Why Should You Trade CFDs?
Reading time: 8 minutes
CFDs, or Contracts for Differences, represent an innovative and (relatively) new way to engage and trade global markets, including major asset classes, such as currencies, stocks, bonds and commodities. CFDs are leveraged derivative products and began growing in popularity in the 1990s. Unlike dealing in physical shares, where the investor takes ownership of the shares of a company that are traded on a regulated public stock exchange, trading CFDs provides access to the underlying asset’s price movement through over-the-counter (OTC) transactions. This means that the trader or investor does not take ownership of the underlying assets, and unlike futures and options, all CFDs are cash settled.
Margin and Leverage
Traders and investors can access favourable leverage in the CFD space, which is why many elect to trade CFDs. Leverage is the ability to increase a trading position’s exposure by putting down only a fraction of the notional value (margin requirement). Put simply, market participants leverage their account equity using margin, hence ‘trading on margin’.
Let’s examine a simple example of a Forex trade through CFDs, using the EUR/USD currency pair at $1.3000, trading a 100,000-unit position. If you physically (void of leverage) buy 100,000 euros at an exchange rate of $1.3000, this will mean a purchase price of 130,000 USD (100,000 * 1.3000). And if the currency pair’s price moved to, say, $1.3100, and you sold back your euros at the new exchange rate, this delivers a 1,000 USD gain, minus any commissions for the exchange (100,000 * 1.3100).
However, you could have generated the same return but only put down a fraction of the 100,000 investment using margin. Assume that the leverage ratio for this trade is 30:1, meaning the margin percentage is 0.33 or 3.3% (1 / 30). So, we would put down 3.3% of the notional amount: 3.3% of 100,000 USD (3,300 USD). The pip value of this trade is 10 USD (0.0001 * 100,000), which means that a 100-pip move would generate a return of 1,000 USD, identical to a position void of margin.
Remember that with currency trading, you can also trade fractional lot sizes. The above example uses a Standard Lot, though with FP Markets, you can trade Fractional Lot sizes, such as Mini Lots (10,000 units of the base currency) and Micro Lots (1,000 units of the base currency).
Range of Markets
Trading through CFDs unlocks the door to the global marketplace.
With FP Markets, variety and flexibility to trade across multiple asset classes are key. A wide selection of Major, Minor and Exotic currency pairs are available to trade, along with more than 10,000 individual equities across major international exchanges, as well as access to popular commodities, indices, bonds, ETFs and digital currencies.
Trade Rising and Falling Markets
Having the freedom to easily trade long (buy) and short (sell) is a benefit for many traders and investors. This is not the case with physical share dealing. Here you must borrow securities from the broker, as you do not own the securities you sell, and then hope that the price of the said shares decreases enough to record a profit. At this point, the shares are bought back, and you return those shares (normally with interest) to the broker to generate a return. This is usually facilitated through what’s known as a broker-dealer.
CFD trading simplifies the process as ownership of the underlying shares does not occur, as highlighted above.
Hedging with CFDs
Like everything in life, there are also risks when engaging with the financial markets. Traders and investors attempt to mitigate this risk by adopting a risk-management system. This can be as simple as employing a protective stop-loss order or setting a logical risk tolerance per trade to more advanced risk-management practices, such as hedging.
CFDs can be particularly useful for hedging risk, given the margin available. Hedging is the action of offsetting risk through inversely correlated financial instruments. As a basic example, if you are long Tesla (TSLA) or Microsoft (MSFT) and feel a correction could be seen, some traders (investors) may elect to offset the risk of an adverse price movement by executing a short CFD position in the same stock. Should the underlying stock price lose value, the losses are offset by the CFD short position. Remember that most CFDs are cash products that do not expire and are automatically rolled over.
Interested in Trading with FP Markets?
FP Markets offers a truly unique trading experience. From market-leading tight spreads to a multilingual 24/7 customer service department, FP Markets caters to all trading styles, including scalpers, day traders and longer-term position traders.
Consider opening a demo account with us today and experience the difference. Account opening takes only a few minutes, with access to a broad range of trading platforms, like MT4 and MT5, as well as cTrader and Iress.