As an investor, understanding the differences between trading instruments is vital to ensure your success in the financial markets. It is essential when comparing two of Australia’s most popular derivatives, Contracts for Difference (CFDs) and Futures contracts. CFDs may provide traders with a higher degree of leverage than future contracts and can be used to trade both rising and falling markets.
Still, futures are underpinned by central exchanges that offer greater price transparency. In this article, we will delve into the details behind each product so that you can determine which one best suits your trading needs.
What is CFD trading, and how does it differ from futures trading?
CFD trading refers to a contract between two parties that seeks to exchange the difference in the value of an underlying asset from when the contract is opened to when it closes. The most common type of CFD product is an index which allows traders to speculate on price movements without needing to buy or sell shares in a company. It means that traders can take advantage of rising and falling markets and benefit from any associated dividends for indices such as the S&P/ASX 200.
The critical distinction between CFDs and futures contracts is leverage. CFDs are typically offered higher leverage levels than futures, meaning investors can access more prominent positions with a much lower outlay. Another distinguishing feature of CFDs is that they are not traded on exchanges, meaning that the pricing of CFDs is determined by the broker issuing them.
What are futures, and how do they differ from CFD trading?
Futures contracts are standardised agreements between two parties, with a set expiry date, to buy or sell an asset at a predetermined time and price. Futures can hedge against risks such as currency fluctuations or commodity prices, which cannot be done with CFDs due to their lack of physical delivery.
The key difference between futures and CFDs is that futures are backed by an exchange (such as ASX 24) where all trades executed will have access to transparent price data and third-party intervention in case of a potential dispute. It assures traders of low transaction costs and greater liquidity, allowing for more efficient price discovery than is available with CFDs.
How do you trade CFDs, and what are the risks involved?
Trading CFDs is a relatively simple affair. All you need to do is select the type of asset you would like to trade (e.g., index, currency pair, or commodity), decide which direction you think the price will move, and place your order with your broker. If the market moves in favour of your position, you can take advantage of it; however, if it doesn’t, losses may occur. As such, traders should ensure they are familiar with any associated risks before entering a CFD trade.
Risks associated with CFD trading include leverage risk – as high leverage magnifies both gains and losses and counterparty risk where one party fails to fulfil its obligations under the agreement. Furthermore, since CFDs are not traded on an exchange, pricing can be less transparent than futures contracts.
How do you choose a good CFD broker, and what should you look for in one?
When looking for a CFD broker, it is vital to ensure that they are well-regulated and offer competitive spreads. It would help if you also looked at the range of products available, as some brokers may only provide limited asset types or expiry dates. It is essential to carefully read the terms and conditions of any account before signing up to understand all fees you will incur.
Finally, it is worth comparing several different brokers to find the one that best meets your needs. It can be done by reviewing customer ratings online or speaking with colleagues with experience using different providers.
Examples of successful CFD traders and their strategies for success
Many successful traders have made good trades when trading CFDs. One recent example is an Australian trader named Tony Smart, who has been trading for over ten years and used a combination of technical analysis and fundamental research to build his portfolio. His strategy involves looking for emerging trends in the markets and using these as entry points for trades.
In conclusion
CFDs can be an interesting and exciting way to trade the markets, but it is essential to understand the associated risks and research a range of brokers before deciding which one to use. With the right combination of research and technical analysis, you, too, could become a successful CFD trader.
