What are stock CFDs and how do you trade them?
Stock CFDs were once for professionals only, but more and more retail investors are getting involved. Here's what you need to know.
Contracts for difference (CFDs) have been around since the 1990s but have become increasingly popular in recent years as more investors become aware of their advantages, particularly during times of market volatility.
Originally developed as a way for professional traders and hedge funds to avoid the need for physical settlement of share transactions, CFDs have rapidly developed into over-the-counter instruments that have been embraced by retail investors.
So, what are they?
In simple terms, a CFD is a derivatives contract that lets you speculate on the price movements of assets, which could be shares, indices, commodities or currencies.
It acts as a contract between two parties to pay the difference between the current price of the asset and its price when the contract is settled. If the price moves in the direction anticipated by the buyer, the seller pays up the difference. If it goes in the opposite direction, then the buyer pays the seller instead.
In Australia, the most common form of CFD trading is in currencies and commodities such as iron ore, oil, gold and wheat. CFDs are also being used to trade futures, cryptocurrency, stock market indices and increasingly, individual stocks.
Take the example of a bank stock. If you think the bank's share price will go up in value, you can buy its stock CFD at the current market price from a broker like IC Markets. If the share price then rises and you sell your CFD, the broker will deposit the difference as your profit.
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How is a CFD different from trading in stocks?
Trading in CFDs is distinct from stock trading in two main ways: leverage and shorting.
Leverage. CFDs are a leveraged product, which means you only need to deposit a small percentage of the full value of the trade (i.e. margin) in order to open a position. This enables an investor to increase their purchasing power far more than would be possible with stock trading. CFDs help amplify any profits, but they can also result in losses that could exceed your investment.
Brokers typically allow leverage up to 10 times on most stock CFDs. This means, for example, that an initial investment of $1,000 can buy CFDs for up to $10,000 worth of stocks.
Shorting. Trading in stocks only allows you to make a profit when the price rises. On the other hand, with CFDs you can go short (sell a contract) if you think prices of the underlying security will go down or go long (buy a contract) if you think prices will rise. CFDs are also often used to hedge an existing physical portfolio.
Apart from this, CFDs offer other advantages over stocks trading:
International markets. CFDs are traded on most financial markets around the world and often several international markets can be accessed from the same CFD trading account. Apart from the US market, most major financial markets, including the UK and Australia, allow trading in a wide range of stock CFDs, giving traders a multitude of options to speculate in financial markets.
Immediate settlement. Stock trades typically take between one and two days to settle and for the investor to gain access to their funds. On the contrary, CFDs don't have a settlement period and any profit or loss is calculated as soon as the position is closed. This makes it easier to enter and exit trades and take advantage of market volatility.
Tax efficient. Because CFDs are only a derivative of the underlying asset, most countries have more lenient taxation rules, with the instruments typically exempt from stamp duty and capital gains tax. This results in lower tax burden for the investor.
Flexibility. CFDs are not standardised and every CFD provider generally has their own terms and conditions. This allows flexibility around trading the instrument, with brokers able to offer more contingencies than the conventional stop loss and take profit actions.
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It sounds kind of risky?
You would be correct. CFDs are popular with traders because they can amplify profits, but they also have the potential to magnify losses. Because CFDs are leveraged instruments and only require a small margin for trade, they can lead to a situation where an investor's losses far exceed the initial deposit amount, if the bet goes awry.
Complex. By nature, CFDs are a complicated instrument more suited to professional investors and require a high degree of discipline and understanding of how markets function. It also requires adequate liquidity and risk margins.
Regulation. CFD markets are typically less strictly regulated than the stock market, making trading in them a higher risk venture. For this reason, trading CFDs is not allowed in the United States.
Asset ownership. An important difference compared to stocks is that CFDs don't allow the benefit of ownership rights, such as voting rights, which are available to a holder of the underlying shares.
Despite the big risks, CFDs have become increasingly popular because they offer a unique way of making money in financial markets without having to own the underlying asset.
The instrument is also well suited to the rising volatility in the markets, with CFDs able to deliver profit even amid turmoil since they allow trading on markets that are heading down as well as up. More and more, they are also being used as a hedge for a physical investment in shares.
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How to buy CFDs
To trade shares via CFDs in Australia, you'll need to sign up to a CFD trading platform.
Keep in mind that not all platforms offer the same list of stocks. For example, while some list only US stocks, others, such as IC Markets, let you trade a range of international stocks, as well as forex, cryptocurrencies and commodities.
Trade with IC Markets
We update our data regularly, but information can change between updates. Confirm details with the provider you're interested in before making a decision.
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