What are the benefits of CFD Trading?

[SJCFDs]

What about the disadvantages of CFD trading? So we can balance out the picture a bit...

Great question - it's the first time I have seen that asked on this forum!

What I think we really need to look at is the "differences" between CFD trading versus other trading formats - after all, what is a disadvantage to one person, may be an advantage to another.

As we have discussed already, there are a few main differences. I will concentrate on comparing CFD trading versus equity trading - (it will be slightly different when compared to Forex, Futures or Commodities) If any one wants to know the differences when compared to these 3 - let me know and I will answer in another post.

Differences:

1) Leverage vs Full price purchase of stock - I wont hammer this point as it has been dealt with above. Basically to hold a CFD position, using leverage there is no need to tie up the full monetary value of purchasing the equivalent stock position. This leads onto:

2) The fact that you are buying/selling on leverage means that you will be charged/credited interest on your position - the interest charged/credited will be equivalent to the interest charged/credited on the full value of the stock position (i.e. the money it would take to buy the actual shares) The interest rate is usually set by the individual broker and again usually set with a spread around the base rate of the country within which the shares are traded. So Uk shares would be based around LIBOR, US shares based around the Fed Rate etc.

Some people have stated that the interest charges make CFDs only useful for short term investments. I have to disagree here - quite strongly!! Without getting too technical - the concept of interest only exists due to the idea of "opportunity cost". If you enter your CFD position on leverage and the rest of the money that you WOULD have tied up in an equity position is just left under your mattress, then sure - you will receive little benefit by holding a CFD - Interest wise that is!!

However - if you were to buy on 5X leverage and then stick the remaining 80% of the money in a high interest account - then that will MASSIVELY offset the interest payments on your CFD position. Of course a high interest account is just the most obvious easy example. But as entrepreneurs know - there are a MILLION things you can do with your money - each one carrying a different risk/return profile. The opportunity cost is the cost of missing the opportunity of using the money tied up in an equity position for anything else. I'm waffling a bit here - but the idea that interest charges become crippling when holding a CFD position over time are completely miss founded and totally miss understand the concept of interest and opportunity cost.

Very simply - It all depends HOW you will use the money left over from leveraging.

3) A VERY important difference between a CFD position and an equity position is that, with CFDs you NEVER actually own any shares. You are entering a "Contract For Difference" - that is a contract to pay or receive the difference in value between the time of opening and closing the contract. CFDs are concerned ONLY with movements in price - NOTHING else. The contract is between you and your broker.

This means that CFDs carry NO VOTING RIGHTS and NO ENTITLEMENTS TO DIVIDENDS. This branches out into issues regarding tax liabilities and investment aims/time frames (e.g. dividend tax, desire for dividend income etc.). You could write a book on this issue alone. If you have any specific questions - please ask!

4) Risk profile/investor suitability. Leverage CAN be a good thing - but of course that only holds for profitable trading - as your profits are magnified by leverage.

The converse is true - any losses incurred will be magnified also. If you are leveraged 5x - for every 1% the stock price goes against you - your deposit will suffer a 5% hit. Leverage 10x and that 1% has just wiped out 10% of your portfolio.

Also - leveraged trading opens you up to the possibility of losing MORE than your initial deposit - you could wipe out you funds and owe MORE to you CFD broker. This can not happen if you buy the physical equities. It CAN happen if you short equities but retail investors will find it nearly impossible to short equities in the physical market.

There are many more subtle differences which affect some people more than others. If there is anything specific you wish me to expand on - please let me know.

Regards

[collegeboy]

Thanks so much for this response. What a thorough answer! Can you expand on how to hold a CFD for long-term? I read somewhere that CFDs are really only profitable short-term but you implied that this is false.

[luckystrike]

nice post SJCFDs but note that you still get dividends with CFDs.

[SJCFDs]

nice post SJCFDs but note that you still get dividends with CFDs.

Hi Luckystrike,

I'm sorry if this sounds a bit pedantic but you are technically not entitled to dividend "PAYMENTS" when holding a CFD.

What you actually recieve/pay out is a dividend "ADJUSTMENT".

Note that your "dividend adjustment" will be credited/debited on the day the stock goes EX dividend (the EX DIV Date, however the "dividend payment" will not occur until the Pay date) This should convince you there is at least a technical difference.

Your profit and loss etc WILL reflect that of holding the physical shares over the same time period, but the make up of your profit will be subject to slightly different tax rules, i.e. when holding a CFD, none of your profit will be subject to "dividend tax" - the entirety will be subject to "capital gains tax".

When holding/trading small numbers of shares, then i guess this becomes a relatively moot point, but for clients trading millions of shares who suffer huge tax bills, then this is an element that a clued up tax advisor can use in their favour.

[SJCFDs]

Thanks so much for this response. What a thorough answer! Can you expand on how to hold a CFD for long-term? I read somewhere that CFDs are really only profitable short-term but you implied that this is false.

Hi Collegeboy,

I have seen this stated a number of times on this forum that "holding a CFD long term is not profitable".

I'm not sure if some of the people posting have just copied and pasted from another post, or whether they actually think that themselves and could back up the reasons why. To the people posting this idea - apologies if I am wrong in thinking this.

I guess the basic premise behind this argument stems from the fact that although CFD brokers will allow you to trade on leverage, any position you hold will be charged/credited interest on the value of the full position - i.e. the equivilant money needed to buy the physical shares.

When you buy the physical shares - any money spent on them is now "gone" as it where - you can not earn interest on money you dont have.

When you buy on leverage, you pay interest on the full value of the position, however you also get to "keep" a proportion of your money (the proportion you "keep" depends on your leverage multiple - 5x leverage, you keep 80% - 2x leverage, you keep 50% etc).

So if you trade at 5x leverage, although you are PAYING interest on 100% of the position, you have the opportunity to EARN interest on the 80% you have left over.

So you can see straight away that there is a differential working against you in the fact that you are paying interest on a higher figure than you are earning. The longer this differential exists (i.e holding a CFD long term) then theoretically the more it works against you.

Also - the CFD broker will charge you the country base rate PLUS a certain % for long positions, however will only pay you the country base rate MINUS a certain %. So that can tend to exaserbate the problem.

BUT - having said all that - i still maintain that people are missing the point when they claim that holding CFDs long term is not profitable.

We have only looked at the difference in potential "INTEREST EARNINGS". But take an example when the other 80% of your cash is placed in a say another CFD that rallies 30-40%. Remember - if you had bought the physical shares - you wouldnt have access to the money to do that. What looks like the better use of that 80% now????

Dodging the interest differential - or was it catching that 40% move???

I know what i think the better deal is.

Dont just think about interest charges. Base it in terms of "opportunity cost".

Interest rates only exist as a reflection of the increased opportunity you get from a $ today versus waiting for that same $ tomorrow. Interest is just one manifestation of attempts to account for the theoretical "time value of money" - i.e. lost "opportunities" of not being in possession of money until a later date.

It all depends on what you do with the cash you have left over from trading on leverage. "Catch all" statements like "CFD trading is only profitable short term" are just incorrect!!!