02:05 PM, 29 Nov 2023 (AUS EST)   The market is currently open       

The Pros & Cons of Trading CFDs

There are many reasons for an investor to trade CFD’s, and a couple of reason why they may choose not to use them. A prudent investor will weigh out the pros and cons of this investment vehicle before giving capital to his CFD provider.

CFD Advantages

1. Massive Leverage and Volatility

For a long time, blue chip stocks were a very undesirable from a high risk, high reward point of view. To engage a highly speculative area of the market, traders would gravitate toward penny stocks. But with these low priced shares came other problems such as liquidity and a lack of solid information to base their trades on.

Then along came CFD’s. The leverage available with CFD’s gave highly leveraged swings that the high risk and short term traders desired, but also allowed them to trade with numerous quality stocks that were previously unavailable. This provided better fundamental figures and improved technical analysis for highly profitable trading.

2. Trading Long or Short with Ease

Depending on the asset, the exchange, and current economic conditions, trading short can be a challenge. With CFD’s, trading both long and short is a simple process. This makes it a great hedging tool where one can purchase short CFD’s to protect their long position on physical shares should the market become turbulent.

3. CFD’s Can Clear Up Liquidity Problems

Imagine you find an excellent stock to trade that you feel is going to rocket up in the near future. The only problem is that the daily share turnover is so low that assuming even a modest position will badly inflate share price.

CFD’s can cure this problem in certain situations. If you choose to trade through a Market Maker you will likely get a less competitive price on the bid / ask. That having been said, the Market Marker has the ability to offer CFD contracts that are not placed in an order book meaning it will not affect share price. They are trading a synthetic market so you will get your shares and the price of the stock remains stable. Your liquidity problem is solved.

4. Variety of Products Offered

Some types of investments are quite limited in scope. They might offer you a contract on a commodity such as coffee, but not on equity shares. Or the exchange might deal with currency, but not precious metals.

CFD’s are available on a variety of products from currency trading (Forex), stock indices (Australia 200), shares from around the world, energies, metals, commodities, rates and bonds, and more. The options are vast that your CFD provider can offer.

5. CFD’s Mirror the Underlying Shares

The problem with some investment types, such as options, is how market sentiment can greatly sway the cost. A call option could have a fair market value of $1 based on a theoretical pricing model, but it may be trading for $2 because of market expectation (implied volatility).

CFD’s generally mirror or match the price of the underlying shares. This means that even though options might be greatly overvalued on a certain asset, you can still pick the CFD up for a competitive price.

6. Low Commissions and Interest

Assuming a large position with the purchase of equity shares can be costly. In many cases purchasing CFD’s can have a more competitive price. Of course, you would need to check with your individual provider for the exact numbers.

As well, you do not have to pay the GST on CFD’s. This is an upfront savings.

In addition to that, if you purchase a short CFD, you will accrue interest.

7. CFD’s Do Not Expire

Imagine the frustration of the options trader that is nearing his strike price and about to make profits when suddenly his contract expires worthless. This problem is removed with CFD’s since there is no expiry date. If you feel the asset has more upside potential, you can continue to hold your position. When you want out, you sell without worry of losing any extrinsic value.

CFD Disadvantages

While there are many upsides to CFD’s, there are a few downsides that need to be acknowledged.

1. Massive Leverage

This was a positive aspect, but it can double as a negative one too. If a trade goes against you the losses can pile up very quickly. This is the two edged sword of trading heavily on margin. Some have likened this to a fire which can be your friend on a cold night, but just don’t let it burn you.

2. Financing

Purchasing CFD’s will accrue financing fees if held overnight. Remember that the cost of financing is on the entire asset amount. CFD providers will also add their own percentage on top of the central bank target.

3. Tax Laws

Taxes are generally levied when each CFD is closed out. This can be viewed as negative, positive, or neutral depending on each person’s circumstance. You may have made many profitable transactions, but be holding a losing portfolio into the New Year. Your losses will only offset your gains if you close out your positions during that year.

Not to give tax tips, but ask your accountant about Internet access, platform fees, and the like as a tax deduction.

CFD Advantages CFD Disadvantages
Trading Long and Short
No or Low Implied Volatility
Low Commissions and Fees
No Expiration Date
Overnight Financing Fees
Tax Laws