CFDs have a range of advantages that make them attractive to investors and traders across the full spectrum. From bedroom traders right up to pension funds and hedge funds, CFDs are traded in considerable volume, both on and off exchange, purely because of their unique package of benefits.
Leverage/Margin
Arguably the key advantage when it comes to trading in CFDs over, say, trading in shares directly is the extensive leverage built in to transactions. CFDs are traded on margin, which effectively puts the trader in the position of borrowing to amplify their positions. In practicality, while a margin requirement of around 5% might mean a 95% loan from the broker, this is more of an automatic transaction than a typical loan, and is offered in real time to facilitate high-gain trading. The effect of this is that when the total position gains 10%, the gross return on investment (before financing costs) when considering the margin requirement is in fact 200% – because the trader has only actually exposed 5% to the total transaction size yet can take 10% gains on the full 100%. Leverage allows rampant gains to be taken over very short periods of time, and is one of the main draw factors for traders considering whether or not to use CFDs as part of their investment strategy.
Tax Efficiency
CFDs are also comparatively more tax efficient than trading in underlying markets directly. Unlike share transactions, which attract an additional Stamp Duty liability in the UK, alongside Capital Gains Tax, CFDs are exempt from Stamp Duty because there is no share transaction actually taking place. Additionally, traders can deduct the costs of the transaction for tax reasons, reducing the amount of any gain and thereby reducing the amount of tax payable on the trade.
Flexibility
CFDs are inherently flexible instruments, allowing traders to take positions on both sides of a transaction. If a share market looks as if it is likely to fall, the trader can quickly jump on the sell-side with CFDs and make gains as heavily as they could on the buy-side when the market starts to fall. Furthermore, CFDs allow speculating on a wider range of markets that are more complex to trade directly, such as commodity markets and a range of indices, depending on what’s on offer from the broker. This makes CFDs a practically useful tool, particularly for those managing more extensive portfolios.
Low Cost
As trading instruments go, CFDs work out to be a more cost effective way to get involved. Aside from the tax advantages discussed above, CFD broker fees are almost always significantly lower than the costs associated with trading through more traditional share brokers, and the only other costs to bear lie in financing, which is a variable cost depending on how long you hold a position for, and is applied daily as a percentage on the financed part of your transaction. For positions disposed over the course of the trading day, there are no interest charges, thus for more short-term traders the costs are even lower.
Liquidity
One of the most important factors to consider when you’re trading anything is liquidity. Whether you’re buying CFDs or cattle or cucumbers, you can’t hope to make money unless there is a market for your product. The wider that market, and the easier it is to realise your notional gains, the more effective a market that is in terms of delivering a return. The market for CFDs is highly liquid because it tracks almost directly the underlying asset market. That means that market movements can filter through into the CFD transaction, making it easier to yield a profit and affording shorter investment cycles.
Hedging
The combination of the flexibility and liquidity of CFDs makes it the perfect instrument for hedging the risks of other positions, as a means of guarding the wider portfolio against unexpected market movements. Hedging is the process of taking out positions to serve as a safety net, such that if the markets move in an unexpectedly different direction to that forecast, all is not lost. The amenability of CFDs to hedging is a particular advantage for those managing wider portfolios, as a means of cutting down the risk profile of prolonged exposure.
No Expiration Date
CFDs have no set expiry date, unlike other forward looking instruments such as futures, which means they don’t decay in price and they are less restrictive. With a CFD, you can hold on to your position for as long as is necessary to yield a result, which gives you the flexibility to ride through market cycles if necessary, without the need to be more specific about the timeframe over which you anticipate the market to move in your favour.
The full extent of the plus points of CFDs is too vast to cover, but suffice to say the major perks outlined above make it a worthwhile means of speculating on an array of markets. While CFDs are no doubt a potentially highly lucrative way to make a splash in the markets, that’s not to downplay the extensive risks and disadvantages they pose.