Benefits and Drawbacks of Trading CFDs

CFDs, the abbreviation of Contracts for Difference, are a common type of derivative trading that allows traders to speculate on the price movements of a wide range of financial instruments, such as indices, stocks, commodities, foreign exchange and crypto currencies, without actually owning the underlying asset. This form of trading is becoming increasingly popular due to its benefits and its inherent flexibility, but this is not to say it does not have its own unique set of drawbacks. In this article, we will explore the benefits and drawbacks of trading derivatives compared to trading actual underlying assets.  

This will be presented by outlining:

• Brief definition of how traders profit and lose through trading

• Presenting the benefits of derivatives trading

• Listing the drawbacks of trading derivatives

Brief definition of how traders profit and lose with CFDs

In layman’s terms, a contract for difference (CFD) derivative is a contract between a buyer and a seller that allows traders to speculate on price movements in financial instruments or other underlying assets. At the end of the contract, the two sides exchange the difference between the opening and closing prices, where the seller will either make a profit or a loss compared to how much they paid for it in the first instance. Brokers, for a small fee, allow traders to trade derivatives on financial markets including shares, indices, commodities and foreign exchange currencies, however, traders do so without taking ownership of the underlying product and are merely agreeing to exchange the difference in the price of the actual assets.

For example, if a trader wants to open a $500 position trade on the popular metal gold, the trader has merely bought the contract worth $500 on whatever gold was worth at that moment and not the actual gold itself.

Benefits of trading CFDs compared to the underlying assets

There are various pros and cons of trading CFDs. Starting with the benefits, these include:

• Wide Range of Markets Available

Brokers usually offer access to a wide range of financial markets and instruments from a single trading platform. This compliments traders’ investment strategies that favour a diverse portfolio not locked into, or dependent, on a single type of asset. For example, they allow investors to trade in metals, energies, futures, indices and foreign exchange currency markets. Additionally, this type of trading usually allows traders to access markets from all over the world, providing them with greater flexibility to take advantage of market movements regardless of location.

• Leveraged Products

Trading with leveraged products allows traders to trade with a small amount of capital but with a larger market exposure. In simple language, leverage is the ability to open a trading position without the buyer actually paying for the entire value of their position. Rather, they only need to supply the minimum margin requirement set by the brokerage firm they trade with, and the broker will loan them the rest. This is a powerful tool that allows traders the ability to maximise their profits, however, it will also maximise any losses they experience. For example, if a trader wants to open a trading position on the EURUSD instrument with a 1:500 leverage, by supplying the margin requirement of $1000, their market position will be $500,000. Any good or bad fluctuations in both directions on the EURUSD, therefore, will affect this position significantly more compared to a market position of $1000.

• Flexibility

This category of trading is also well known for the high flexibility it offers with regard to the size or volume of a trading position and short selling. This is typically not available when trading actual assets. This helps traders tailor their strategies to their specific needs and investment goals.

• No storage or security costs

As mentioned above, CFD traders do not own the underlying asset, which in turn, eliminates the need to pay high fees for storage and security costs. This can be particularly advantageous for investors who predominantly invest in volatile or expensive markets, such as oil or gold. Traders who invest in the actual physical assets in commodities need to bear in mind additional associated costs such as insurance, security, and administration. With derivative trading, these associated costs do not apply.

• Accessibility

Trading is usually incredibly accessible anywhere in the world, at any time, with an internet connection. This makes it particularly attractive to traders who have either limited time to trade or who live their lives on the go travelling. Most brokerage firms offer the ability to open trade from laptops, tablets, and even their smartphones, affording traders the added flexibility to take advantage of market movements and opportunities as they arise.

Drawbacks of trading derivatives

With every yin, there is a yang. Bearing in mind the positives of trading derivatives, one should always also keep in mind the drawbacks this type of trading compared to actual underlying assets. These include:

• High Risk

While one could argue any kind of investment carries a certain degree of risk, derivatives trading has a disproportionate amount of it due to the leveraged trading aspect. Investors who are especially risk-averse or have limited trading experience should certainly boost their educational portfolio before beginning to trade. Thankfully, many brokers offer a ‘demo’ account upon registration, allowing beginner traders to experiment with fake virtual money on live markets using leverage products. This is a great way to build an experience completely risk-free, before taking the investment decision to deposit real funds into a trading account.

• Complex

Derivatives trading can be complex and certainly requires a good understanding of trading techniques and financial markets. For inexperienced traders, this may be challenging to fully grasp all concepts surrounding this form of trading. Furthermore, it tends to involve a high level of technical analysis and advanced trading strategies, which may take inexperienced traders more time to perfect, master, and implement.

• Regulatory Protections

While trading CFDs is a regulated activity, as a first step, traders should certainly do thorough research on the broker when they are in the process of considering brokerage firms and ensure that they are reputable and regulated before investing any capital.

Key Takeaways

Trading CFDs has, as outlined above, a wide range of pros and cons compared to investing in the underlying assets involved. Access to a wider range of markets, flexibility, leverage and accessibility have all been cited as examples of the benefits of trading, while risks, complexity and regulatory protections have been used to showcase the drawbacks of trading. Traders should always carefully consider the pros and cons of any investment decisions and always reference their risk tolerance and overall investment strategy. It is fundamentally important to only invest capital that can be affordably lost and to always have a well-designed risk management plan in place to minimise any potential losses.

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Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.

It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.

Trinota Markets (Global) Limited does not give warranty as to the accuracy and completeness of this information.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 80% of retail investor accounts lose money when trading CFDs with this provider.