In this edition of our CFD trading series of articles, we’re taking a look at the advantages of CFD trading. We’ll include the main advantages CFD providers publicise on their websites and consider other, more nuanced advantages of trading CFDs.
The flip side
Before we begin, we need to address that investments like CFDs, contain a great deal of risk. So much so, that CFDs are often compared to gambling like poker or roulette. These comparisons aren’t as unfair as they may first sound – both consist of short-term bets that combine skill and sometimes luck. They are both thrilling experiences – users of a crypto poker & casino will probably recognise the kick of adrenaline they will feel as they place their first CFD trade and watch the market begin to move.
Pressing ‘trade’ activates similar dopamine receptors as clicking ‘bet’ on a glitzy gaming interface. Considering that the majority of CFD providers disclose that most of their retail clients lose money when trading CFDs, we could conclude that a house edge exists in each format also.
So before we move into the list of advantages of trading CFDs, it is responsible of us to help you bear in mind that the levels of risk involved in CFDs does create a rebate about whether this form of investing is like gambling. We strongly believe that long-term investing in the stock market is clearly different from gambling in many ways, but when using derivatives the lines become very blurred.
The advantages of trading CFDs:
Speed of execution
Trades are placed directly with the CFD broker as counterparty, rather than being placed by the CFD broker on an exchange or off-exchange trading pool on the investor’s behalf. The advantage of this is the speed of trade execution and settlement, as the investor is dealing directly with the counterparty and therefore no middleman or clearing banks are required.
When CFD trading, trades are executed in almost an instant. Waiting for settlement periods to pass before you can put the proceeds of closed positions to work will be a thing of the past. In theory, this will allow you to trade with less capital because at any one time you won’t have money tied up in settlement.
Stamp duty is an ancient UK tax that was first introduced in 1694 and has remained, in one form or another, ever since. The current Stamp Tax is a 0.5% tax on the value of shares purchased. This tax is calculated and collected by client-facing stockbrokers.
Because CFD trading does not involve buying an underlying asset, it is exempt from the requirements in the Finance Act 2003. Therefore, you won’t pay a penny while trading CFDs.
Please note that some brokers provide both CFD trading and share dealing, so stamp duty would be applicable if you chose to buy shares.
When using CFDs, you will have access to trade all of the financial markets offered by your CFD provider in your country.
For example, CMC Markets offers the following markets for trading to UK retail clients:
- Shares (9,400 shares from 23 countries)
- Forex (330 cash and forward currency pairs)
- Indices (80 indices, including UK 100, similar to the FTSE 100)
- Commodities (100 cash and forward instruments including oil & gold)
- Treasuries (including US and UK government bonds)
This provides wider access to speculate on the financial markets than a traditional retail stock brokerage account.
Many traditional stockbrokers do not allow investors to invest directly in corporate or government bonds, nor can they use a stockbroker account to hold exposures to commodities (beyond Commodity Exchange Traded Funds). If bonds are offered, the minimum investment value is often very high, making them prohibitively expensive to own as part of a diversified portfolio.
This means that for many investors, CFDs unlock a cost-effective way to gain short-term exposure to commodities and other assets with a high degree of correlation to the underlying price.
As we explained in our earlier CFD trading introduction, CFDs are leveraged, which means that only a small portion of the underlying exposure is used to open the position.
For example, a £100 cash balance in a CFD trading account could be used to take a long position in £500 of shares. As only 20% of the underlying value is backed by the traders’ capital, this is known as trading at 20% margin, or 5x leverage.
Leverage makes CFDs a very popular way to trade forex markets because underlying forex pairs aren’t usually very volatile compared to equities.
However, the leverage provided by CFD accounts means that even small movements in the GBP:USD pair would result in sizeable gains or losses for CFD traders, relative to their starting capital.
At the time of writing, CMC Markets offers a 3.33% margin (30x leverage) on the GBP:USD currency pair, meaning that £1,000 of investor capital could be used to gain exposure to £30,000 of USD.
If the GBP equivalent value of that USD increased by 1% in the day, the investor could see a return of just under 30% of their capital. Naturally, the same leverage would also result in large losses relative to capital if the value of the USD fell.
Other advantages of trading CFDs:
When trading CFDs, you can take a long or short position of a size of your choice, allowing you to utilise small sums such as £50 or £100 to take a position. This is because the CFD is bespoke to your requirements.
In contrast, instruments traded on public markets have fixed denominations to ensure they can be interchangeably swapped between market participants.
For equities, the lowest denomination is the share price, because this is the minimum cost of buying one share. Companies with relatively low share prices, such as Go Pro ($5.20 at the time of writing), give an investor flexibility on how much to invest. However, firms such as Berkshire Hathaway Inc ($418,000 per class A share) are difficult for investors to purchase.
Bonds are also traded in large quantities, known as ‘lots’ of 1,000 or 100,000 which effectively increases their instrument size to the value of a lot.
When trading CFDs, you can take on the precise amount of exposure you plan because you dictate the exact size of the trade.
CFD providers such as CMC Markets operate a refined trading app, which traders can use to place their trades on the go. The app is optimised for Android and Apple devices, including iPad.
Practically, this means that traders are no longer constrained to a large desktop terminal with multiple monitors. Trades can be placed when the trader is away from their desk, reacting to news and events.
Practicalities of trading commodities
CFDs are popular ways to trade commodities because commodities are expensive to buy, expensive to store and impractical. Other derivatives that deal with this asset class are complex and may not be suitable or accessible to retail investors.
CFD platforms often offer a free demo account that allows potential traders to test the platform and trade with pretend money before they decide to commit funds to an account and trade with real money.
Using a demo account is a great risk-management strategy because it allows you to familiarise yourself with the steps of opening, monitoring and closing trades. This includes other trade types that operate in different ways, such as buy limit orders, sell limit orders, stop-entry orders and guaranteed stop-loss orders. If you are familiar with how the interface works and how these order types are executed, you will reduce the risk of making an error or confusing these features when trading with real stakes.