Learning about CFDs

Submitted by Craig Strzelecki on 2 June, 2008 - 12:20

Let's learn about (Contracts For Difference) CFDs, find out the benefits, advantages and disadvantages of trading with CFDs

Contracts of Difference (CFDs) appeared in the decade of 80s in United Kingdom. They are now popularly known as equity swaps or CFDs in today’s institutional market. They are basically an agreement between the investor and the dealer or broker who provides Contracts of Difference to reconcile the difference between the opening and the closing price of a CFD trade position of an investor. The overall agreement is done on cash basis. So let’s learn about CFDs!

Pros and Cons of CFD Trading

CFD portrays the actual performance of stocks in the market. You do not actually need to own the shares but the profit or loss is determined by the buy and sell price of any stock. Since CFDs are traded on margin, you need only a small amount of over all value of the position to start trading.

Corporate changes also affect CFD prices. They also become instruments of profit in a falling market. You can easily sell those shares that you actually do not own and buy them back when the market has improved. CFD share owner is entitled to cash dividends as well as participation in stock splits. This means traders get a small “leverage” in to stocks for a small upfront investment.

On the other hand, one must remember that CFDs are after all OTC or Over the Counter derivatives. The CFD provider provides you CFDs at his terms and conditions and not according to the Securities Exchange. Most of the time these terms and conditions are designed to benefits the provider himself and not actually the investor.

The margin money is actually a security deposit to prevent the provider against susceptible losses. You may be asked for more money if they have bought the stock thinking that their price may appreciate. In order to prevent such a condition, you must exercise the percent stop loss facility that is as per your individual leverage. However, the CFD provider is not obliged to stop losses specified by you and they may ‘bundle’ all the orders from other traders and may give you an average price.

Benefits of CFDs

CFDs offer a greater leverage level to the CFD provider. Guaranteed Stop Loss can help the provider to cap the margin requirement and he can set a leverage level suited for his style.

CFDs also allow you to quickly cut your losses and offer greater control risk control especially in a volatile market. At the same time, they also reflect the true value of your current equity if you use a CFD provider who offers “at market” value. You should always put Automated Stop Loss when you do not trade actively in the market and are busy with your daily life in other businesses. You can use CFDs as an alternative to Exchange Traded Options and you can hedge your positions in equity portfolio.

Lastly, you would need to pay commission to the CFD provider for hedging. However, you would be entitled to receive the net interest as you would be shorting the stock.

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