Contracts for Difference or CFDs have been in the market for decades. However, they only began featuring among online trading platforms a few years ago and now; most online brokers are adding CFDs amongst their trading instruments.
Additionally, when CFDs were first introduced, they used to feature unique asset classes such as Indices, but over the last couple of years, traders have been able to trade Stock CFDs on various platforms.
This means that traders can now trade the shares of Apple, Google, Facebook or Yahoo via CFD brokers, rather than via a traditional brokerage house. This makes a huge difference in the stock market.
So, what exactly are CFDs?
Just like the phrase itself, a Contract for Difference is the difference between the point at which a trade is entered and the point where the trader exists the trade. It is simply a tradable instrument whose pricing is based upon the pricing of an underlying asset, which can be a stock, an index, or a currency pair among others.
Trading CFDs does not result in actual ownership of the underlying asset, but traders can receive dividends when a position held qualifies for a dividend payment (meets the dividend issuance requirements as per different companies).
Some brokers may not offer this, but one of the top online CFD trading brokers Forex Capital Markets (FXCM) does pay dividends to its clients depending on their holdings. FXCM offers CFD trading via its UK branch.
CFD trading is not currently permitted in the US due to the stringent regulatory requirements for trading in stocks, but traders from several parts of the world can participate.
How CFD trading works
Normally, if you are looking to sell short a stock, some brokers will ask you to provide a 50% margin in order to execute the trade. So, for instance, if you are looking to sell short 100 shares of a stock of XYZ company, which trade at $130 per share, you would need a cash outlay of at least $6,500.
Now, with CFDs, you only require a margin of about 5% because of the leverage provided by the broker, which means that instead of having to deposit $6,500 in your account, you will only need to deposit $650.
In other words, CFD trading gives you the ability to trade in huge volumes than you would possibly have been able to if trading shares via a traditional brokerage house.
How CFD trading affects the stock market
Many traders from countries that allow CFD trading are now shifting to online brokerage companies that have CFD trading as part of their trading instruments.
This means that most traders are now turning away from the traditional value investing philosophy to speculative trading, aiming for short term profits. While corporate investors are still the main drivers of stock prices and liquidity, High Frequency Trading via various online platforms has become a major topic of discussion amongst financial bodies.
So, should you choose CFDs over traditional stock investing?
This depends on the investing philosophy one chooses to use. Short-term traders will be more inclined towards CFDs while long-term investors might choose traditional investing. This does not necessarily mean that you can’t mix the two strategies.
While long-term investing might be profitable because of the additional payments that investors receive in terms of dividends, stock buybacks and other company incentives, short-term trading allows traders to capitalize on the volatility of the stock market through CFDs.
The biggest benefit of trading volatility is that it does not matter whether the market is in a recession or boom. Normally, when in a recession, traditional investors might be required to top up their margins in order to take short positions on stocks. This is not the case when it comes to CFDs. In fact, instead of topping up the maintenance margins, short-term traders of stock CFDs benefit from high leverage provided by online brokers.
In addition, with CFDs trading, traders are not required to own the stock in order to trade it. This means that even pure-play Forex traders can trade stocks on the forex brokerage platform, which ensures high levels of liquidity.
In traditional investing, liquidity is affected significantly during recession because few people are looking to buy stocks. In most cases everyone tends to be looking to sell.
In summary, CFD trading is certainly a smart way for retail investors to approach the market, but this form of trading also comes with various risks, such as the one associated with the infamous margin trading. High leveraging can lead to massive losses when a trader’s open positions go against his predictions.
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