What’s a CFD?
A CFD (Contract for Difference) is a contract between a "buyer" and a "seller" certifying that the seller will pay the buyer the difference between the stock price at time of purchase and its price at time of sale. In other words, buying a CFD allows the buyer to profit (or lose) from the difference in stock price without actually buying the stock itself.
Under certain conditions, as described below, and if your broker allows you to choose between stock or CFD trading, I recommend you choose CFD without a moment’s hesitation! CFD is executed in exactly the same way as stock trading. In fact, if your broker does not expressly state what you're trading in, I'd wager you won’t even notice the difference.
How does CFD Trading Differ from Stock Trading?
When you buy stocks, you buy them through the stock exchange from a person interested in selling them at the exact same time you’ve decided to buy. One of the biggest issues with the stock exchange is the scope of supply and demand. But we don’t always find the buyer or seller with the required amount, and we often need to “chase the stock.” Chasing stock generally costs us both money and health. But when you buy CFD, you're not buying stock at the exchange; you're buying a contract identical to the stock from your broker.
The advantage of this method is that your broker can allow you to buy or sell any quantity without linking it to stock exchange liquidity.
Here’s an example: Let’s say you want to buy 1000 shares, but sellers are currently only offering 100 shares. You would have to wait for additional sellers, or possibly pay a higher price for additional stock. When you trade in CFDs, you are not limited by quantity, and therefore the instant you hit BUY, you receive the full amount you wanted, even if that supply of shares is not currently available in the stock exchange. Similarly, when you wish to sell 1000 shares, you will not have to wait for buyers to take the full quantity. You just sell by hitting the SELL button. If you have experience in the market, as I have, you understand that this method is nothing short of amazing!
Have you ever heard the claim that students in trading courses who use the "demo" (allowing one to practice trading without using actual money) almost always profit? That’s a true claim. One of the main reasons for their success is that training programs, like CFD trading platforms, do not limit the trader to market liquidity. You press the button – you’ve bought the stock! You press the button again – it’s sold! Any quantity, and at lightning speed. Traders in the real market can only dream of such immediacy. Ask any experienced trader what his or her biggest problem is, and the complaint topping the list will probably be speed of execution and liquidity.
A Few Other Benefits of CFD Trading
- No Limit on Shorts – In the stock market, some stocks carry limits on shorts. That’s not true for CFDs. Nor is there any uptick limit which, in the real market, limits the broker’s ability to execute shorts unless the stock rises by one cent.
- High Execution Speed – Buy and sell orders of regular stock go through a long process where the order is sent to the broker, who sends it to the stock exchange, and back. CFD trading is between you and your broker alone, making execution super-fast.
- High Level Margin – CFD brokers are not limited to the usual scope of leverage on stock and can therefore let you margin up to 20:1. How does that translate? If you deposit a sum of $10,000 in your trading account, you can execute trades up to a total of $200,000. A word of warning: high leverage is a blessing to very experienced traders, but can be extremely dangerous for new traders.
What to Check before Choosing Your CFD Broker
- Buy/Sell Spread – You need to check if you broker allows you to trade in regular market spreads. In other words, check that he does not "open" the spread between the seller and buyer price beyond what is shown in the stock exchange where the real share is being traded. I know of CFD brokers who, instead of taking execution commissions, open the spreads by three to ten cents and even more. In this regard, I can say that the broker I use, COLMEX, allows me to trade in real market spreads.
- Diversity of Stock – Some 10,000 stocks are traded on the American stock exchanges. Of these, for a variety of reasons such as volume of activity, only about 2000 are suited to CFD trading. Some brokers only offer a small range, some offer dozens or a few hundred, and some, like COLMEX, offer a few thousand, which is all that’s needed for trading. So, be sure to check with your broker to know how many stocks can be CFD traded.
CFD trading is legal, accepted, and supervised by the regulatory authorities in most countries in the world…but not the USA. If CFD trading is so good for traders, why is it blocked to USA traders? As I explained above, a CFD doesn’t trade the stock itself. If all market activity focused on CFDs instead of trading in stock, the stock exchange would lose its main raison d’etre: recruiting capital for companies.
In short, if you live outside of the USA, you might prefer to open a CFD account after checking with your broker that they offer real market spread, a reasonable commission and a broad supply of stock. If you live in the USA, the only way to trade in CFD is by joining a group of proprietary traders operating outside America, who may be looking for traders, including Americans, to broaden their trading base.
A Word of Caution
It’s for good reason that the United States has set day trade regulations requiring a minimum of $25,000. In the past, when this standard was determined, commissions were far higher. When the minimum commission stood at tens of dollars per transaction, the trader had no choice but to operate in large amounts of money to offset the impact of these commissions. If a trader did not have a serious deposit in the account, the commissions would gobble up all the trader’s profits. Now, with commissions far lower and the minimum currently at about $1.50, the trader can buy and sell small quantities without lessening his or her chances of success. In some countries where Tradenet is active, such as areas of Eastern Europe, the monthly profit target is $1000, which equates to twice the average monthly salary. In short: America is not the whole world, nor is the entire world American.
Nonetheless, relative to the profit levels and your cost of living, years of experience have taught me that the higher the initial deposit, the greater your chance of survival…and the greater your chance of reaching success.
To learn more about the stock market and to begin your own journey toward financial independence, visit Meir Barak's site Tradenet and check out his book "The Market Whisperer."
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer