Contract for differences are financial instrument which constitutes an agreement between two parties. Each of the parties agrees to pay the difference between the current asset value and its value at a future time to the other party. Initially those instruments were created for and were only used by large institutional investors. During the last decade, this has changed and the ease of CFD trading itself has become the main reason why these products became so popular among the retail audience. Trading CFDs can earn you profits, save taxes and diversify your investment portfolio. However, you should be aware of the risks as well as to have a profound knowledge of the markets you trade. Below, I have listed some main points to consider.
Usually CFD Providers classify clients depending on their trading experience and other factors. Several classifications exist – retail client, professional client and eligible counter-party as those may vary depending on the local financial regulation. Retail clients get the highest level of protection since they are considered inexperienced in trading financial products. Being classified as a retail client you will get many advantages. Not only your funds are protected against your broker bankrupt but the execution of your trades will be the best possible. Conversely, being a professional client you will not get the same privileges and protection since you will be considered as “aware of risks and nature of trading”. There are cases where professional clients ask for retail classification in order to get the desired level of protection and possibly better execution.
CFDs are leveraged products and being such they impose risks of losing your initial investment. Understanding how leverage works is essential for your success long-term. A brief description of how leverage works would be: buying an asset for a fraction of its price. For example a leverage of 100:1 will allow you to buy shares quoted at $1000 with just $10 available in your account. If the price rises to $1200, you can sell those shares and get real $200 as a reward. Conversely, if the price falls to $990, you will be asked to deposit more money in your account since the $10 you initially had is no longer sufficient to cover the loss. Of course, this is a rough example of how things work. In fact there are many factors to consider when trading CFDs and one of the most important ones is trading costs.
Before entering the market you should have a clear idea of the costs you will incur. CFDs have many advantages related to the trading costs as opposed to traditional shares trading. First of all, the minimum amount to open an account is quite low; sometimes as little as $50. In addition, contracts for differences are stamp duty free which increases the interest of both retail and institutional investors. Rollover costs are fees charged to your account overnight for holding a position more than one day. If trading long-term, you should carefully calculate your rollover taxes and include them in the equation. Finally, take into account the spread and especially if it is fixed or variable. This is the difference between buy and sell price and can be a significant cost in some cases.
Many traders make the mistake of opening a real money account before having gained the knowledge and experience needed. Most of the CFD brokers offer a demo (risk-free) trading account representing the real trading conditions. It is highly recommended to practice for at least 2 months and test different trading strategies and tactics prior to going live. When you finally decide to open a real account, start with smaller amounts and keep in mind that demo trading is completely different than real trading, especially the speed of execution.
Understanding your broker T&C
Before opening an account you should carefully read and understand your broker Terms and Conditions. Special attention should be paid to Conflicts of Interests policy. Basically, trading with your broker is in fact trading against your broker because each of the parties hopes that the price goes in different direction. That is why it is important to know how your broker handles those conflicts. Being a retail client, for example, will grant you the best possible execution and protection in this case. Also, check the margin call and auto-close levels of your positions. You should be aware when you can be taken out of the market at all times.
The above were just few trading best practices among many. Based on my trading experience I have learned that the knowledge and deep analysis are the foundation of success. If anybody has any comments or additional advices, I will be more than happy to discuss them.