Advantages of CFD Trading: Key Benefits for Traders

CFD trading has many benefits for traders who want to profit from price movements without owning the underlying assets. If you want to trade Contract for difference CFD, you can speculate on the rise or fall of an asset’s price with great flexibility and potential profit opportunities. 

CFD trading enables traders to easily buy or sell positions, open and closing trades quickly, and use various trading strategies, including short selling.  CFD traders can open positions with relatively low margins and leverage their capital efficiently. Moreover, trading CFDs is usually more cost-effective than traditional methods since it involves lower transaction costs. It also avoids capital gains tax in certain jurisdictions.

CFD trading is very popular among traders in financial markets. Therefore, in this article, we delve deeper into the main features of derivatives and the crucial advantages of CFD trading. 

We will also see how CFD trading works, and will discuss the role of the Financial Conduct Authority in regulating CFDs, and the significance of choosing the right trading strategy. 

Whether you’re considering enhancing your trading strategy or opening a CFD position, understanding the pros and cons of CFDs can help you make informed decisions in the dynamic world of trading in financial markets.

CFDs or Contract For Difference Definition

CFD, as you already know, is the abbreviation of ‘contracts for differences.’ CFDs belong to the family of derivatives. They are modern financial instruments that allow trading stocks, indices and commodities (such as gold or oil) in a simple and inexpensive way.

The investors do not buy or sell the underlying assets. They simply has an agreement with his financial intermediary stipulating that the difference, gain, or loss resulting from the transaction will be credited or debited to his account. Hence, the name CFD.

CFDs can be compared to other popular products such as turbos, warrants, options, and certificates. However, none of these products offer a wide choice of underlying assets. In addition, CFDs are much simpler to use because. They have no expiration, no time value, etc.

The price cannot be influenced by the issuer, as is often the case for warrants and certificates (provided you choose a broker that offers its CFDs at a price identical to that of shares on the stock exchange).

CFDs are also interesting because they allow you to invest (both upwards and downwards) in many financial assets, such as stocks, stock indices, commodities, currencies, and cryptocurrencies.

How does CFD trading work?

To help you understand how CFDs work, we must first explain some concepts, including derivatives.

What are derivatives?

The first thing you need to understand about CFDs is that they are derivatives. This simply means that the product you are trading has no value and derives its value from another asset. Therefore, you will not own any asset; rather, you will speculate on the price of an underlying asset.

The most commonly traded types of derivatives are:

• Futures (forward contracts)
• Swaps
• Options
• CFDs
• Warrants

The most common underlying assets are

• commodities, 
• stocks, bonds, 
• and currencies.

Professional traders highly seek derivatives as a form of diversification or hedging. In fact, the global derivatives market size was USD 21980 million in 2020, and it is projected to touch USD 59170 million by 2032. 

To put that into perspective, the global stock markets are only worth around $90 trillion, according to CNBC.

However, according to a Bank for International Settlements (BIS) report, the market value is only $12 trillion!

How to use leverage in CFD trading?

Using leverage in CFD trading requires careful and informed risk management. To begin with, you need to understand that leverage is used to increase your exposure to a financial asset, which can amplify gains, but also losses.

When you open a leveraged position, you only invest a small portion of the total value of the position, called the margin. The rest is financed by the broker. For example, with a leverage of 1:10, you can control a position of €10,000 with only €1,000 of capital.

To use leverage, you must first select the desired leverage level. This will depend on your risk tolerance and trading strategy.

Next, you must define your position (buy if you expect the asset to rise, sell if you expect it to fall), and finally, determine the size of your position.

It is crucial to constantly monitor your position, as market fluctuations can quickly affect the value of your investment. Some traders use stop loss orders to limit their potential losses.

Remember that leverage is a powerful tool that can help you maximize your profits, but it can also lead to losses greater than your initial investment.

Main Advantages of CFD Trading 

There is no lack of advantages. Let’s stay focused on the main advantages of CFD trading. 

#1. No Stamp Duty

In some countries, trading CFDs can be more tax-efficient than traditional stock trading. People may ask, “Why?” 

We need to note that CFDs don’t involve purchasing the underlying asset. This means that traders don’t have to pay stamp duty, which can be a significant cost saving. 

#2. Profit from Rising and Falling Markets

CFD trading allows traders to take long (buy) and short (sell) positions, enabling them to profit from rising and falling markets. This flexibility is extremely important in volatile markets where prices can fluctuate rapidly. 

By short-selling, traders can capitalize on market downturns, which isn’t possible with traditional buy-and-hold strategies. 

#3. Hedging Capabilities

It is possible to use CFDs to minimize losses. For example, if a trader holds a substantial share in a company and anticipates a short-term decline in its stock price, they can open a short CFD position to offset potential losses. What’s important is that this ability to hedge effectively adds a layer of risk management to the trading strategy. 

#4. No Expiry Dates

CFDs don’t have expiry dates, unlike options or futures contracts. This means traders can hold their positions for as long as they choose, provided they meet the margin requirements. This flexibility allows for both short position trading and long-term investment strategies.

#5. Direct Market Access

Many CFD brokers offer direct market access (DMA), which allows traders to place orders directly into the underlying market. DMA also provides greater transparency and control over trading strategies.

The advantages of CFDs for trading on the stock market

The first advantage of CFDs on the stock market, therefore, concerns the variety of values. Almost all financial products on the stock market have a CFD attached to them. This CFD follows the same quotes as the underlying that it represents. 

The investor can therefore easily trade shares, stock market indices such as the CAC40 (for index trading we recommend that you read our article on ETFs for investing in the stock market), raw materials, etc. 

There are no restrictions on using CFDs to invest in the stock market. In addition, CFDs are quoted 24 hours a day.It means that a trader who wishes to trade a Euronext share is not bound by the opening hours of the Paris Stock Exchange. 

The second advantage of using CFDs is undoubtedly the leverage effect. Indeed, these derivative products allow for significant leverage, often greater than 20 times the amount invested. 

It allows investors with a very small portfolio to invest in the stock market and generate significant gains. This leverage effect also includes the possibility of short-selling. It allows a financial asset to be sold at a certain value before buying it later (in the hope of buying it back at a lower price than the one at which the investor sold it). 

The big advantage of CFDs concerns periods of stock market crashes, periods in which internal authorities often prohibit short-selling on certain values, particularly national shares. CFDs are generally not affected by these rules.

Disadvantages of CFD Trading

Traders should also take into account the disadvantages of CFD trading. 

While leverage can amplify profits, however, it also magnifies losses. Trading on margin means that a relatively small adverse price movement can result in substantial losses, potentially exceeding the initial capital investment. 

#1. Complexity and Learning Curve

CFD trading involves a steep learning curve and a higher complexity level than traditional stocking. 

Traders should learn more about various aspects, such as margin requirements, leverage, and the CFD market in general. Inexperienced traders may struggle to grasp these concepts, leading to potential mistakes and losses. 

#2. Overnight Financing Costs

Holding CFD positions overnight incurs financing charges, often called swap rates. These costs can increase over time, especially for long-term positions, reducing profitability. 

So, traders must factor in these charges when calculating potential returns and be aware of their impact on their trading strategy. 

#3. Market Volatility and Liquidity Risks

CFD markets can be extremely volatile, with rapid price fluctuations that can lead to sudden and significant losses. Furthermore, low liquidity in certain markets can result in slippage, where the execution price differs from the expected price. It can affect trading outcomes, particularly during times of high market stress rating volume.

#4. Counterparty Risk

CFDs are over-the-counter (OTC) products. As a result, CFDs aren’t traded in a centralized exchange but are directly traded between the trader and the broker. This introduces counterparty risk, where the trader relies on the broker’s financial stability and integrity. If the broker fails or becomes insolvent, the trader may face difficulties recovering their funds.

#5. Regulatory Risks

CFD trading is subject to varying regulatory environments across different jurisdictions. Regulations differ from country to country. 

It is important to remember that changes in regulatory policies can impact the availability and terms of CFD trading, potentially affecting traders’ ability to operate in certain markets.

#6. Psychological Pressure

The fast-paced nature of CFD trading, coupled with the use of leverage, can create psychological pressure. Traders may experience stress and anxiety, leading to impulsive decisions and emotional trading. A trading plan and managing the psychological challenges associated with CFD trading is vital.

To sum up, the advantages of CFD trading outweigh the disadvantages. Nevertheless, it also comes with substantial risks, such as high leverage risk, complexity, overnight financing costs, and counterparty risk. 

Aspiring CFD traders should conduct thorough research and develop a solid trading strategy. They should also practice disciplined risk management to navigate the challenges and maximize the benefits of CFD trading. 

What does the FCA say?

In the past, there was little regulation of the leverage available for CFD trading. Some traders even used leverage up to 500 times. 

The FCA determined in 2019 that this should be restricted to a ratio of between 30:1 and 2:1 in the case of retail investors. This was but one of the modifications implemented by the FCA. The sums of money that regular investors were losing were the primary cause of this.

The FCA has more recently “seen a rapid increase in new investors choosing high-risk investments” as part of its three-year plan (2022 to 2025).  

This has prompted the regulator to consider closing the “gap between investors’ risk appetite and the actual risks associated with the investments they choose,” especially for younger investors.

Bottom Line

 The main interest of CFD trading is to take advantage of a multiplier coefficient in order to increase your profits by two or five. 

Some trading platforms even offer much more (while others limit this leverage) by providing stop-losses. This is what is then called limited-risk CFDs. 

The choice of broker is therefore essential before investing (discover our comparator on the best trading platforms). In addition, CFDs do not have an expiry date, allowing them to be kept for an indefinite period. Unlike traditional stocks, CFDs can be traded at any time and outside of financial market opening hours.

This trading method allows for potential profits or losses, with each trade influenced by the opening price and closing price. 

Leveraged products like CFDs enable traders to open an account with a smaller initial investment while still gaining significant market exposure. 

Whether you go long or short, understanding the dynamics of CFD trading can enhance your strategy and improve your trading outcomes.