Pros and Cons of Trading CFDs

While CFDs can make you a significant amount in certain trading sessions, they can also be risky. Here, we look at the pros and cons of trading CFDs.

November 23, 2021

Pros and Cons of Trading CFDs

CFDs are among the most popular financial strategies available in the market today. They are offered by most online forex and CFD trading platforms, with you being able to open a position with as little as $5.

They usually have shallow margins compared to day trading, making them accessible even to beginners. On top of that, they offer incredibly high leverage, allowing you to earn significant returns on your investment when prices are moving in the right direction.

What are CFDs?

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CFDs are contracts for difference, where the buyer and seller don't exchange physical assets but merely make payments based on how much they think one investment will rise or fall in value.

The two parties involved in a trade do not have to hold the underlying asset itself. This often makes them a more flexible and convenient financial tool for both professionals and novices. They can use CFDs to hedge their risks in other markets or go all-in on a particular asset without physically owning it.

What Advantage Does This Give Investors?

CFD trading allows you to bet on the movement of an underlying asset without actually buying it, which means you can make profits no matter which way the market moves. This reduces most of your risks, except for counterparty risk.

Because you don't have to deal with security issues or with finding a buyer in case prices fall before you've had time to buy back your CFD, you can focus on the price movement itself. This allows you to be more aggressive with your trades, giving yourself more chances of making money.

What Are Counterparty Risks?

Counterparty risk is when the person or organization entering into a contract won't deliver what he promised at the end of an agreement.

When you trade CFDs, you always deal with a third party, which is why you should always take counterparty risks into account.

On the other hand, while dealing with fewer risks than buying and selling assets themselves, traders should also remember the cost of commissions and spreads: these can include fixed spreads and a variable fee based on the volume of a transaction.

How Do CFDs Work?

As explained earlier, a CFD is a contract between you and your broker. For every point that the price of an asset rises or falls, you will gain or lose a corresponding amount of money relative to the underlying cash market for that asset.

You will not own the asset itself, but your broker will hold the underlying asset for you. CFDs are leveraged products. This means that if you buy a CFD on a stock worth $10, it effectively costs you only $1 to buy the CFD - this amount is called 'the margin.'

Your broker will charge you interest or a 'margin interest fee' (usually 4-5%) for using this leverage. If you decide to sell your CFD before the expiry date, you will need to 'close' your position. Your broker will do this for you automatically if you give them the instruction, or you can do it yourself.

The difference between buying and selling prices is your realized profit' or 'realized loss.' It means that if prices have gone up, you will receive more cash than you initially put in to buy the CFD, and if prices have gone down, you will lose money.

The Advantages of Trading CFDs

The Leverage is Higher in CFD Trading

With CFDs, you can trade on margin; this means that with a relatively small initial investment, you can control a much larger value of capital. While a standard trade requires a sum of 100% of the price to be paid upfront, an equivalent percentage in a brokerage account would require both buying and selling shares at once.

With CFDs, you can hold your position until the price favors either you or the broker.

Although higher leverage gives you a higher reward when done right, it also presents a much higher risk, and things go south. This will translate to more significant losses in the loss column. Always make sure you know how much of your capital you are putting at risk for each trade.

Trading Opportunities are Plenty

CFD traders are blessed with the opportunity to be part of all financial markets. As an individual or business entity, you can take advantage of CFDs for trading commodities, currencies, indices, and stocks across the world. With one position on a CFD, you can diversify your portfolio by accessing multiple markets.

Minimum Requirements to Trade

Compared to day trading, CFD trading isn't limited to multiple restrictions such as lot size, margin requirements, and short selling. The one thing that CFD trading has in common with day trading is that it does require some money management strategy, such as setting a maximum loss per trade and sticking to it.

Easy Access of the Global Market

The ease of trading in foreign markets due to the accessibility provided by CFDs is one of its most significant benefits. Through these contracts, traders can speculate on an extensive range of stocks, indices, and currencies traded in several countries worldwide.

No Restrictions

Unlike when trading stocks or shares directly, there are no restrictions applied with CFD or FX trading. This is because actual ownership of the underlying instrument never actually occurs, just a mere contract between parties for future delivery on an agreed price at some point in time.

Disadvantages of Trading CFDs

Significant Risks

While they offer very high returns, CFDs are also the riskiest financial products available. If you make the wrong choice of the asset to trade with or if your timing is off by even a minute, you can end up losing more than what was in your original investment.

This is because once the initial investment is made, any subsequent rise in the market value of the CFD is not yours but instead subject to a contract for difference.

Unreliable Regulations

As mentioned earlier, the CFD industry is not regulated, and there is no governing body to monitor and restrain abuse. This approach, which the trading companies claim ensures freedom of trading activities, has put consumers at risk on many occasions.

The unregulated nature of this industry also makes it hard for investors to seek redress when these firms have wronged them.

You Pay for the Spread

Traders lose the opportunity to profit from minor changes since they must pay for the spread on entries and exits. Because the spread depresses winning trades by a small amount compared to the underlying security, it will raise losses by a similarly minor amount.

So, Should You Trade CFDs?

There are both positive and negative aspects of CFDs, so you should understand what is involved before deciding if it's a suitable investment for you.

First of all, like any form of trading (stocks, commodities, currencies, etc.), they can be risky due to volatile market moves. But this risk needs to be put in perspective as only a tiny portion of your portfolio should be in CFDs. And if you're a skilled trader, your chances are reduced over trading stocks directly. But the biggest risk from investing in CFDs is from leverage itself.

Ensure that you take this risk seriously. Before buying CFDs, check if the provider offers to let you trade less leverage than usual(which can help reduce losses).

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