For starters, the term ‘CFD’ is an abbreviation for Contract For Difference.
Contracts for difference (CFDs) enable traders to speculate on the price movements of underlying financial assets (instruments) such as shares, indices, commodities, currencies, and treasuries.
Now, many of you may be wondering – do traders really need to purchase the real commodities like Gold or Brent Crude Oil if you ‘buy’ them using CFDs?
Nope! There is no delivery of physical goods or securities with CFDs.
In fact, a CFD investor never actually owns the underlying asset but instead profit based on the price change of that underlying asset or security through a financial contract.
The value of a CFD contract does not consider the asset’s underlying value: only the price change between the trade entry and exit.
3 Key Things to know about CFDs
Before we delve into the pros and cons of trading CFDs, there are 3 key things to know about them.
#1 The Ability To Go Short
One of the main reasons behind the popularity of CFDs is that it allows for short-selling aka. ‘bet on falling markets’ as opposed to the usual ‘Buy Low and Sell High’ mantra.
This means that investors can now sell first when the price is high and buy it back when the price drops.
In addition, you can utilize CFDs as a hedging tool or what many call ‘buying insurance’ for their main portfolios.
This involves going for an opposite position to what they already have on stocks to prevent any losses due to short-term down trend in markets.
Let’s take for example – you hold $10,000 of Singtel shares as part of your bigger dividend portfolio.
You are concerned that it is due for an imminent sell-down (perhaps due to poor results expected). Through short selling $10,000 of OCBC Bank CFDs, you can help protect your share portfolio.
This is because should Singtel’s share prices fall by 10% in the underlying market, the loss in value of your share portfolio would be offset by a gain in your short sell CFD trade.
In this way, you can protect yourself without going through the expense and inconvenience of liquidating your stock holdings and missing on the dividends too.
#2 CFDs grants you the power of Leverage
Want to buy $10,000 worth of Apple shares but only have $1,000 cash lying around?
Now you can do that with CFDs.
CFDs allow traders to buy/sell a much larger value position with a smaller upfront capital, known as margin. This strategy is also known as margin trading, which allows traders to make their capital work harder for them and achieve a higher return on equity.
Here’s an analogy on how leverage works for a trader.
Shares of Stock A is currently quoting a price of $2.00 and Ben intends to buy 5,000 contracts of Stock A.
Assuming Phillip CFD sets the margin for Stock A at 10%, then the initial margin Ben puts up will be 10% x $2.00 x 5000 = $1,000.
If Ben were to buy the same shares of company A using normal stocks on cash market, he would be required to put up $2.00 x 5000 = $10,000.
In this situation, Ben has leveraged 10 times of his capital. This effectively frees up his capital for other savings/investments or he can simply add on his position for bigger potential profits.
That said, trading on leverage is a double-edged sword. This allows traders to maximise profits, but it can also exacerbate losses without proper risk management.
#3 Access to Wide Range of Asset Classes
As previously mentioned, if you are looking to trade the indices, forex or commodities, chances are that CFDs would be the best option.
At Phillip Futures, you gain unparalleled access to more than 330 instruments across 3 global markets including:
- Indices such as the HK Index, S&P 500 and STI
- FX Currency Pairs such as EUR/USD, USD/JPY and NZD/SGD
- Shares such as OCBC Bank, Meituan DianPing and Apple
- Commodities such as Oil, Silver and Gold
In short, it’s important to go for a CFD trading brokerage providing access to a big range of asset classes because you may never know which counter is ripe for trading given the market dynamics.
How does CFD Trading work?
To recap, trading CFDs offers the opportunity to profit whether or not a market moves up or down.
In addition, traders are allowed to trade plenty of different underlying assets, like shares, currencies, indices, and commodities like oil or gold.
Here’s the P&L formula of a CFD contract:
Profit or loss = (no. of contracts x value of each contract) x (closing price – opening price)
Assuming you go long for STI index SGD5 contract with the below details:
- Opening Price: $3.00
- Closing Price: $3.50
- Value of each contract: $5
- of contracts: 100
- P&L = 100 * $5 * (3.50 – 3.00) = $250
To get the full picture, spread costs, commission and finance charges must be factored in as well. You can check out this link for more details.
Pros and Cons of CFD Trading
Now that you have seen how to calculate the P&L for CFD trades, it’s time to look at the overall pros and cons of CFD trading.
Pros of CFD trading
- It can be used as a hedging strategy.
- Enable a trader to trade on both rising and falling markets.
- Grant traders the ability to go both long and short on underlying assets.
- Offer a wide range of markets. A trader can enter various markets, like commodities, currencies, shares and indices from the same trading platform.
- Provide higher leverage. CFD brokers typically offer CFDs with higher leverage than other traditional financial instruments.
Cons of CFD trading
- Costs of spreads and ongoing finance charges – if you keep CFD positions open
- Higher leverage (double-edged sword) – you can win big or lose big.
- Ease of accessibility – It means that some trading beginners may overtrade if they are not savvy enough.
In essence, trading CFDs can be risky and you should approach it with an comprehensive strategy for risk management.
Conclusion – Choose the Right CFD Broker
To start your CFD trading, it is important to choose the right broker who can offer you a reliable online CFD trading platform.
You should look for a broker who is regulated, licenced, secure, and experienced, and one you can trust. With that, Phillip Futures fit the bill in many areas.
Below is why you should consider trading CFDs on Phillip MT5:
- 3 Global Markets (US, HK & SG)
- More Than 330 Contracts (inclusive of forex & precious metals)
- Up to 10 Times Leverage
- Free Dedicated Platform, Live Charting & Education
- Competitive Rates & Promotions
- Live Price Feeds Available
- No Minimum Deposit to Open an Account
- Round the Clock Support
- No Inactivity Fees
To end off, you can trade shares CFDs with as small as 1 share CFD, with no min. fee and no platform fee on Phillip MT5.