What are CFD and How Do They Work

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What are CFDs and How Do They Work

CFD or Contracts for Difference

CFD are contracts that exactly follow the price movement of the underlying market, and are also priced in such a way, as if you traded the real thing, there’s no pricing difference, and even tax legislation treats CFDs in the same way as real asset trading, because CFD traders gain exactly the same market exposure as real investors, if not better. Hence they offer direct market access and superior liquidity, which in some cases is better than even the real thing.

Large investors and banks cannot use CFD because CFD cannot facilitate very large size trading, they are made for retail traders and investors, and for trading size of up to about $100 per point or cent. Investment banks use Futures, which are also leveraged instruments, but these are more expensive to deal in, and don’t have linear pricing at all, which means they are not suitable for accurate trading because a Future contract’s price tends to deviate from the underlying market significantly, because as the name implies, it has to do with the future.

This is the reason why wise traders use CFDs, and not Futures to do their trading. Because CFDs are superior in their pricing structure, and much more beneficial. As far as leverage goes, many instruments offer leverage, and it is not a big deal, the big deal is in the hidden benefits of CFDs which many new traders often fail to see.

Trading CFD

When you trade CFD contracts on stocks, you buy or sell the equivalent of number of shares, in the case of a stock, and the equivalent of a quantity of gold, in the case of gold. And every asset is quoted in the usual specific currency, gold is always quoted in US dollars, as is crude oil. Stocks are quoted in their local currencies. This brings in forex market fluctuations into the equation, and these can be significant over one week or more, as your open CFD trade will be exposed to the effects of the forex market.

CFD offer superior liquidity, and even allow you to go short on major US stocks, even when actual short selling is temporarily restricted in the US, this happens only once every 10 years, during some bear market conditions, but it does happen, and CFD traders have a tremendous advantage over non CFD traders. This benefit alone may save you or make you $100,000 in one month, in such market conditions, while classic stock traders cannot do anything about it.

Trading Stocks through CFD

When you want to buy shares of ABC company, through CFD, you simply click on the trading platform and choose to buy the number of shares that you want, 10, 100, 1000 etc. You only need to maintain sufficient funds in your CFD account to hold the trade, and to have appropriate stop losses, large enough to match market volatility. If ABC stock price rises by an X amount, you end making a profit which is X times the number of shares dealt, is that simple. But the benefit is that CFD price follows the actual stock price very very closely, you don’t miss a penny of price movement, as is the case with Futures or spread betting.

This is called price linearity, and this is why CFD traders do so much share dealing through CFDs, the other reason is that enhanced liquidity which enables them to trade these stocks in any market conditions, and at the best price, always.

The leverage offered by CFDs is huge, and in some cases it can be as much as 400 to 1. Leverage is misunderstood by some traders, but it’s not so complicated to understand, it’s trading on margin, which is borrowed money. In some strategies, leverage is very important, and traders use it in many different ways.

The most useful application of CFDs is on protecting a long stock investment, against a temporary price drop. The stock price may fall by few dollars, but the investor doesn’t want to sell that stock because it’s part of a long stock portfolio, where they receive dividends, and they also don’t want to incur the high costs of selling and then buying the stock again. So the entire temporary loss because of the price drop, can be turned into a profit, by selling a CFD contract, where the investor sells the same amount of shares, through the CFD, so as to offset his portfolio exposure.

Portfolio risk management is by far the most popular way and easy way to see some of the benefits of CFDs, and to start making use of more short term trading strategies, as opposed to the old strategy of buy and hold, which can be boring and dry.

CFD for Commodity Traders

CFDs are used by commodity specialists mainly because they are very linear and liquid, leverage is important but leverage is not unique to CFDs, and many sites promoting CFDs and even CFD brokers themselves often fail to mention these two biggest benefits, which are truly unique to CFDs. Commodity traders are very demanding traders, not because they trade fast, or look to day trade the next report or the news, but because they pay attention to the one commodity market they trade, and they want to be well positioned in the market, so as to manage possible risks, and to stay properly exposed to profit potential.

This is why commodity traders are volatility analysts, supply and demand analysts, and they are also forex traders, since most commodities are priced in US dollars. Some can predict and trade the US dollar risk, while others can’t, and simply hedge the risk.

The biggest innovations and indicators in trading have come from commodity traders, so it is wise to stay in their path, and watch the way they trade. The fact that they use CFDs in their trading, and not Futures, has got to mean something about CFDs. Only US based traders have to still use Futures, because CFDs are banned in the United States, but Futures are messy, not linear financial instruments, they are not suitable for short term trading at all.

The CFD Liquidity Pool and Direct Market Access

CFDs have their own unique liquidity pool, and all trades have direct market access (DMA), that’s why there is so perfect price linearity, so close to the movement of the underlying market. This is so important to retail CFD traders, that makes a big difference to their trading. In some ways, the CFD market is actually better than the real thing, which makes you think that only complacent traders would ever trade commodities through the spot market.

The real market is the spot market, but with it come real liquidity problems, and the CFD liquidity pool acts as a buffer, protecting you from shortage of buyers or sellers, right when you need them. That’s why the CFD market is actually better than the real market. And this is possible because CFD traders are retail traders, and this means they are actually small compared to the real market. Even a trader trading $70 per point, is small compared to the market. And liquidity always flows from the large market to the smaller market, always! And always from the spot market to the CFD market.

Large banks and billionaire investors cannot use CFDs, they are left outside, since the CFD market is perfect but is too small for them, so in that regard the small retail CFD trader actually has an advantage over billionaire investors. And liquidity always flows from the billionaires to the smaller investors, it’s a market fact. You want to buy, someone else will sell to you, you want to sell, someone else will buy from you, and if that someone else is much larger than you, you will always be at an advantage.

Large, non CFD traders always run into problems, and even when their orders are filled, they end up getting worse prices than they expected, resulting in reduced profitability on the winning trades, and increased losses on the losing trades.

The CFD liquidity pool has more power than you think, and it’s extremely useful for facilitating even complex market trades, such as commodity and forex related trades, and even complicated Carry Trade forex trades.

Forex Trading with CFD

Forex trading is very efficient with CFDs, and it matches the performance of some of the best ECN forex brokers. In tough market conditions, when market price becomes too volatile, CFDs may actually be better than even ECN brokers. And you can actually have guaranteed stop loss orders, through their Limit type orders, and to also avoid slippage upon entering a trade. CFDs can be used in many different ways to overcome problems of other brokers.

CFD traders can trade many different assets, all from one account, and gain a better understanding of those various markets, commodities especially.

On fast day trading and scalping, some ECN brokers work very well, but they have variable spreads, which can be too costly, especially in scalping. In such cases a CFD broker may solve the problem. It depends on the exact strategy employed, but CFDs certainly can meet traders’ demands in such volatile conditions.

Forex trading is very profitable, as long as you know your market and the markets impacting your market. Different currency pairs tend to trade differently and to require different analysis methods. CFD traders have found that EURUSD for example is too choppy and volatile on an intraday basis, so that moving averages and swing trading theory do not really work on this pair. But on other non US dollar crosses, these analysis method can work very well.

Many forex trading veterans who now trade CFDs have explored every possible way to trade each particular currency pair. It is believed that each currency pair tends to work best with certain indicators, and certain time frames. That’s why EURUSD, even though it’s the largest currency pair, it tends to work poorly with most indicators, market size is not a criterion for choosing to trade that market. CFD forex traders were the first to explore these concepts, and most of them come from a spot forex background, having traded all kinds of accounts.

There’s the issue of taxation with CFDs, in many countries, but when one is a profitable trader, tax issues don’t really matter. Moreover, it’s actually possible to avoid paying tax on your profits altogether, it really is possible through the markets themselves and the broker marketplace. To this day, no wise trader has turned down CFDs because of tax issues.

Seeking a Trading Edge

CFD traders are among the wisest traders in the world, and their advice carries a lot of weight, now think about wise CFD forex traders you can find in online forums and ask for their advice on forex market issues, and even commodity market issues.

CFD traders are likely to have explored more about the markets, than anyone else, and this is evident in the fact that veteran CFD traders already knew about the big liquidity and linearity benefits of CFDs, long before anyone else did, even before CFD brokers themselves talked about it.

Some of the tips of CFD traders are amazing, including the tips that have nothing to do with CFDs, such as the tip on watching ECN variable spreads, as a volatility indicator. But the reason they themselves trade CFDs is because they get better liquidity, or some kind of guaranteed stop loss order, which ECN brokers could not offer them.

Trading experience is priceless at every level, and you can learn a lot from veteran CFD traders, covering many markets, from stocks to bonds, and from commodities to currencies. But traders in general are street savvy individuals, who tend to think originally, and are less likely to be fooled by tricky financial products and snake oil salesmen. They are good enough to spot real and fake things from a mile away. That is why their advice is priceless.

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