How do CFDs work?
CFDs work pretty much exactly how any other asset works. A trader simply places a trade on the market based on what he or she had researched and then waits for the results. One important difference is what CFD traders actually call “buying” and “selling.
They refer to them as “long” and “short”, but the names don’t necessarily have any meaning in them. They’re just words.
The most unique answer to how does a CFD work is that it’s an instrument that can help people make payouts even when the market is going down. That’s right, if the trader had predicted that the market was going to go down and made a “short” trade, he or she will still find some payout.
Advantages of CFDs
There are so many advantages to talk about for CFDs, so let’s try and make a list before we begin:
- Payouts from decreasing markets
- Margin trading on stocks and commodities
- Variety of assets
Now let’s try and break all of these down one by one.
Decreasing markets - as already mentioned before, one of the biggest advantages of CFDs is that traders have a unique opportunity to make payouts even when the market is going down. All they have to do is simply “register” their prediction in the system, and if it turns out to be true, they make a payout. Such trades are impossible in regular Forex or stock markets.
Margin trading - margin trading is not necessarily considered an advantage for beginner traders, but it is very important for expert traders. It basically allows a person to buy or sell much more than they have available on their account. Let us try and bring an example of how does CFD trading work with margin.
Imagine that a company’s stock is worth $10, so you buy 1000 CFDs because you believe the price is going to increase very soon. However, you soon find out that the margin rate for this company is 10%, so you only need to deposit 10% of your trade size. 10x1000=10,000 which is the actual amount you were supposed to deposit. But thanks to the margin rate, you need to deposit only $1000 now.
Let’s say your prediction was correct and the company’s stock is now at $15. That immediately puts your trade size to $15,000. Take away the $9000 that was given to you by the broker and you are left with a $6,000 payout. This would be very hard to do without margin.
Variety - when it comes to variety, it’s safe to say that CFD traders have hit the jackpot. No matter what instrument they want to trade, it’s available right in front of them, if the broker supports it.
Almost every single financial asset can be traded through CFDs, which makes diversifying your portfolio quite easy.
In a sense, it is considered to be the best way to diversify a portfolio by some traders. You are not only trading different assets, but you are trading in completely different markets. So the effects are different as well. If FX is doing terribly, people simply switch to stocks or commodities.
Disadvantages of CFDs
Although there are more than enough advantages, there is an equal number of disadvantages with CFDs as well.
- Can’t have long-term positions
- Leverage risk
Let’s try and explain all of them one by one as well.
Deadlines - these are sometimes referred to as the biggest problem that CFDs have. You see, every position a trader opens needs to have some kind of deadline given to it. These are usually a week, but there have been cases when people were given only 24 hours to close their trades.
If the trader fails to close their trade before the deadline, it will be automatically closed no matter if it is in a good or bad position. The only way to postpone the deadline is to pay a fee, which can sometimes be quite a lot. Considering that there are a lot more fees associated with CFDs, it can sometimes get very expensive.
Long-term positions - another big disadvantage of CFDs is that traders cannot open long-term positions. Well, you still can, but it would require postponing the deadline over and over again. That can get so expensive that by the time you’re ready to close the trade, you’ve already spent the exact amount you were supposed to get as a payout. So your total payout would be zero. Considering how some assets take a long time to grow a lot, this could become a problem for traders down the line.
Leverage risk - Sure we first mentioned leverage or margin trading as an advantage, but it also has its dark side as well. You see, a leveraged CFD trade may bring quite a lot in payouts if it is successful, but if it is not, then it will make the trader lose much more than they would have without the leverage. This is one of the biggest CFD trading risks that hold traders back. Most traders simply don’t use the leverage at all; but at that point CFDs pretty much lose all of their value too.