What are CFDs?

CFDs (Contracts For Difference) are a financial derivatives which allows us to trade in financial markets with additional leverage.

As their name implies, it is a contract between two parts, normally the trader and the broker.

The majority of transactions in these markets are synthetic, what means that the counterpart to our trades is the broker. In some cases, the broker will allow us to send the order through Direct Market Access (DMA), as if we are trading the real market even with market depth.

What are CFDs shares

CFDs transactions would be basically similar to that of stocks, except for the fact that with them we can use a lot more leverage. That means, if we buy a $10 stock, the majority of stocks CFDs will allow us to trade 20 times that amount.

European brokers normally do not offer leverage for stocks. American brokers, however, usually offer 2 to 1 or even 4 to 1 for day trading.

As we see, CFDs offer more probability of speculative gains and losses.

That makes CFDs a very dangerous product, but at the same time, a useful tool at the hands of professional traders.

Why are CFDs dangerous?

CFDs are dangerous because if we use any financial derivative that allows us to trade using a small margin (big leverage), the probability of ruin isvery high, I would say that almost 100% for most traders who use it, specially novice traders.

A lot of candidates to trading think fancifully that they can get rich once they discover the “tricks” of leveraged financial trading. As not many people know about the reality of this world (1), it seems that it is not that difficult to win “there”.

Reality is a lot harder nonetheless.

For that reason CFDs, or any financial instrument in general, should be treated with maximum care.

What is CFD leverage?

Novice traders should forget completely about 20 to 1 leverage in stocks, or 100 to 1 in indexes or commodities. Even experienced traders who know very well what they are doing, never use that sort of leverage.

A professional trader have enough with a 3 or 4 to 1 leverage in stocks, and not a lot more for other instruments.

The objective of any trader should be to win a 20% annually, for which a low leveraged is desired.

What are CFDs in forex?

Years ago, when they gained popularity, CFDs were associated mainly to stocks trading. As time went by, the retail CFD industry has expanded to a lot more markets, like indexes, commodities, bonds, currencies (2).

In fact, the most efficient CFDs today are probably the main indexes and some commodities like gold, where we can find conditions not too bad.

As for stock CFDs trading, there is a lot of variety in the markets. There are some brokers that offer DMA conditions. And, there are a lot of market makers which are offering in-house prices. The latter try to reflect the market price as close as possible and they will charge an additional spread. And, even so, some brokers will not quote the real price of some assets.

If we want to trade fairly, we should make sure that the prices the broker quotes do not differ too much from the real market.

What are CFD trades?

For instance, let´s imagine Apple had a minimum of $100 yesterday in the real market. If I had an order to sell at 99.98, it was not executed.

However, if the trade was a CFD, it may be possible that the broker executed the order since their spread is bigger than the real one.

When broker quote bigger spreads, they have the “right” to sweep some of our orders. What is worse is that some brokers could be tempted to do extra “sweeps” in an artificial way, aka stop hunting.

For instance, moving a stock CFD price significantly below their real price, to which we should protest since stock markets are perfectly centralized. Brokers will usually say that they had to increase their spread due to market conditions or whatever.

CFDs commissions

  • DMA brokers have similar conditions to stock trading. They apply the same spread as the real market plus a commission for every trade, which will vary depending on the broker (usually 0.1%). Normally, those brokers have a minimum commission, what makes this sort of CFD providers only suitable for accounts with a decent size. If your account is €1000, you will not get too far.
  • The majority of retail brokers offer the possibility of trading without commissions, but with a bigger spread. This bigger spread is quite often a lot more expensive than the brokers that charge commission. Normal spreads could be 0.05 or 0.1%, but these brokers quote from 0.2 to even 1%, or more depending on the stock.
  • Index, commodities and bond CFDs, in general, do not apply commissions. They charge the spread.
  • CFDs have no expiry date, unless some contracts related to the future underlying. Thus, most CFDs have financing costs that we have to pay every night we hold the position, normally LIBOR plus a small rate. There are significant differences between brokers in this regard.

CFDs are good to trade the long and the short side, contrary to stocks that usually are only allowed to trade in the long side. This is a fact that makes CFDs good instruments for the active trader who does not want always play the same side of the business: the bullish one.

It is not the same if you win 10% trading actively, than holding your stocks for the long run.

The latter method will provide us with tremendous drawdowns occasionally that will wreck our nerves (remember the Cyprus bear market).

Any trader would rather earn less in the good years, and not lose in the bad years.

However, to reach the point in which a trader can say he wins an average of 10% annually, is very difficult and takes a lot of experience and talent.

What are CFDs trading?

For that reason, any inexperienced trader that approaches the world of CFDs would do well in doing it very timidly, betting small amounts and with the strictest risk management.

The first years we should be looking for learning, even though we lose.

The important fact is to learn and not to lose too much. There will be time to win later.

  1. Except those who work in brokerages and know that the majority of traders lose. Not to mention if they do day trading.
  2. Forex markets work in a similar way than those of CFDs, since most retail Forex trading is synthetic. In other words, the counterparty to the trades is the broker.

 

Thanks for reading and sharing.