While you’ve no doubt heard of trading stocks, there are other instruments available for trading, such as CFDs, also known as “Contracts for Difference.” CFD trading involves the buying and selling of said “Contracts for Difference.” A CFD broker may serve as an intermediary between the buyer and seller, giving both a platform for their exchange. A CFD broker might also take a more hands-on approach, creating the actual CFD market itself.
What are CFDs?
Before we get started on CFD brokers and how they can help you, it is important to know the definition of CFDs. As aforementioned, the term “CFD” means “Contract for Difference.”
CFDs are derivative products, meaning that they involve speculation. You speculate on different financial products, such as forex, commodities, indices, and shares, all without actually taking ownership of those four underlying assets.
In a CFD trade, the trader expects the asset price to rise or fall. The trader trades the asset with the broker, all without a physical delivery of the underlying asset. When the trade is closed, the trader experiences a profit if the price of the asset has risen or a loss if the price has fallen. Traders speculate on price movements. CFD trading allows for speculation on the movements in either direction.
Short CFD Trading
Short CFD trading, or “going short,” lets you open a CFD position that profits when the asset’s underlying market decreases in price. In this case, you are speculating on a loss in profit. “Going short” is also called “selling.”
Long CFD Trading
“Going long,” or long CFD trading, lets you open a traditional CFD trade. The trade profits when the market rises in price. When you’re “going long,” you’re “buying.”
Comparison to Other Markets
When compared to other financial products, CFDs somewhat resemble the futures and options markets. However, there are some major differences. For example, CFDs have no expiration date, and the contract is usually 1:1 with the underlying asset. Minimum contract sizes are smaller than futures and options, so you can, theoretically, trade just a single Contract.
What assets can you trade with CFD brokers?
A broker acts as a go-between. You place your trade with the broker, and the broker places the trade on the exchange. Brokers are members of the exchange, and you need a broker to trade CFDs. How hands-on you want your broker to be depends on whether you choose a DMA or market maker broker.
DMA Brokers vs. Market Makers
DMA brokers are “Direct Market Access” brokers, and they are one of two main types of CFD brokers. A DMA broker enables the trader to trade on the CFD markets but doesn’t play a role in executing the trade. The trader places the trade directly in the markets. The buyer or seller on the other side must link with them to complete the trade. The DMA broker is in it for the commissions, and they are, essentially, hands-off middlemen.
A market maker is the second type of broker, and they are more hands-on than a DMA broker. Market makers create the market on which the CFDs are traded, and they are far more than just a portal between trader and market. The trader abides by the market maker’s pricing when making a trade.
Pricing with market makers tends to be less advantageous when compared to the pricing on real-life markets. But, there is a tradeoff, as market makers absorb more risk and offer more real-time liquidity and input to traders. Market makers are also often faster in execution; there is less delay because the broker and market are one and the same. The role you want your broker to play determines the type of broker you will pick.
Assets You Can Trade with CFD Brokers
Traders use four underlying assets when trading with CFD brokers: indices, stocks, currency pairs, and commodities.
Indices measure the performance of a group of shares on a stock exchange. Trading indices might expose you to an entire country’s economy. Or, you can scale back your trading to just one sector of an economy. For example, the three most popular indices in America are NASDAQ, Dow Jones, and S&P 500. A less popular index is the Wilshire 5000, which has all the stocks from the American market.
Stocks are likely the commodity about which you’ve heard the most. They are an investment in a company and the company’s products. Stockholders who buy shares of a company’s stock have part ownership of the company. Stocks have also been called “equities.”
Currency pairs are two different currencies, and the value of the first currency is quoted against the second. The base currency is the first pair listed, while the quote currency is the second pair. Major currency pairs include EUR/USD, USD/JPY, USD/CAD, AUD/CAD, NZD/USD, USD/CHF, and GBP/JPY.
Commodities are the fourth underlying CFD asset. They are an economic good that has substantial, if not full, fungibility and interchangeability. The market treats the commodities as equal, no matter who produced them. Examples of commodities include natural gas, beef, gold, oil, and grains. These traditional commodities have been traded on the stock exchange for centuries, and there are many more commodities from which to choose in today’s world.
How Do CFD brokers make money?
DMA brokers and market makers both make their money through commissions and fees to use their platform. That is why it is essential to research a broker’s fees before signing up. While some fees and commissions are inevitable, you don’t want to put a hole in your wallet.
Is CFD trading legit?
CFD trading is legitimate, but CFDs are high-risk investments. Even the most skilled traders experience periodic losses. Though the trading is legitimate, not all CFD brokers can say the same. For example, some brokers are just automatic trading robots that place inaccurate trades automatically. They make money from commissions, but the investor doesn’t benefit at all.
Can you trade CFDs in the US?
CFD trading is, unfortunately, banned for American citizens. After the 2008 financial crisis, the CTFC and SEC cracked down on CFD trading amid an intense period of regulatory scrutiny. If you are an American trader, you cannot trade CFDs. Hong Kong, Belgium, India, and Brazil have also banned CFD trading.