Pros and Cons Trading CFDs
In short, CFD (contract for difference) is a contract between buyer and seller that requires the buyer to pay the seller difference between the current value of an asset and its value at the time of contract.
The buyer is commonly referred to as a trader or investor, and the seller is a broker or a brokerage firm.
CFDs allow traders to take advantage of price fluctuations without physically owning the assets.
A keynote to add here is that the value of CFDs is determined by price change at the entry and exit point, and not the asset's underlying value.
Pros of CFD Trading
1. High Leverage
CFDs provide traders with high leverage. Traders use leverage to buy assets in the financial markets. Traders get a borrowed capital from brokers for higher potential returns.
Leverage can vary from broker to broker, keeping in mind that EU brokers do not offer leverage higher than 1:30. Higher leverage means trader's minimum capital and potentially higher returns. However, it is a double-edged sword.
2. Lower fees
CFD brokers provide traders with a lower fee than traditional brokers.
Brokers' fees depend on the difference between the asking price and the bidding price, known as a spread.
If a trader wants to buy an asset, he/she needs to pay an asking price. On the other hand, if a trader wants to sell an asset, he/she needs to pay a bidding price.
Although brokers can offer fixed spreads, the value of the spread depends on the volatility. The higher the volatility, the higher the spread.
In the forex market, major currency pairs like EUR/USD or GBP/USD have lower spreads than minor currency pairs such as NOK/MXN.
3. No shorting rule
Certain markets prohibit shorting and require traders to go long before short. In CFDs, traders can short any asset. Like taking long positions, traders can take short positions.
4. Multiple trading assets
CFDs instruments comprise of forex, stocks, commodities, indices, and sectors. This is helpful for those who want to try different markets and diversify their investment portfolio.
5. Global accessibility
CFD platforms allow global accessibility. Traders can trade round the clock, five days a week.
6.Negative Balance Protection
In order to be safeguarded throughout your trading experience, look for brokers who offer NBP (Negative Balance Protection). This ensures that you cannot lose more than what you have invested.
Cons of CFDs
Paying for entering and exiting the trade kills potential profits, especially when you have a small trading account. The spread also decreases the wins and increases losses by a small margin.
CFD instruments can be complicated for some individuals; therefore, they require extensive research and analysis.
In addition, there are certain risks associated with CFD trading. To keep your positions open, you need to maintain a certain margin requirement. If the price goes below this margin, your position will be automatically closed.
Besides this, leverage is a double-edged sword and can increase your potential losses. There can also be lags in trading execution, which can hurt your profits.
Trading CFDs requires a deep analysis of the underlying assets. A trader should consider its pros and cons before investing.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.