Is CFD Trading Better than Trading the Underlying Asset?

The global contracts for difference (CFDs) market is forecasted to expand at a CAGR of 4.3% between 2023 and 2028. CFDs allow traders to make the most of price fluctuations in their favourite instruments without needing to own the underlying assets. Find out why there’s growing popularity in CFD trading across the globe.

CFDs are derivative instruments that derive their value from the price movements in the underlying asset. These contracts for difference are between the buyer and the seller. In CFD trading, traders usually enter into contracts with their brokers and pay (or receive) only the difference in the asset price from the opening of the contract to its closing. The trader is speculating on the difference between the open and close prices of the asset, without taking possession of the underlying asset like physical gold, currencies, oil or stock certificates.

Why Trade CFDs?

There are several reasons for the popularity of CFDs:

Exposure to a Variety of Markets

CFDs are available across a wide range of financial instruments, including shares, forex, and commodities. This allows traders to gain exposure to a variety of asset classes to diversify their portfolios.

Low Entry Barrier

CFDs are traded with margin or leverage. This means traders need to fund only a part of the position, allowing those on a limited budget to gain exposure to high-priced assets, such as mega cap stocks and precious metals. Additionally, CFD trading entails lower costs and stamp duty since no exchange of assets is ever done. In some jurisdictions, capital gains made via CFD trading are tax-free since no “goods” are exchanged. This makes all kinds of markets accessible for traders, irrespective of their capital availability.

Ownership-Free

CFD traders don’t need to own the underlying asset to trade it. Consider a trader who wants to add gold to their trading portfolio to hedge against economic uncertainties. Trading bullion brings with it the risk of transporting and keeping the physical gold safe, the hassle of ensuring its purity, and, needless to say, high cost of entry. However, trading via CFDs allows them to take advantage of price movements in the yellow metal by speculating on the price difference without ever having to own or take care of gold bars.

Instant Settlement

Profits from CFD trading are realised in near real-time. The absence of an actual asset exchange drives instant settlement when the position is closed. This means greater liquidity and opportunities for traders to optimise the use of their capital to enter more trades.

No Expiry Date

CFDs do not expire, allowing traders to hold the underlying assets indefinitely. This facility is suitable for a buy-and-hold trading strategy. However, traders must consider overnight fees to weigh the profit potential against holding benefits. Short-term traders use CFDs to open and close positions on the same day, which is often not possible with shares or certain OTC instruments.

Trade in Any Direction

CFD traders can open both short and long positions. Short positions allow traders to take advantage of price drops in their chosen markets. No need to wait for the market to turn up. This opens up trading opportunities in both bull and bear markets. 

Trading CFDs with Leverage

The use of leverage increases the purchasing power of traders. For instance, a leverage of 1:20 means that a trader with a purchasing capacity of 1 unit of the traded instrument can purchase 20 units. The price of the remaining 19 is taken as a loan from the CFD broker and returned when the position is closed.

However, traders must keep in mind that leverage has the potential to amplify both gains and losses. This necessitates the use of sound risk management strategies when trading with leverage.

Hedging with CFDs

Traders popularly use CFDs to hedge against their other investments.

Suppose you expect the price of an asset worth $10 per unit to rise by 10%. You then open a long position worth $500 (50 units) and plan to close the position when it hits $550. Simultaneously, you can open a short hedge position worth $200 (20 units) on the same asset using CFDs.

If the price rises to $11 per unit, your portfolio will look like this:
$500 rises to $550 = +$50 (profit)
$200 rises to $220 = -$20 (loss on hedge)
Total profit = $50 – $20 – trading fee.

However, if the price declines by 10%:
$500 declines to $450 = -$50 
$200 declines to $220 = +$20
Total loss = $20 – $50 – trading fee. 
The extra $20 is your buffer that offsets the loss.

CFD Trading Could Become Even Better

Financial analysts are predicting that advances in artificial intelligence (AI) may transform CFD trading. AI assistance may improve risk management, considering traders’ capital availability and risk appetite. Advanced traders use AI to automate their trades for high-frequency trading and scalping. This eliminates emotional decision-making, increases trading speed, and can also enhance speculation accuracy. CFDs are already available for cryptocurrencies as well, giving traders exposure to this nascent and highly volatile class of instruments. As facilitators integrate blockchain technology in CFD trading, transparency and security will improve, giving traders greater confidence.

While all these facilities are great for enjoying elevated CFD trading experiences, it is crucial to practice on demo accounts to understand how these contracts work and refine their strategy.

To Sum Up

• CFD trading does not involve the exchange of assets in physical form.
• CFDs have a low entry barrier due to the availability of leverage.
• Traders can gain exposure to a wide variety of markets with limited capital.
• CFD trading allows taking advantage of both uptrends and downtrends.
• CFDs do not have an expiration date.
• Risk management is critical for CFD traders using leverage.
• Advanced technologies are improving CFD trading experiences.

Disclaimer

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