The following is a sponsored blog post:
The on-going digitization of trading continues to create new and exotic derivatives of traditional market instruments that allow access to increasingly complex trading strategies to increasing numbers and types of traders. Contemporary CFD (Cash For Difference) brokers offer the opportunity for retail investors of all sorts to make leveraged long and short trades across an enormous variety of markets.
By offering traders the opportunity to take positions in the market without the added hassle and complexity of actually ever having to own the underlying securities, commodities or currencies, CFD brokers such as CMC Markets, for example go beyond traditional margin trading to offer a new world of leveraged trading to retail investors.
What Is Margin Trading?
Traditional margin trading is simply a service offered by brokers where trading accounts are allowed to hold fractional deposits as collateral for purchased securities, commodities and currencies.
Since the brokers are “holding” these market instruments for the trader anyway, as part of their clearing and custody service, they can offer what is, in essence, a loan to the trader with the market instruments being held acting as collateral. If the price of the collateral (the market instrument) goes down, and the trader is unable to cover the new margin, then the broker can simply sell the instrument to cover their loss.
In this example, the second trade is made with £100,000 extra that is borrowed against the security purchased. When the £240,000 worth of security is sold, the £100,000 is repaid to the broker. Had the price of the security gone down, then the value of the stock used as collateral for the borrowed funds would have decreased, and the trader would have had to either top up the margin with extra cash or sell some of the security to cover the difference.
What Is a CFD?
A CFD (Cash For Difference) contract is a newer form of market derivative offered by some brokers that allows traders to take positions in the market without any actual market instruments needing to be bought or sold. Instead of purchasing a security at one point in time, and then selling it for a profit or loss at another point in the future, the trader and the broker agree on a derivative contract where the difference between the present and future price at a point in time determined by the trader is either paid to the trader by the broker (rise in the price of the underlying market instrument) or to the broker by the trader (fall in the price of the underlying instrument).
These contracts can also be reversed so that the trader gains in the event that the underlying market instrument price falls. Hence the name “cash for difference”, where the only factor that matters is the difference between the price of the underlying market instrument at the start and end of the contract, which is then paid out in cash.
The Key Differences Between Margin Trading and Trading CFDs
The defining feature of CFDs is that they are not legally associated with any form of ownership of the actual market instrument the contract is based upon. The fact that all CFD brokers offer margin trading services for traders using CFDs is unrelated to this defining feature; it is merely an additional bonus beyond the differences of trading CFDs instead of the underlying market instrument they are based upon. The key differences between trading CFDs and trading the underlying instruments are:
1. No Stamp Duty for CFDs: since CFDs are only derivative contracts and not actually instruments of ownership, there are no stamp duty taxes applied to their purchase.
2. CFDs Make it Much Simpler to Short Market Instruments: Setting up a short position through a traditional broker can be extremely complex and expensive. Many exchanges have additional rules and limitations on short positions, and it may be difficult or prohibitively expensive to short many types of market instruments. CFDs are not restricted by these limitations, and most CFD brokers offer simple short contracts on the full range of market instruments they deal in.
3. CFDs Cover a Broad Range of Markets in One Location: Many traditional brokers have limited or no presence in various markets, meaning that you need to procure the services of a number of brokers to trade in all the market instruments that interest you. CFD brokers cover a huge range of market instruments in one convenient location.
4. CFDs Offer No Actual Ownership Rights or Obligations: Since a CFD is not actually a form of ownership, you have no rights to the benefits of, or obligations to, a market instrument beyond the rights in the CFD contract associated with differences in its face value over the contract duration. Therefore, you will not receive dividends or coupon payments, nor be able to attend shareholder meetings and so on.