Contracts for difference, AKA CFDs, are a grey niche market in the financial markets. There is a legitimate reason for those who view the CFD market as unnecessary as the CFD market is, sort of say, a secondary market for those who do not wish to enter the complicated process of exchanges and securities regulation. There are some advantages to the CFD market though. Let’s put it all out there, good and bad.
- CFDs, plain and simple – What are they?
- CFDs – good or bad?
- What are the pros and cons of CFDs?
- Is it legal to trade CFDs in the United States?
- CFDs Brokers
- If you decide to trade CFDs, then…
CFDs, plain and simple – What are they?
OK, imagine a friend offers you to trade against him on the gold price. Let’s say the gold price is $1200, and your friend tells you to choose the direction (up or down). You choose to buy gold, meaning every increase (the difference from the price you bought the security) in the gold price will be paid by your friend, otherwise you will pay your friend the difference. In that case, your friend is now a market maker, hence, he’s making a market, even if he has for the moment only one client. And in a way, you are playing against each other.
In order to understand better CFDs, let’s understand leverage. Then, imagine you are not that rich but your friend has some pocket money. He tells you then that he can leverage your amount of money, hence if you deposit 1,000 USD it will be equivalent to 10,000 or 100,000 (depends on the leverage he provides). For you, it’s an opportunity to make a high profit with a relatively low amount of money. For him, you are now statistics.
However, it’s still a fair transaction if both sides know all the risks and rewards.
The CFD market suffered many years of defamations and criticism. Is there a need for this market? Aren’t the regulated exchanges (stocks, futures, ETF’s, etc) enough for investors and traders?
In addition, CFDs brokers were perceived as scams companies, changing rates, offering excessive bonuses and holding your withdrawals when you wish to pull out your funds. And, it’s partly true, they did some of those things. So far, it has been an unregulated industry managed by the quick buck management.
So what is the need of retail investors/traders in CFDs brokers? It will never be a market with a purpose, such as futures exchanges, stocks, and bonds that provide a tool for companies and investors to recruit capital and grow. The CFD market, however, can provide other benefits to traders.
The CFD industry has changed – regulators realized that the industry is here to stay. There are many traders that find this type of trading more attractive than stocks or futures – it’s fast, dynamic and volatile. Moreover, several things have changed the industry in the past years towards a sort of legitimate industry:
First, ESMA and other regulations that restrict the brokers:
- Brokers are not allowed to offer bonuses in order to attract investors
- The leverage, which was previously determined by the brokers’ is now limited to 1:30
- A disclaimer must be mentioned with the broker content (Ads, articles content, reviews, etc)
- Documentation and authorization of new customers are mandatory and inline with the broker’s authorized regulation.
Another good thing that happened in the industry, at least for the traders, is the concentration of brokers. Instead of many unknown small brokers (which some are still in the market), today, there are 5-10 big brokers with capital and the stability to pay back their loses. Those brokers include AvaTrade, Plus500, IG, and Forex.com (for US residents).
What are the pros and cons of CFDs?
- The possibility to trade with a small amount of money
- Trading platforms and functions are easy to learn and operate
- Commissions are relatively low
- The option to earn a high profit with a low amount of deposit
- Compared to banks and investment banks – easy to open an account
- High risk and again, high risk to lose your money
- Leverage can be an obstacle
- Not fit for long-term investments (check for overnight interest rate and hidden commissions)
Is it legal to trade CFDs in the United States?
Trading CFDs in the United States is illegal unless the broker is regulated through the SEC. There are some brokers that provide CFD trading for US residents – Forex.com and Oanda provide this service.
As mentioned above, for those who are located in the US, Forex.com is one option. Other options include Oanda and Interactive Brokers.
Risk warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money
If you decide to trade CFDs, then…
Do not use high leverage! It can work once, twice and maybe ten times but eventually, you will lose.
Don’t go too crazy with your first deposit, the only way to have a profitable account is if the profit or loss match your tolerance. Otherwise, you will lose in a second. It’s a mind game.
Do not listen to any of the analysts at the broker’s side. Even if they are not against you, they are not on your side.
Be ready to lose. No one can always win in CFDs day trade.
If you are a long-term investor or wish to take a steady and stable investment, it’s not for you…
*Risk Warning. CFD trading carries a high level of risk and may not be suitable for all investors. CFDs are highly leveraged over-the-counter derivatives. You can lose more than your initial deposit and your potential losses may be unlimited.