Is CFD good or bad?

CFDs, for most traders, are the most accessible way to trade prominent global assets. However, in various finance discussions, the safety and quality of CFD trading is consistently put into question.

This article will explore why, as well as put CFD markets against traditional trading.

Wat zijn CFD´s?

To understand how CFD markets differ from traditional ones, let’s look at what they are. CFDs, or contracts for difference, are a derivative financial contract that two parties (a trader and a broker) make. It allows the trader to close the contract at will, and capitalise on the difference in value from when it was opened.

CFDs being derivatives means they derive their value from an existing financial asset. As such, they are closely tied to the market, and allow very little fluctuation from that.

Contract is another key word here. It means that traders aren’t purchasing the assets themselves. They can’t, for instance, become a major shareholder in a company. However, as we’ll see later on, this makes very little difference for the vast majority of traders.

To put that explanation into practise, let’s look at a hypothetical market situation. Let’s say Amazon shares are sitting at $50 today. A trader can go to a CFD broker and purchase 10 Amazon share CFDs at $50 (disregarding spreads, which will be touched upon later). A month passes, and Amazon shares jump to $70. The trader will be able to terminate their contract and collect $200.

If that sounds nearly the same as spot trading, that’s because it is. In reality, CFDs have very little functional difference from traditional markets.

Does ownership matter?

At first glance, underlying asset ownership may seem like a huge difference. It’s also why some people are afraid of CFDs, since they feel unsafe not actually owning the asset. However, this aspect of safety comes from the trader’s broker, not the CFD market itself, and ownership won’t matter for most retail traders.

There are three significant cases where owning an asset may matter, one of which was already mentioned:

• Dividends
• Majority shareholders/sitting on boards
• Asset delivery

Dividends, as in payments for holding a company’s stock, can’t be achieved through CFDs, since traders don’t actually own the stock. Realistically, this may prove to be a significant disadvantage for traders who primarily trade shares. Similarly, they won’t be able to become a significant shareholder, although traders who can do that are unlikely to be reading his article.

Lastly, asset delivery is somewhat fringe, but may sometimes be useful for commodities. Since traders who buy oil or metals like gold, for instance, actually own the physical asset, they may have it delivered if needed.

Of course, these instruments are sitting in warehouses, and spot traders who want them delivered need to pay shipping costs. Again, this is a very rare occurrence, but it’s a tactic sometimes used by companies to capitalise on low prices for the physical goods they use.

What are the advantages of CFDs?

If these three were the downsides and CFDs had no other benefits, it’d be fair to say that spot trading was strictly better. Of course, that’s not the case.

The first, and most notable benefit of trading CFDs is their accessibility. Through CFDs, traders from any country where they are allowed can access top global assets. This is not the case for spot markets.

Going back to the previous Amazon example, a trader from India, for instance, wouldn’t actually be able to buy spot shares without jumping through hoops. These hoops often include extra costs, making the trading process less profitable as well.

Meanwhile, CFDs, since there’s no ownership, have no such limits. Traders can freely access assets from any country and market, provided their broker has them on their trading instrument list. This is a major benefit for countries with weaker local markets, and traders who want to join the big leagues and trade top global assets like US stocks.

The next significant benefit is the ability to go long or short easily. Those who remember the Gamestop scandal a few years back know the havoc short selling can wreak on traditional markets.

However, with CFDs, since they only use price differences through contracts, there are no such consequences. This means that traders can go short at any time, with very few limitations imposed by brokerages.

Leverage is another potential upside, although it requires much more caution from the trader. CFD brokers often allow their traders to magnify their capital through leverage, thus increasing potential gains and losses. This lets traders tweak their risk profile and take larger positions with less capital.

Spot vs CFD pricing

It is often said that to make a profit in trading, you only need to win 51% of the time. And while this sentiment may be true in theory, it doesn’t hold up as well in practise. Brokerages attach the costs of their services to trading, tipping the odds a bit further. For traders, of course, it’s better for these costs to be lower.

CFDs mostly offer a spread-based pricing structure. Spreads already exist naturally in markets, but are often slightly inflated by brokers as a cost for their services. For spot trading, costs mostly come in the form of flat fees, either per asset purchased or per trade.

For low and mid-budget traders, which means most retail traders, the spread structure ends up being more beneficial. Because flat fees can sometimes take up a large portion of a smaller trade, they end up being more expensive than spreads, which scale with trade size.

Again, neither one or the other is strictly better. For larger trade sizes, spot markets may have better pricing, and in times when market spreads are particularly high, spot markets may offer a better pricing structure.

Additionally, since CFD brokers often have overnight fees for holding positions multiple days, they are more suitable for traders who tend to open and close positions fairly quickly, rather than buy-and-hold investors.

Transparantie

As noted earlier, CFD safety is a point of contention in the trading community. Again, this comes from bad apples, online brokerages that capitalise on inexperienced traders and operate dishonestly. It’s not an inherent quality of CFD markets.

CFDs as a whole are a highly regulated market, with strict rules of conduct in place. A safe CFD broker will never harm its users and would face harsh fees from their regulators if it were to attempt anything. The same regulators often offer compensation structures for customers to prevent any losses incurred by such situations if the broker is proven guilty.

However, in finance, there will always be scammers. Large amounts of money are moving around and they want a cut, and won’t hesitate to cause financial harm to get it. The same issue exists in spot markets, so this doesn’t really have anything to do with CFDs.

Here are some tips for CFD traders to stay safe:

• Choose a regulated brokerage and check its license number to verify if it’s actually regulated or falsifying its credentials.
• Read reviews from online outlets and other traders.
• Prioritise longstanding brokerages; scammers often pack their bags and start a new service when they’ve been made.
• Find brokerages that outline their services clearly.
• Ask questions if anything is less than 100% clear. If the broker hesitates to answer, that may be a warning sign.

The verdict on CFDs

To answer the question at the start of this article, CFDs are good. For a lot of traders, they are the only way to reach top global trading instruments, offer a better pricing structure, are simpler, and more varied in function.

That’s not to say that they are universally better than spot trading, with each of them having clear-cut weaknesses and strengths, depending on circumstances. But from this article, it should be clear that both are entirely valid ways to trade.People will still continue to doubt CFDs, mostly because of malicious actors in the space.

However, it’s on traders to stay safe. That’s not to say it’s a trader’s fault if they get scammed, but the existence of scammers necessitates caution. Traders who are careful, however, can have their minds at ease while enjoying the streamlined, and often stronger, trading experience of CFDs.

Disclaimer: This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.