Forex Education | What are CFDs?
Now that I have defined Forex you may have a better understanding of the industry and I can shed some light on CFDs.
These are financial instruments used to speculate on the Forex Market. A CFDs is an acronym for Contracts for Difference. These financial instruments were created to hedge for possible risks, but subsequently evolved into speculation instrument. They give traders the opportunity to benefit from the price movements of a specific financial instrument (like: stocks, commodities, equities, equity indexes, forex) without owning them.
A CFD is a tradable instrument that mirrors the movements of an underlying asset. It is perfect for profiting from short term trades without having the costs associated with the ownership of the asset. It can also be considered a contract between the client and their broker. Trading CFDs have several major advantages, and these have increased the popularity of the instruments over the last few years.
Advantages of trading CFDs:
· Higher leverage:
Trading a CFD provides a higher leverage than traditional trading. Depending on the underlying asset the leverage could go from 1:2 (50% margin) to 1:100 (1% margin and most common in Forex Market) or all the way to 1:1000 (found only with the underlying asset FX). Indices, commodities and stocks normally have a smaller leverage.
Lower margin requirements mean less capital outlay for the trader or investor, and greater potential returns. However, increased leverage can also magnify losses.
· A wider range of trading instruments:
Most CFD brokers offer instruments from all the world’s major markets. This way traders can easily trade any market while open from their broker’s platform.
· Trading on both sides
Thanks to the fact that a trader, using CFDs, doesn’t have to own the underlying asset they can enter both long and short positions. Certain markets have rules that prohibit shorting at certain times. This requires the trader to borrow the instrument before shorting or have different margin requirements for shorting as opposed to being long. All of these features are not generally present in the CFDs market.
· Professional execution with no extra fees
CFD brokers offer many of the same order types as traditional brokers. The includes Stop Loss, Take Profit, Stops, Limits and contingent orders such as One cancels the other and If Done. Guaranteed stops are also available in some type of accounts.
· Low deposit requirements
Due to the of the small margin requirements for trading CFDs, most brokers reduces their first minimum deposit.
· Low fees per transaction
Many brokers, depending on the type of account, do not charge commissions or fees of any kind to enter or exit a trade. The broker makes money by charging the trader for the spread. The trader must buy the ask price and sell/short. In addition, the trader must take the bid price.
The spread depends very much on the volatility and the liquidity of the underlying asset. It is usually small in a high liquidity and low volatility, market and big in a low liquidity and high volatility market.
As you can see trading CFDs comes with a series of advantages, like low margin requirements, easy access to global markets. Moreover, no shorting or day trading rules and little or no fees. However, high leverage could magnify losses, but the risk can be limited with Stop Loss orders.