What are CFDs?
First of all, what is a CFD? CFD (contracts for difference) are financial instruments that replicate the movement of instruments such as shares, currencies, commodities, bonds and etcetera.
The difference with the traditional financial instruments is that, by buying CFDs, you do not own the underlying product. This fact means that when you trade CFDs you are betting against the broker. The brokers are willing to provide this service because they know very well that the majority of retail traders are losers, and the business is worthwhile.
CFDs allow us to trade the markets with a very low margin, as low as 5% for stocks. That means; we can buy 10.000$ of shares with only 500$. It ensures that if the instrument goes up 5% we could win 500$ minus commissions. And if the instrument goes down 5% we would lose 100% of our account. With this kind of leverage, the brokerages make it easier for people to try doing day trading. That is why brokerages promote day trading day and night. But day trading is very difficult. You have to be very careful with it and with all those that promote it. I do not recommend it at all. Let alone if you are a novice trader.
Advantages of trading CFDS
- Huge leverage. More leverage, more chance of bigger profits, but bigger losses as well.
- More convenient access to the global markets for the retail trader who has not a big pocket. For instance, you can trade the SP500 CFD with one $ per point instead of 50$ that you need to trade the future.
- You can trade the short side almost without restriction.
- The execution of orders and conditions are the same as in stocks.
- There is no limit to do day trading. You need more than 25.000$ to do day trading in the United States. You do not have that problem with CFDs. You can open CFDs account with 500$. Although, in those cases I recommend you to trade CFDs indices, not individual stocks. To trade individual stocks CFDs efficiently, you need a bigger account in my opinion. Nevertheless nowadays there are more brokers that offer the possibility of trading orders as low as one stock without commission.
Disadvantages of trading CFDs
CFDs seem very attractive at first sight. The fact that we can win so much money from home if we use the proper leverage seems to guarantee that we can reach richness in a short time. But we should be very careful. Some problems are:
- The spread is usually a lot bigger than in traditional stocks. That is a very big problem for those who do day trading. For instance, if you try to trade the SP500 CFDs with a spread of two pips (0.5$) it is probably not a good idea. Since you can trade the future with only one pip spread (0.25$). If you trade several contracts per day, that means a lot. Though conditions are quite good in some CFD brokers, where we can find the same spreads as in the real market. In those cases, the broker will charge a commission.
- There are significant costs for trading in the medium term. When you trade with leverage, you will have to pay interest in one way or another.
- You can find significant discrepancies between the real market and the CFD provider in instruments with no liquidity. You have to be very careful when you let an overnight position open with a lot of leverage.
- There is not centralized market for CFDs as there is in futures and stocks. You will be basically betting against the broker. That means that there could be a conflict of interest. But the honest brokers do not care about this because there are so many losers that it compensates for the unusual winners. Anyhow, if a trader is capable of winning big trading CFDs, he will be trading futures and more liquid instruments like institutional forex and stocks. CFDs are for traders with smaller accounts, normally less than 20.000$. In my opinion, you cannot trade futures efficiently nowadays with less than 50.000 $. In Europe, it is not possible to get leverage for stocks and it is not easy to short them. You can get those two things in CFDs: leverage and the possibility to go short.
CFDs have advantages and disadvantages.
I am not against them, but I recognize that trading CFDs can be dangerous if you are a novice trader. But the greatest danger is if you try to do day trading.
Day trading CFDs
So the problem is for the novice trader that is usually attracted to this world by promises of big profits in a short time.
Most of them end up doing day trading with leveraged products, and almost all of them go bust. The most important advice I can give you is to forget doing day trading.
CFDs are very useful for the retail trader who wants to do swing or trend trading.
Commodities CFD trading?
CFDs for commodities are usually very expensive. The typical spread for the oil contract is four pips, and sometimes 10. The future spread is one pip. If one pip equals 10$ you can imagine how expensive compared to the future contract, the oil CFD is. This problem can be reduced if we trade in a longer timeframe. For instance, there is not such a big problem if we pay a four pips spread in oil if we have a 150 pips stop loss.
One of the best instruments for CFD trading is stock indices. While it is true that CFD´s spreads are bigger than those of the futures markets, they can be quite decent for the main stock indices such as SP500, Nasdaq, Dow, CAC, DAX.
If we trade the DAX and use stops of 150 points, it is not a big problem if the spread is 3 or 4 points. Only when your account is well capitalized, let us say over 50 or 100 thousand € I recommend you to trade the futures instead of CFDs.
The SP500 CFD gives you so much flexibility that you can trade the most known future instrument in conditions almost identical to those of the real market. It is an ideal way for novice traders to trade and learn.
The best advantage of CFDs is the fact that they give us a lot of flexibility and if we have a 10.000 $ account we could trade the markets almost like a professional.
The problem of futures contract size
With a 10.000 $ account, we can trade different instruments at the same time without risking too much. For instance, we could trade 10 SP500 CFDs with a 1% stop loss order; at the current price (1980), we would risk 198$ of our account. We could still trade some other instrument.
However, if we try the future it would be very difficult to do so with a 10.000$ account. Because, for the same stop loss, we would be risking 1000$, which is 10% of our account. If we lose three trades in a row, our account has a very big problem. That is why most people recommend doing day trading. All the guys who work for the industry try to sell you the fact that you can do day trading and get rich, and you can start by opening a futures account with 10.000 $ or €. That is the shortest way to bankruptcy. So you better not listen to it and try to study a swing and medium term strategy. And CFDs can be good products for a small retail trader. If you have more than 100.000 $, then you should have a look to the futures markets.
Futures are more efficient than CFDs. But if you have a small account, they are not efficient at all. In that case CFDs are more convenient to trade.
P.S. This is a personal translation from my spanish blog www.brokerparacompraracciones.com.
Thanks for reading and sharing.