CFDs are instruments that provide exposure to the markets at a small percentage of the cost of owning the actual share. They are traded on margin which enables investors to buy or sell an instrument at a lower rate at only 10 percent of the price of the underlying share. CFDs, therefore, serve as an ideal instrument to use for trading notably for those who prefer a commission free instrument.
Contracts for difference were originally developed by the derivative desk of Smith New Court in the early 1990s. Smith New Court is an independent and highly successful trading house based in London.
CFDs offer several advantages compared with certificates and warrants. They are more flexible and open up more trading opportunities to investors.
- As a trader does not own the physical stock, he or she does not need to pay stamp duty.
- Being a derivative, one can easily buy or sell a CFD.
- There are no time limits on CFDs including the index and stock contracts unlike futures contracts. In other words, a trader does not need to worry about any expiration date. The contracts are normally rolled into the next month.
- Trading of CFDs also take long hours and many underlyings can even be traded 24 hours a day. This is unlike the limited hours involved in the local exchanges. With expanded trading hours, traders can make a stop order any time even during the early hours of the morning if the need arises.
- As contracts for difference are traded using leverage, they are considered more efficient to use when trading currency. This is so because a trader allots only a small proportion of his position"s total value to get a deal while still gaining full exposure to the market.
- As CFDs are traded on margin, investors need only a small proportion of the total value of their position to be able to trade. They allow you to have from one percent to 10 percent margin only.
- Traders can profit from CFDs even when the markets fall. In falling markets, an investor can hedge his long share positions by shorting with CFDs. And in this type of financial market, investors can take long or short positions.
As in any form of trading, CFDs involve high risks which mean they are not suited for anybody just wanting to trade in the financial market. It is ideal that one understands the nature of the contract he or she is going to be involved in as well as the extent of risk exposure.
Careful research and application of appropriate risk management strategies are vital notably during unfavorable market conditions. Keep in mind that while leveraging could work on your favor, it could also go against you.
Financing costs should also be taken into consideration especially in maintaining long positions. A bought position maintained for a longer period of time will incur more costs than short positions.
These are just some of the major risks that any CFDs trader should take into account. Keep in mind that different levels of exposure to risks are always involved when trading different financial instruments.