices. Top exchanges often partner with liquidity providers around the world to offer the best rates.
Should you trade CFDs?
Before making an investment, you need to understand the pros and cons of this form of trading. From here, you will be fully aware of the risks you are taking and decide if the risk is greater than the return.
Advantages of CFDs
CFDs offer great flexibility to traders and speculators.
Trading CFDs would not be popular if it didn’t bring certain benefits to traders.
A CFD trader can make more money than an underlying asset trader. In our example above, you can earn $4,900 (112 million VND) investing $1,800 (41 million VND) in gold CFD while you can only earn $50 (1,150,000 VND) ) if buying physical gold.
This example demonstrates how much more profit you can make from a CFD than with an instrument without leverage. However, the higher the return, the higher the risk.
Requires little capital
Usually very few private investors can afford to buy an Amazon stock for $3,000 and pay the full cost. And we’re just talking about an action!
In contrast, with CFDs, an exchange will be able to offer you 1:100 leverage with a margin requirement of just $30 (VND690,000) to buy an equivalent Amazon share. As a result, CFDs allow traders with limited capital to take advantage of the financial markets.
Profits on the upside and downside
When you buy stocks, you can only make a profit when their prices go up. With CFD trading, on the other hand, you can speculate on price movements in both directions.
So, if you think the price of Amazon stock will go down, you can go short by opening a short position on its CFD. You can do this because CFDs are derivatives and you don’t need to actually own Amazon shares to be able to sell their CFDs.
If you sold the AMZN CFD and the group’s share price fell, you could profit by buying the CFD back at a lower rate and pocketing the difference between your entry and exit prices.
No expiration date
CFDs are not time-bound like other derivatives such as options or futures. They do not have a fixed expiration date and have very few restrictions on closing positions.
This provides considerable flexibility for scalpers to be able to get in and out at any time with no strings attached.
Disadvantages of CFD trading
CFD is a risky product so you need to be cautious and careful.
Leverage has the potential to cause big losses
CFDs can cost you more money than expected. Leverage is a double-edged sword that can amplify your profits but also increase your losses.
In fact, potential losses can be higher than expected profits like the example we presented above. With trading 100 ounces of gold with 1:100 leverage, you are losing $5,100 (117 million VND), which is more than half of your capital if the price drops to only $50 (VND 1,150,000). Conversely, if you buy physical gold, that loss will be only $50 (VND 1,150,000), which means your capital is only 0.5% deficit.
The manipulation ability of exchanges
Many traders have complained about arbitrary slippage or re-quotes when placing orders through CFDs. Although cases of price being manipulated by exchanges are rare, they are not unheard of.
Since the exchange monitors all transactions, there is almost no fraud in centralized markets. This does not apply to CFD contracts that are offered directly to customers by exchanges.
There are several ways that unscrupulous exchanges can fool new traders. You can avoid becoming a victim by choosing a regulated exchange.
Investors in stocks, ETFs, and mutual funds are still likely to receive dividends, but CFD trading is not. CFDs are synthetic products and you cannot invest in any real assets.
Overall, CFDs offer certain advantages to traders. However, due to the large potential return, this type of investment is always high risk. You need to do the relevant analysis carefully before opening a position and focus on risk management.