Do CFDs represent a viable investment alternative?
Contracts for difference (CFDs) are becoming an increasingly popular investment alternative for frequent and experienced traders in today’s financial market. Industry analysts forecast that from 2019 to 2023, the CFD market will grow at a compound annual growth rate of 9.04%%.
However, with more and more people trading and investing professionally—or as a secondary source of income—having a firm understanding of the investment world is necessary to avoid losses.
Outside of stock investments and spread betting, one form of trading that is worth looking at is CFD. It is a financial derivative product that allows investors to trade by speculating on the underlying security movements, without the need for ownership and physical settlement of the underlying security.
The underlying security refers to common shares listed on a stock exchange, but can also be foreign currencies, bonds and indices where there is a transparent market of price and traded volumes.
Generally, CFDs are traded over-the-counter (OTC) and follow the economic performance of the underlying security based on its price movement. Investors can take long or short positions on the underlying security, and unlike futures contracts, they have no fixed expiry date or contract size. Anyone who holds a long contract, usually intra-day, is a beneficiary of the upward price movement of the underlying security and receives payment for the profit earned from the issuer of the contract.
The contract is usually between a trader and a broker is generally closed out by the end of the trading day—with the settlement of profit and loss, less related commissions, paid in full.
Michael Yeung, head of CMC Markets Canada, said CFD is a great investment that allows clients to trade underlying assets they would typically have challenges accessing at a low cost.
For example, rather than purchasing an ETF that attempts to track oil, CFD is the closest to actually purchasing crude, said Yeung.
“With a CFD, you are buying it by the barrel. You specify the amount in barrels and either go long or go short. The price you see on our platform would be the same that you hear on the news,” he said in a report.
“You are not buying an ETF which has an irrelevant price, you are buying at exactly what you think and hear, for example, if you think oil is going to go to $80 a barrel.”
Yeung invests about 5% of his personal money in CFDs and assesses his position weekly, advising that investors must be careful when searching for a reputable broker.
CFD brokers act as the middle-men between the market and the traders. These brokers define the contract terms, the trading assets (stocks, indices, and commodities) as well as the margin requirements. Also, they provide traders with the trading platform, technical analysis tools and the right execution speeds for quick trading.
A sophisticated software system like Friedberg Direct by Avatrade that interfaces the issuer with the intermediary and the end client is needed for trading on-line CFD products in an OTC market.
This system allows the issuer to effectively monitor its exposure to open contract positions that it has issued instantaneously. It provides price feeds from listed markets where the underlying equities and indices trade—or OTC market places where underlying bonds or currencies trade. It can also provide the investor with all the necessary investment tools such as charts, news, price quotations and position monitoring.
CFD trading brings a lot of advantages to traders looking to expand their investment strategy. Unlike purchasing shares, CFDs are free from stamp duties and during its lifecycle, traders are entitled to any dividends paid or stock splits issued by the company whose shares you’re purchasing.
Furthermore, the flexible contact sizes allow for partial closing of positions with low margin requirements ranging from 1% to 10% and low execution costs ranging from 0.2 % to 0.25%. Investors canalso trade in numerous stock market indices, such as the FTSE 100, as well as a range of currency exchange rates.
CFD provides exposure to foreign markets with no physical settlement of the underlying. Investors can profit from both rising and falling prices. Nonetheless, there are risks associated with CFD but the key is controlling leverages, using stop losses without exception, and trading with caution.
CFDs are currently available in listed and/or over-the-counter markets including the United Kingdom(UK), South Africa, New Zealand, Switzerland, Singapore and Italy. In Canada, it is legal to trade CFDs but with a registered broker with the Investment Industry Regulatory Organization of Canada (IIROC). However, CFD dealers are restricted from selling to a client who isn’t a retail client and meets the legal definition of “qualified party”.