CFD Trading: An Introduction: Part 1

Contracts For Difference or frequently referred to as CFDs is a financial vehicle gaining in popularity with private traders for its flexibility and features. A CFD has many advantages and for any trader it is yet another useful tool to use in the business of trading. CFD trading has been used in the UK stock market for a number of years now but the trading was largely restricted to large institutions. Recently the scope for CFD trading has expanded to include private investors in the action. This enables the small private trader to participate in trading the performance of a stock as opposed to owning the actual equity.

CFD trading has revolutionized the personal share trading industry by allowing traders to enter into a trade without putting up the full capital into the investment. Trading CFDs has allowed traders to have a low cost exposure to equity movements which is especially important for the trader’s bottom line. Depending on which country you’re in this financial instrument attracts no stamp duty. These unique CFD features are an attractive advantage for traders who make a living from the markets.

You must remember that CFDs are a derivative of an actual vanilla price. That is, CFDs derive their value as a result of the price of an underlying instrument or price – such as the price of the actual share or commodity. Therefore CFD trading encompasses gearing and hence this financial vehicle should be used with caution by beginners.

The origin of CFD’s began when the need of non market makers to be able to short stock increased in the 1990s in the UK equity market. This is the story of the beginnings of CFD trading. Before this push for CFDs by non market makers, only the market makers were able to short stocks and these were mostly large investment banks. The users of this system managed by the investment banks were typically the hedge funds, arbitrageurs as well as other funds utilizing neutral market strategies. Demand grew out of long contract transactions to be able to short stocks. No stamp duty is paid on CFD trading because no real stock transfer of ownership takes place. And as no actual change of ownership takes place, the trader does not have any ownership rights such as the right to vote. But on the other hand CFDs expose the trader to the real time performance of a stock price including dividends and corporate actions.

Now when traders enter into a trade most CFD firms choose to hedge their position directly into the underlying market for all CFD transactions. This feature may or not be one of the important points in choosing a CFD provider, as some may not hedge all positions. It is your decision whether you will risk having a provider that hedges every trade or simply a provider that hedges some trades. For those providers that directly hedge all their trades, CFD liquidity is almost always a reflection of the liquidity of the underlying stock in its underlying marketplace. And with today’s technology, CFD trading transactions are instantaneous.

George Polizogopoulos is a staff writer for MyShareTrading.com, an information hub for traders: forex, shares, derivatives, CFD's. MyShareTrading.com also provides free blogs for traders who wish to share their market experiences.

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