Although contracts for difference are a popular way of investing and engaging in the markets, they are still something of an unknown property for many because they are still relative newcomers to the world of financial trading instruments. Originating from other forms of derivative trading, including Futures and Options, CFDs developed over the 90s in London and first became over-the-counter (OTC) when they were used by big players to hedge exposures.
Allowing short selling and offering leverage, the fact that stamp duty exemptions also applied made them an attractive option to many. The other major appeal lay in the fact that a CFD trade never actually involves ownership, as there is no buying and selling of the underlying asset on which the trade is based. This means that a successful CFD trade can result from the value of an asset going up or down and that short or long positions can be taken.
Mirroring
In effect, a contract for difference trading position mirrors the performance of the asset involved, whether it might be a share in a company, a market index, a forex pair or any of the other available markets. In essence, the ‘trade’ is really an agreement between two parties to exchange the difference to be found in an underlying asset when the position is opening and when it is closed. If that difference is a positive one, the ‘seller’ pays the ‘buyer’, with the opposite taking place if the difference is negative.
Costs
Every day that a position is left open runs up charges, which is why short-term trading is the most popular use for the tool, and often means ultra-short timeframes that can be counted in minutes and even seconds. This is all part of the in-built flexibility of CFD usage which sets the process apart from other derivative instruments which operate on set time frames.
Commission is most often charged at 0.10% of the face value of the CFD on both opening and exit points. Different brokers will have various deals on offer and some use fixed prices with no hidden charges added with fees being levied separately. Often commission-free trade deals will look like a good proposition, but it can actually work out to be more expensive depending on how long the position is held and how the cost is factored into the spread.
Leverage
Another big influencing factor in trading successfully with CFDs is leverage, which allows investors to hold a position traded on margin, so they only need a small percentage of the total value of a trade in order to open it. Although this means that large results can come without the access to major capital funds, it also raises the risk of bigger losses too.
Trading successfully with CFDs has to take into account the effect using leverage has. Although it can be powerfully positive, it adds risk to the situation and must be treated with respect. Having a watertight trading plan is key to success and knowing how to utilize all the tools available, such as stop loss orders, is a learning curve that needs to be undertaken before trading even begins.
Pairs trading
Due to the fact that CFDs allow money to be made from successfully shorting assets, forex markets are a popular choice for traders using them. The ability to go short means pairs trading is an effective way of taking a position, essentially this means ‘buying’ a currency and ‘selling’ exactly the same amount of another, with the expectation that the long currency will outperform the other. While this effectively means forecasting on the relative performance of two assets rather than their actual individual performance, it is perfectly suited to the way in which forex markets work and reflects their fast-paced environment which is perfect for CFD trades.
Trading behavior
As with each different form of trading, CFDs have their own set of behaviors that need to be adopted in order to make a success of things. Keeping a record of activity lies at the basis of knowing how well a trading plan is doing and also allows the integration of technical analysis into personal planning.
Because CFDs are based on trading underlying assets, there is no need for an emotional attachment, in fact, this can be a negative factor that leads to holding a position longer and seeing losses multiply. Decisions about entry and exit points for each position need to be taken with indifference to the asset itself in terms of its composition, only its value needs to be considered and assessed.
Of course, any trading environment also needs patience on behalf of the investor. Although that might seem strange when applied to the notoriously fast-moving trading environments usually favored by CFD users, it doesn’t relate to the type needed by ‘buy and forget’ long-term players. Instead the discipline and patience must come in the form of treating losses as inevitable events on the longer road to success.