What are CFDs in trading and how do they work?
What is a CFD?
According to https://dotbig.com/ the CFD (Contracts For Difference) is a type of derivative financial product. When we say derivatives, we mean derivatives of lifelong stocks. Other derivative products are options (perhaps they sound more like “stock options”) or futures.
In any case, CFDs are products that can be bought and sold, like stocks, within their own market. Of course, money can be made from them. And a lot.
Some conventional brokers allow you to trade CFDs, although there are brokers exclusively dedicated to this type of product.
Now that you know what CFDs are in trading, let's see some features for trading them.
Differences between CFDs and stocks
There are several reasons for doing this. CFDs can be an exciting option. Let's see why:
You access different markets through the same product
The price of the CFD quite accurately matches the price of the stock, so, to a certain extent, it is the same to have shares or CFDs.
The difference is that, in addition to having CFDs on Spanish stocks, there are also CFDs on American stocks. But, in addition, there are also world indices, commodity futures, etc.
That is to say, suddenly, you have access to speculate at the same time with such diverse underlying assets such as Microsoft, BBVA, S & P500, gold, crude oil, soybean oil, German bond, euro against the dollar, etc.
You can take short positions.
As you know, it is difficult, if not impossible, to find a broker that allows short positions with stocks (which is our weapon to make money when the stock market goes down). However, any broker that offers CFD trading will allow short positions on these products. In conclusion, you can be profitable both on the ups and downs.
A typical feature of financial derivatives is leverage. This means that with little money you can move a lot. You can have it physically or not, but it is common to move twenty-five times more money than you put on the table.
For example, if you buy $1000 in Telefónica shares, you have to give your broker $1000. If it goes up 5%, you will have won $50. However, with CFDs, you only need to give your broker $40 to control the equivalent of $1000 in shares, so with just $40, you would have won $50. This advantage is undoubtedly wild, but it also has a wild dark side: Leveraging means multiplying the risk. If you, with $1000, can control the equivalent of $25,000, you can win as if you had them, but you can also lose as if you had them.
However, the power of leverage can be used or not and, if resorted to it, can be used to a greater or lesser extent. That is, even if I have $1000 and only need to put $40 to move the equivalent of $1000, I can still immobilize my $1000, so that, deep down, I am not leveraging myself. I can also leverage slightly if, instead of immobilizing $1000, I only immobilize $700.
In any case, if you are a newbie, your destiny is to lose money on average, so you better never leverage yourself because you would accelerate your loss in the same proportion as you would leverage. Once you see that you can win consistently, you can leverage yourself to multiply your profits by moving much less money.
Advantages of CFDs
- It can be traded both long and short. We can take advantage of both the ups and downs.
- A multitude of underlying that allow you to have a wide range of opportunities. Products from various countries in a wide variety of currencies improve the diversification of our portfolio.
- They have leverage. With a few small guarantees, we can move a higher nominal. This gives us the possibility of obtaining good returns with small market movements. That is, they give us access to intraday trading.
- It only moves based on an underlying. There are no other variables that determine its oscillations. If the market closes, the underlying CFD stops.
- Possibility of entering conditional orders such as OCO (One Cancel the Other) or If Done and related orders of all kinds (stop, limit, moving stop, stop if bid, etc.)
Drawbacks of CFDs
- Some low-volume stocks are not short and/or do not allow leverage.
- Leverage will become inconvenient if we do not use protective stops and respect our capital management and risk control.
- The CFD does not perfectly replicate the movement of the underlying, so on daily charts or lower (shorter time frame), we have to trade directly with the broker's charts. ( ProRealTime is no longer valid, for example).
- They are not especially cheap. Global commissions, whether in the form of commission or spread, are usually relatively high.
Now that you know what CFDs are and what they entail, I will tell you in detail the truths and lies about them.
The first thing you have to be clear about is that if you lose money doing CFD trading, it is your fault.
But, (but), that does not mean that CFD trading is easy and that you do not have to consider some things (which we are going to see now) to make money trading CFDs.
The truth about CFD trading: You won't have it easy
Look, it's true: The CFD broker is against you.
Not only rumors and gossip say it. It is true.
Virtually all CFD brokers will deny it when you ask them directly (I always do), but to a greater or lesser extent, they are all market makers (they are market makers ).
That means that you are his direct opponent. If you win, they lose, and vice versa.
What does this mean?
Does it mean you can't win?
No, it's not that either. Yes, you can win.
For three reasons:
1. The first is that they take advantage of the fact that the market is good enough and the mass is stupid enough for the vast majority to lose money. By structure. No need for your intervention.
I repeat: the broker does not need to gamble you expressly so that you lose money against the market. If you are not an expert and with a level much higher than the average, you will crash into the market by yourself, and you are going to lose money. A capital that they will earn. I insist, without doing anything special.
2. The second is what is known as “netting” (from netting ):
Put yourself in the shoes of a CFD broker who has many clients:
Some of your clients (imagine 50) will want to buy a CFD on gold. And others will want to sell a CFD on gold (imagine 45).
The broker could counterpart the 50 buyers on the one hand by selling them a CFD on gold. And also to the other 45 vendors, buying it from him. (And, in theory, by going to a CFD market to find or place all of these contracts individually.)
But what is usually done is to neutralize the clients' positions among themselves so that they sell each other without ever reaching the market positions. So only the net result of positions (in this case of 5 CFDs) is what the broker has to support by sending to the market.
This allows you to win without losing money to the broker.
3. The third reason why it is not impossible to win is that the broker chooses whether it is worth fighting with you or not:
I mean, he already knows that most of his clients lose money. So, by default, he ranks against his clients as a whole, with the game won beforehand, statistically.
But what if it turns out that you are a crack, and you start to win much more than you lose?
Easy: the broker only has to pass your orders directly to the market instead of matching them himself.
If you are a loser, the broker will be happy to be your opponent. If you are a winner, let the market take care of you.