The popularity of contract for difference (CFD) trading has been steadily growing in the UK, and many new traders are diving straight into it. They are attracted to the option of leveraged trading with a much lower investment, not to mention the flexibility, low commissions and tax benefits. However, what about those investors who have been happily trading traditional shares for many years? Is it worth making the switch to CFD trading?
That will depend on a few different factors, including capitalization, trading style and overall investment aims. This also, of course, requires a willingness to make changes and learn a new investment model. It does take time and effort to learn CFDs, but an experienced trader in any market will find the concepts and skills involved in successful CFD trading to be familiar.
CFD trading allows investors to profit from price movement on an asset without ever actually owning the asset itself. It involves a contract between the client and the broker, and investors only need to put down a small percentage of the value of the asset as security, making it an extremely efficient way to invest in short-term trades.
Trading CFDs is similar to trading shares, with a few noticeable differences. Traders never actually own the asset, so they do not have shareholder status or voting rights. They do, however, get most other benefits, such as capital gains and dividends. In the UK, CFDs are exempt from stamp duty, offering another attractive benefit over traditional share dealing.
CFDs provide a wide variety of trading opportunities, including stocks, commodities and forex trading. There are no minimum amounts of capital required to day trade as in some other markets, and many brokers require a reasonably low minimum deposit to open a CFD account. Most brokers will provide a free demo account for new traders, and the quality of research and education offered by top CFD brokers is usually extremely high in quality.
Disadvantages of CFD trading include the risks inherent in taking advantage of high leverage and the financing fees involved in that leverage. As traders put down only a small percentage of the value of the asset, they effectively borrow the outstanding amount, and as with any loan, this comes with an interest charge. It is generally no more than a couple of points above the published lending rate, but you certainly need to be a factor it in when developing CFD trading strategies and putting money management guidelines into place.
To be successful at CFD trading, investors require the same traits as an accomplished trader. In particular, successful CFD traders are:
Sensible about leverage
Strong on technical analysis
Dedicated to good risk management
CFD trading can provide high leverage and low margin requirements. The low capital layout and greater potential returns are a big attraction for investors, but increased leverage can, of course, also magnify losses. Successful CFD traders are highly disciplined in the way that they use available leverage.
Most CFD brokers will offer leverage based on the size of the position that the investors are trading and the instruments that they are trading. A 10:1 leverage ratio, for example, means that the trader’s minimum margin requirement is 1/10, or 10%. So, the trader needs to put down at least 10% of the total value of the trade in cash. This means, of course, that with a leverage of 4:1, the requirement goes up to 1/4, or 25%. Lower margin requirements are likely to be available on smaller positions, and leverage can vary depending on whether you are using CFDs for share trading or forex trading.
It is important to realize that, regardless of what a broker offers as maximum leverage, it is the trader who controls the amount of leverage that he or she is actually trading with. A quick way for an inexperienced CFD trader to go broke is to start trading with too much leverage. It is highly advisable to be conservative when you start with leveraged trading, even if you typically have an aggressive approach to risk.
Technical analysis is vital to successful CFD trading. CFD traders are effectively betting on price movement, so they need to calculate the asset’s movement between trade entry and exit. They are concerned only with the price change, not the actual value of the underlying asset.
Many traditional traders are also strong on technical analysis, but they might pay a lot of attention to fundamentals and take a long-term view. Many CFD traders are day traders, and almost all base their trading strategies on the short term, relying heavily on technical indicators that allow them to accurately monitor price movement.
Risk management is another factor that all traders will be familiar with. CFD trading adds a few more considerations, however. In CFD trading, the price is “marked to market” each day, and trader accounts get credited or debited according to the change in price value and the interest charge on leveraged funds. In practical terms, this can result in a margin call if funds decrease, which requires topping up an account with fresh funds. CFD traders practicing good money management will only invest about 50% of available funds at any time to protect against this eventuality.
It is also advisable to be conservative in terms of the percentage of funds used on any one trade, with many CFD traders risking just 1% or 2% of overall capital on each trade.
There are some big advantages to trading CFDs and some important issues to consider if you are more used to traditional share trading. Keeping the above in mind, though, should enable you to make an informed decision and a smooth transition if you decide that CFD trading is definitely for you. If you are still thinking of switching from share trading to CFDs, then it might be a good idea to take a close look at our CFD-specific trading tips.