Pros and Cons of Trading CFDs

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CFD is short for ‘contract for difference’. If you have no experience trading CFDs, you might be wondering if these instruments are right for you. While every trading instrument has its own merits and demerits, CFDs are unique. This article written by our forex trading expert takes a look at the pros and cons of trading CFDs

Pros of Trading CFDs

Flexibility when trading CFDs

CFDs can be traded on any market and asset class. This means that a CFD trader can trade any market they like at any time. It allows traders to take advantage of price movements in the underlying asset. They can also place both long and short positions on the same contract. That means they can make money from going short if they think that the price will go down. Or if they think it will go up, they can buy and make money from going long.

This flexibility also helps with risk management because there is no need to tie up funds in one particular market. Traders can close their position if things start to go wrong. This is one of the trading habits you should adopt.

Leverage in CFDs

Leverage allows traders to open positions with relatively small amounts of capital. For example, if you want to trade stock but don’t have enough money to buy 1 share directly from your broker. You can buy 1 CFD for each share instead. As such, if the price of the stock rises by $1, then your CFD position will increase in value by $1 per share as well (minus fees).

Leverage is also useful when trading CFD because it allows traders to take short positions on assets. Short selling involves borrowing an asset from someone else and selling it before buying it back at a later date at a lower price. This would not be easy to do without leverage. It would require borrowing the full value of the asset instead of just borrowing a portion of its value like with CFDs.

Your risk is limited

When you trade CFDs, your maximum loss is limited to the money that you put into the trade (your initial margin). This means that if the price of an asset drops below your purchase price, your loss will be limited to your initial investment. For example, if you buy a contract for 100 shares at $20 each and then sell them at $19 each, your loss would be $100 (£76). This compares with buying shares directly, where your losses could be unlimited if the share price fell below zero.

No stamp duty

When you buy shares, you have to pay stamp duty on the transaction. Stamp duty is calculated at 0.5% of the value of the shares. However, a CFD trader does not need to pay stamp duty when they trade CFDs. That’s because they are not considered securities and therefore don’t fall under the same regulations as stock exchanges.

Cons of Trading CFDs

Venturing into the CFD market can be a lucrative way to make money, but some downsides are also apparent. Here are the main disadvantages of trading CFDs:

Leverage

Leverage is a double-edged sword when it comes to trading CFDs. On one hand, it allows you to trade with higher amounts of money than you would be able to use if you traded shares or futures. For instance, if you wanted to buy 100 shares at $10 each and the share price dropped by 2%, you would lose $20. If you wanted to buy 200 CFDs at $10 each and the share price dropped by 2%, you would lose only $40. Assuming the CFD was trading at 1:1.

On the other hand, leverage can also work against you in times of volatility. If a stock drops by 2% during a price movement, it will likely drop further in a falling market. This means that if you have leveraged yourself, this could wipe out all your profits and more!

Varying spreads

The biggest disadvantage of trading CFDs is the spread. This refers to the difference between the price at which you can buy and sell. If you trade CFD with a broker, the spread will be included in your total cost. With a CFD provider, it’s part of your profit or loss.

The spread varies depending on how liquid a market is and how much volume is being traded there. And it’s highest when markets are volatile, so you’ll pay more when there’s a lot of activity on a particular asset. In other words, if there are a lot of people buying and selling an asset, then your broker will charge more for you to do so as well.

Higher risks

Like spread betting, the higher level of risk associated with CFD trading is one of their main disadvantages. The fact that you don’t own the underlying asset means you’re not exposed to losses on that asset if it were to drop in value. Similar to cryptocurrency trading, there’s no limit to how much you can lose when trading CFDs in contrast with buying and trading physical commodities or stocks.

Take Away

The truth is CFD trading can be an effective way to make money, but it is also a high-risk venture. There are many different things that affect the price of assets, and there is no guarantee that you will know when they will change.

To be on the safe side, you can open a risk-free demo account on a CFD trading platform to practice and get grips with a trading strategy of your choice. You can also open up a live forex trading account if you feel you are ready.

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