What Is CFD?

What is CFD when it comes to trading?

Traditionally you can buy actual shares in a company, or an actual commodity.

However, in the 1990s CFDs were developed in the UK, to enable traders to trade the rise and fall of stock and commodity prices without actually buying the underlying stock.

Here you can see that there is a market maker, that is a company that provides a trading platform where you can profit from rises or falls in a stock price for example, without being real owners of the share or commodity.

The reason why they became popular include:

1. Leverage: traders can use leverage to magnify their trading results. For example, a CFD requiring 10% margin means that you need to provide 10% of the position value to enter the position.

2. Low commissions: originally in the 1990s and early 2000s CFD trading were often commission free, ie with zero commission, and so attracted many traders, as the combination of leverage and low or zero commissions, combined with well trending markets meant good potential results. Now, there is typically low commission, usually lower than that of trading stocks or shares.

3. Ability to go short of long on many shares. Depending on the market situation, assuming no major fall and ban on short trading, one can go long or short on CFDs to make profits on rising or falling stocks. It increases the opportunity to profit from market movements.

See more about advantages and risks of CFD trading here in this article review.

CFD Types:

There are typically a variety of CFD products available:

• CFDs on stocks and shares
• CFDs on commodities
• CFDs on indices

CFDs on a variety of international markets int he above products

CFD Costs:

Costs of CFD trading include:

• Commissions
• Interest for long positions > 1 day
• ASX or WebIress fees if requiring data for certain platforms or markets

Differences between CFD providers:

Since CFDs are in fact a diverse group of products, and providers vary between each other in what they offer to traders, it's important to keep these points in mind:

1. Different CFDs are offered

Typically the top shares in an exchanged are offered, but some may not be

2. Different margin requirements

Some providers require smaller margins eg 10-20% for some stocks, and up to 80-100% for others, and this varies between providers, so check their lists and pdfs

3. Different commissions

These vary from nil to % costs with a minimum cost also is typical

4. Different spreads

What many peoplr don't realise is that the spread can vary between CFD brokers and in some providers with zero commissions, there is the spread (difference between the bid and ask prices) that the provider makes their money on

5. Different types of orders

Some providers offer stop entries, whereas some don't and only have limit entries. Some provide guaranteed stops (at a cost) and some don't.

6. Different ways stop losses are triggered

The rules here can be varied from stop if touched, stop if the bid or ask goes through the price. Also, some require enough liquidity in the underlying stock to enable your position to go through. Some count your trade size as part of that liquidity, some don't.

7. Different interest costs

If you hold overnight positions, ie positions greater than a day, then interest is paid, or if short, then you are paid interest. The rate is usually based on a bank's base rate.

See more about CFD brokers and providers here.

What to look out for in 2012:

CFD trading always emerges and changes with the times.

The potential things to look out for in 2012 and beyond are:

1. More competition in CFD providers

2. More products offered such as specific commodity CFDs

3. Possibly more reduced use of leverage from traders, as traders take more care in their position sizes

4. Exchange based CFDs, where the official country's stock exchange is offering the CFD instead of a private company, such as the ASX is doing more of

5. When and if a strong trend emerges, trading in general includig CFD trading may increase significantly

So there you have it, a summary of what is a CFD or what is Contracts for Difference when it comes to trading.

More people who are interested in other forms of trading such as commodities and forex are venturing into CFDs to see what they offer in terms of potential returns and costs compared to more traditional investments.

Learn more about what is a CFD in these CFD tutorials for beginners and advanced here.