What are CFDs?
When thinking of investing or trading, purchasing straightforward equities likely comes to mind for most folks.
For those looking to venture outside traditional investment paths, CFDs or ‘contracts for difference’, are a viable option, offering unparalleled opportunities in today’s global markets.
Presented as leveraged products, CFDs quote via bid (a value traders can sell at) and ask (a value traders can buy at) prices. Additional benefits include the choice of trading both long and short positions (buy/sell) and, for UK residents, CFD traders avoid paying stamp duty tax.
It is important to remember, though, unlike the equity market, CFDs are derivatives designed to mirror underlying price movement. As a result, you’ll never own the underlier.
A bit of history
Popularised by a number of UK companies, CFD products entered the retail derivative domain in the late 1990s, allowing clients to sell markets while using leverage. CFDs, according to research, were originally developed by a London derivative brokerage firm called Smith New Court.
It wasn’t until around the year 2000, nevertheless, did CFDs witness notable growth. CFD providers, also known as brokers or dealers (the term is interchangeable), expanded their offering from the London Stock Exchange shares to include indices, global stocks, bonds, commodities and currencies. Indices quickly became the most popular form of CFDs.
CFDs vs. options and futures
Although CFDs, options and futures are all derivative products and, in simple form, represent an agreement between two parties, each market possesses notable differences.
An option contract is an agreement providing the option buyer the right, but not the obligation, to buy (a call option) the underlying asset at a strike price on a specific future date, known as the expiration date. An option writer, who sells a call option, on the other hand, takes on the obligation to sell the underlying asset to the buyer, should the buyer decide to exercise the option.
A futures contract is an agreement to buy or sell a particular asset at a predetermined price at a specified time in the future, also known as the expiration date.
Options and futures contracts are normally traded through exchanges (Chicago Board Options Exchange [CBOE] and Chicago Board of Trade [CBOT]), whereas CFDs tend to trade over the counter, or OTC (not channelised via any centralised exchange). CFDs operate through a network connecting various banks, dealers, and brokers.
Unlike options and futures, CFD products typically have no expiry. A contract for difference trade closes at the end of each trading day and is ‘rolled forward’, meaning (assuming you have the funds) you can effectively keep your position open indefinitely.
Wide range of markets
Trading several financial markets all from your IC Markets MetaTrader 4/5 (and cTrader) platform is possible with CFD products:
- Index tracking CFDs: present an opportunity to gain broad market exposure more easily than with many other instruments. Like other derivatives, IC Market’s index CFDs allow traders the opportunity to participate in the returns from movements in the underlying Index, without actually owning it. You can trade a number of Index CFDs with IC Markets, including US (United States) Indices, European Indices, Asian Indices and the AUS200 Index out of Australia, with leverage up to 1:200, low spreads, deep liquidity and no commissions.
- Foreign Exchange (FX) CFDs: derives its pricing from the real-time exchange rates of foreign currencies. FX CFDs allow you to receive many of the economic benefits of owning the full value of currencies without physically owning it. Over 65 currency pairs are available to trade with IC Markets. Additional benefits include competitive spreads, deep liquidity and leverage up to 1:500.
- Commodity CFDs – although some CFDs are based on spot pricing, many have the futures market as the underlying value. IC Market’s Commodity CFDs are an easy way to gain access indirectly to commodity markets, such as, cotton, wheat, sugar and oil. Over 19 commodities are available to trade with IC Markets offering tight spreads, leverage up to 1:500 and deep liquidity.
- Bond CFDs: are government bond futures, such as, US Treasuries, Japanese Government Bonds (JGBs) and European Bonds. IC Markets bond CFDs permit access to popular global bond markets using smaller contract sizes and lower margins, making it more accessible than the futures market. Over 6 bonds are available to trade with IC Markets, along with no commissions, leveraging capabilities up to 1:200 and deep liquidity.
- Cryptocurrency CFDs: allows exposure to price movements in cryptocurrencies. Additional features from IC Markets include leverage up to 1:5, the ability to trade long and short, ASIC regulation and no commissions.
- Share CFDs: provides exposure to individual shares, mirroring movements in the price of the underlying instrument directly from the share itself. IC Markets single stock CFDs gives traders the ability to trade the world’s most popular companies, such as, Apple, Facebook and BHP Billiton. Stocks are available exclusively on the IC Markets MetaTrader 5 platform which offers advanced functionalities for both new and experienced traders who require world-class execution and superior charting tools.
For available trading hours for specific markets please refer to: https://www.icmarkets.com/en/trading-pricing/trading-hours/.
You can also view the trading hours for each CFD market from your Market Watch window (Ctrl+M) on the MT4/5 platform. Simply right-click anywhere inside the window and select ’Symbols’. Following this, select ‘Specification’ for the financial instrument you would like to view and note ‘Trade’ hours.
CFDs trade on margin. Margin is the amount of money needed as a deposit in order to open a position with your broker. Margin requirements vary from instrument to instrument and can be changed at any time to reflect market conditions. IC Markets offer very reasonable margin rates as low as 0.5% on most global stock indices.
Leveraged trading permits you to trade larger amounts than you normally could. In essence, it offers the ability to control a large sum of capital using very little of your own funds. Trading CFDs with leverage is straightforward, though can be considered high risk if not controlled accordingly. For every $1 in your account you can control $X amount where X is greater than 1. For instance, 1:100 leverage means you control $100 for each $1 in your account. If you have $1,000 in your account this means you can control $100,000 in positions.
For newer traders, avoiding highly leveraged positions is advised
CFD trade example
Say the AUS200 index is oversold and ripe for a long trade.
- Market price currently trades at 4950.00/4951.00.
- One contract equates to a $1 per index point.
- No commission on indices.
The trader goes ahead and buys five contracts at 4951.00 (the ask price). In this example the point value equals $5. Price moves in favour and rallies to the set take-profit target at a closing price of 4990.00/4991.00. The outcome of this trade, therefore, equals a 39-point gain from this CFD position:
- $5 per point.
- Entry price of 4951.00.
- Exit price of 4990.00.
- Total profit = 39 points, or $195 gross profit (39 points * 5 contracts).
To calculate the net profit, however, you must include any financing or dividend adjustments. Financing adjustments are applied to Indices daily. In the case of a buy trade, interest is debited from the trader’s account, and with a sell trade interest is credited. Dividend adjustments are also applied whenever a stock in the relevant index goes ex-dividend.
If you’re unsure about how CFDs work, consider applying for an IC Market’s demo trading account (https://www.icmarkets.com/en/open-trading-account/demo/) prior to opening a live account.
The demo account mirrors live trading platforms and provides a virtual balance to trade with. This enables you to become familiar with the platform’s features and trading tools, and ultimately allows you to decide (risk free) whether CFD trading is suitable for you.