May 10, 2013

CFDs: A Dynamic Young Trading Market

Although Contracts for Difference are still a young market, their popularity is growing rapidly, particularly among warrant traders and hedge fund managers. That is, they are popular with smart traders. It’s worthwhile to understand what they are and why CFDs have moved from an institutional trading tool to the retail market.

What is a CFD?

A Contract for Difference or CFD is a hybrid of options and futures contracts that is traded much like common stock through a CFD broker. Like other derivatives and financial securities, CFDs are mathematical abstractions. In this case, two parties agree to trade on the change in the price of an asset between the current time and at a future date. Usually, the two parties are described as buyer and seller, but that is something of a misnomer. Since their gain and loss profiles are the same, they are effectively just trading partners.

For example, if a buyer agrees to pay a seller the difference between the price of a particular asset today and at some future date and the price goes up, the buyer pays the seller. If the price goes down, the seller pays the buyer. That is, one party is long and the other is short. If that sounds just like trading in the stock market, it is. So, what’s the fuss all about?

Like most forms of financial innovation, at its base, it’s all about transaction costs. In this case, if a government like the UK imposes a tax on transfers of common shares, a clever finance guy creates a derivative that mimics the returns without transferring any. But, that’s just the beginning. Some of the more obvious advantages include:

• Low transaction costs: The CFD broker makes money on margin interest, which is loaned at a premium as well as on the spread. Do your homework. The Research CFD brokers to make sure that they have a good reputation for filling winning orders.

Hedging: Traders can be both long and short simultaneously, just like stock traders, but at a much lower cost.

• Leverage: Margin is readily available from 1%-10%. Trading on margin magnifies small gains even on carefully hedged positions. Losses add up too, of course, so follow the usual rules on disciplined, prudent risk management.

• Broad Access: CFD traders take positions on thousands of publicly traded securities.

• Transparency: CFD contracts closely track changes in the underlying asset.

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