Contract-for-difference (CFD) trading is a popular alternative to traditional investing because of its ability to maximize capital investments and, in turn, increase your potential profits or losses. This approach to forex trading has grown in popularity over the past decade, especially with some brokerage firms offering negative balance protection to limit heavy losses that would put your trading account into debt.
So what are the advantages of CFD trading? Here’s a look at some of the other key benefits.
Greater Leverage in Trades
In more traditional investment vehicles, traders have to commit 100% of their capital to a trade if they want to open a position. Think of the standard way most traders purchase stocks: If you want $1,000 of a stock, you have to tie up all of that money in the investment.
But with CFD trading, the current margin requirement for opening a position is just 5%. With less capital required to open a position, traders can increase their potential profit margin. If you want to open a $1,000 position in a forex pairing, for example, you need to allocate only $50 to that investment. Meanwhile, the other $950 remains free for you to commit to other positions.
This approach does create the potential for much larger losses, but negative balance protection can mitigate some of this risk. This creates a net positive when you’re looking to use leverage to maximize potential gains.
Earnings Potential in Both Bear and Bull Markets
CFD trading allows traders to open positions in both rising and falling markets, giving you the ability to capitalize on any type of market fluctuation.
With greater flexibility in pursuing opportunities, traders enjoy greater control over how, where, and when they open positions in a market.
Flexible Lot Sizes
Given the potential volatility of CFD positions, many brokers offer flexible options when it comes to trade size. In doing so, brokerages are able to accommodate a wide range of traders—especially beginners and casual traders looking to experiment with investment strategies while limiting their risk.
While lot sizes may be restricted by your forex platform and the type of trades you’re trying to execute, CFD trading often allows more flexible lot sizes as traders balance the amount of margin they’re using with the amount of risk they’re taking on. A standard lot of 100,000, for example, represents the number of quote currency units required to purchase your base currency.
At the time of this writing, a single unit of GBP is worth $1.31 USD. To purchase 100,000 units of the base currency, GBP, you would need 131,000 units of USD in a standard lot order. At a 5% margin in a CFD trade, it would be $7,050 USD to purchase a standard lot. But alternative lot sizes may also be possible, including a microlot of as little as 1,000 units.
Since the amount of money being staked to your lot is much smaller than the actual lot purchase, your platform will likely offer expanded options. Familiarize yourself with these options as you develop your strategy for making a CFD trade.
If you’re new to trading, consider starting with the smallest allowable lot sizes to minimize your risk. As you gain confidence in your trading strategy, you can always increase your lot sizes.
Lower Trading Costs
Compared to those of more traditional trading methods, CFD brokerage fees tend to be much more cost-effective. Brokerages typically draw their earnings from daily percentages earned by financing the transaction. For example, when you spend $50 to open a $1,000 position, the brokerage charges a small fee to cover the $950 difference.
In addition, traders usually pay the “spread” on a position when they decide to sell. Always ask to see a broker’s fee schedule before you open an account and start making trades. You want to know exactly how you’ll be charged for your trading before you give your money to a firm.
Broader Hedging Options
Thanks to the limited capital commitment needed to open a position, traders have access to funds that can be used to implement hedged positions and limit their risk at any given time.
This is a useful strategy when you’ve taken a risky position on a CFD, or when a long-term position is accruing losses. Instead of selling at a loss and draining your account’s funds, you can open additional positions in hopes of generating earnings that balance out your initial position. When used correctly, a hedging strategy can balance some of the risks that come with CFD trades.
No Expiration Date
Unlike other investment instruments, CFDs don’t depreciate over time. They also don’t have set expiration dates, and they feature far fewer restrictions on closing a position than other types of investments, such as futures.
As a result, traders can be patient when taking long positions. Day traders may not see much benefit, but if you’re able to take a long-term approach to your investment, you can ride the market through multiple cycles and wait until the time is right to sell.
What to Keep in Mind When Trading CFDs
Now that we’ve examined what the advantages of CFD trading are, if you’re interested in trading CFDs to boost your potential profit margins, you also need to understand the potential risks and pitfalls that come with this strategy. Before taking action to engage in CFD trading, remind yourself of the following risks and conditions:
- CFDs can put you into debt. If you overextend yourself and suffer big losses, you don’t only stand to lose the principal you’ve invested. If you invest $500 at a 5% margin and purchase $10,000 of a currency, a 30% decline in this asset value—$3,000 USD—would create a net loss of $2,500 that you would be obligated to repay.
- CFDs are highly complex trading tools. Given the risk and complexity in leveraging CFDs for profit, only experienced forex traders are encouraged to try this trading strategy.
- CFD clauses could catch you by surprise. Make sure you know how to read these contracts carefully—otherwise the rules or provisions of the contract could affect your plans and your net profits.
- A CFD provider represents another kind of risk, known as counterparty risk. Since the contract is executed by your contract holder, there are many ways your profit potential could be undercut by the counterparty’s actions. Delays in purchasing your desired assets, for example, could result in that purchase being executed at a worse price. The contract holder may also close out your position per their discretion, securing losses against your will—and with little option for recourse on your part.
- CFD losses can pile up quickly. Just as quick profits are possible with CFDs, losses can occur swiftly, putting you in a deep hole before you have had a chance to react.
There are a number of distinct, potentially lucrative advantages of CFD trading. But because of their significant potential rewards, these investments still represent significant risk and need to be carefully considered before a position is opened.
To maximize their opportunities with this investment strategy, traders should follow the best practices of CFD trading, thoroughly research investments before opening a position, and exercise caution when committing capital to any CFD trade. Meanwhile, make sure you understand the fee schedule of your preferred broker, and seek out a broker who offers risk-limiting features such as negative balance protection.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.