The contract for difference (CFD) offers European traders and investors an opportunity to profit from price movement without owning the underlying asset. It's a relatively simple security calculated by the asset's movement between trade entry and exit, computing only the price change without consideration of the asset's underlying value. This is accomplished through a contract between client and broker, and does not utilize any stock, forex, commodity or futures exchange. Trading CFDs offer several major advantages that have increased the instruments' enormous popularity in the past decade.
How a CFD Works:
If a stock has an ask price of $25.26 and the trader buys 100 shares, the cost of the transaction is $2,526 plus commission and fees. This trade requires at least $1,263 in free cash at a traditional broker in a 50% margin account while a CFD broker often requires just 5% margin, or $126.30. A CFD trade will show a loss equal to the size of the spread at the time of the transaction so, if the spread is 5 cents, the stock needs to gain 5 cents for the position to hit the breakeven price. You'll see a 5-cent gain if you owned the stock outright but would have paid a commission and incurred a larger capital outlay.
If the stock rallies to a bid price of $25.76 in a traditional broker account, it can be sold for a $50 gain or $50/$1263=3.95% profit. However, when the national exchange reaches this price, the CFD bid price may only be $25.74. The CFD profit will be lower because the trader must exit at the bid price and the spread is larger than on the regular market. In this example, the CFD trader earns an estimated $48 or $48/$126.30=38% return on investment. The CFD broker may also require the trader to buy at a higher initial price, $25.28 for example. Even so, the $46 to $48 earned on the CFD trade denotes a net profit, while the $50 profit from owning the stock outright doesn't include commissions or other fees, putting more money in the CFD trader's pocket.
CFDs provide higher leverage than traditional trading. Standard leverage in the CFD market current starts as low as a 2% margin and can go up to 20% but will rise substantially under new rules set to go into effect later this year. Lower margin requirements mean less capital outlay for the trader/investor, and greater potential returns. However, increased leverage can also magnify losses.
Global Market Access from One Platform
Many CFD brokers offer products in all the world's major markets, allowing around the clock access.
No Shorting Rules or Borrowing Stock
Certain markets have rules that prohibit shorting, require the trader to borrow the instrument before selling short or have different margin requirements for short and long positions. CFD instruments can be shorted at any time without borrowing costs because the trader doesn't own the underlying asset.
Professional Execution With No Fees
CFD brokers offer many of the same order types as traditional brokers including stops, limits and contingent orders like "One Cancels the Other" and "If Done". Some brokers offer guaranteed stops that charge a fee for the service or recoup costs in another way. Brokers make money when the trader pays the spread and most do not charge commissions or fees of any kind. To buy, a trader must pay the ask price, and to sell/short, the trader must pay the bid price. This spread may be small or large depending on volatility of the underlying asset and fixed spreads are often available.
No Day Trading Requirements
Certain markets require minimum amounts of capital to day trade, or place limits on the amount of day trades that can be made within certain accounts. The CFD market is not bound by these restrictions and all account holders can day trade if they wish. Accounts can often be opened for as little as $1,000, although $2,000 and $5,000 are common minimum deposit requirements.
Variety of Trading Opportunities
Brokers currently offer stock, index, treasury, currency, sector and commodity CFDs so speculators in diverse financial vehicles can trade CFDs as an alternative to exchanges.
Traders Pay The Spread
While CFDs offer an attractive alternative to traditional markets, they also present potential pitfalls. For one, having to pay the spread on entries and exits eliminates the potential to profit from small moves. The spread also decreases winning trades by a small amount compared to the underlying security and will increase losses by a small amount. So, while traditional markets expose the trader to fees, regulations, commissions and higher capital requirements, CFDs trims traders' profits through spread costs.
Weak Industry Regulation
Also note the CFD industry is not highly regulated and the broker's credibility is based on reputation, life span and financial position rather than government standing or liquidity. There are excellent CFD brokers but it’s important to investigate a broker's background before opening an account.
The Bottom Line
Advantages to CFD trading include lower margin requirements, easy access to global markets, no shorting or day trading rules and little or no fees. However, high leverage magnifies losses when they occur, and having to pay a spread to enter and exit positions can be costly when large price movements do not occur.
What Is Forex?
The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.
The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of August 2012, the Bank for International Settlements (BIS) reported that the forex market traded in excess of U.S. $4.9 trillion per day.)
One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.
Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading and numerous forex brokers, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.
What is the spot market?
More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.
What are the forwards and futures markets?
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.
In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.
In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.
Both types of contracts are binding and are typically settled for cash for the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.
Note that you'll see the terms: FX, forex, foreign-exchange market and currency market. These terms are synonymous and all refer to the forex market.
Commodities, whether they are related to food, energy or metals, are an important part of everyday life. Anyone who drives a car can become significantly impacted by rising crude oil prices. The impact of a drought on the soybean supply may influence the composition of your next meal. Similarly, commodities can be an important way to diversify a portfolio beyond traditional securities– either for the long term, or as a place to park cash during unusually volatile or bearish stock markets, as commodities traditionally move in opposition to stocks.
It used to be that the average investor did not allocate to commodities because doing so required significant amounts of time, money and expertise. Today, there are several routes to the commodity markets, some of which facilitate participation for those who are not even professional traders.
Commodities: A History
Dealing commodities is an old profession, dating back further than trading stocks and bonds. Ancient civilizations traded a wide array of commodities, from seashells to spices. Commodity trading was an essential business. The might of empires can be viewed as somewhat proportionate to their ability to create and manage complex trading systems and facilitate commodity exchange, serving as the wheels of commerce, economic development and taxation for a kingdom's treasuries. Although most of theprincipals were people who actually created or used the physical goods in some way, there were doubtless speculators eager to bet a drachma or two on the upcoming wheat harvest, for instance.
Where to Invest Commodities
There are still multitudes of commodities exchanges around the world, although many have merged or gone out of business over the years. Most carry a few different commodities, though some specialize in a single group. For instance, the London Metal Exchange only carries metal commodities, as its name implies.
In the U.S., the most popular exchanges include those run by CME Group, which was formed after the Chicago Mercantile Exchange and Chicago Board of Trade merged in 2006 (the New York Mercantile Exchange is among its operations), the Intercontinental Exchange in Atlanta and the Kansas City Board of Trade.
Commodity trading in the exchanges can require standard agreements so that trades can be confidently executed without visual inspection. For example, you don't want to buy 100 units of cattle only to find out that the cattle are sick, or discover that the sugar purchased is of inferior or unacceptable quality.
Investment Characteristics of Commodities
Basic economic principles of supply and demand typically drive the commodities markets: lower supply drives up demand, which equals higher prices, and vice versa. Major disruptions in supply, such as a widespread health scare among cattle, might lead to a spike in the generally stable and predictable demand for livestock. On the demand side, global economic development and technological advances often have a less dramatic, but important effect on prices. Case in point: The emergence of China and India as significant manufacturing players has contributed to the declining availability of industrial metals, such as steel, for the rest of the world.
Types of Commodities
Today, tradable commodities fall into the following four categories:
- Metals (such as gold, silver, platinum and copper)
- Energy (such as crude oil, heating oil, natural gas and gasoline)
- Livestock and Meat (including lean hogs, pork bellies, live cattle and feeder cattle)
- Agricultural (including corn, soybeans, wheat, rice, cocoa, coffee, cotton and sugar)
Volatile or bearish stock markets typically find scared investors scrambling to transfer money to precious metals such as gold, which has historically been viewed as a reliable, dependable metal with conveyable value. Precious metals can also be used as a hedge against high inflation or periods of currency devaluation.
A cryptocurrency is a digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of this security feature. A defining feature of a cryptocurrency, and arguably its most endearing allure, is its organic nature; it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation.
BREAKING DOWN 'Cryptocurrency'
The first cryptocurrency to capture the public imagination was Bitcoin, which was launched in 2009 by an individual or group known under the pseudonym Satoshi Nakamoto. As of May 2018, there were over 17 million bitcoins in circulation with a total market value of over $140 billion. Bitcoin's success has spawned a number of competing cryptocurrencies, such as Litecoin, Namecoin and PPCoin.
Cryptocurrency Benefits and Drawbacks
Cryptocurrencies make it easier to transfer funds between two parties in a transaction; these transfers are facilitated through the use of public and private keys for security purposes. These fund transfers are done with minimal processing fees, allowing users to avoid the steep fees charged by most banks and financial institutions for wire transfers.
Central to the appeal and function of Bitcoin is the blockchain technology it uses to store an online ledger of all the transactions that have ever been conducted using bitcoins, providing a data structure for this ledger that is exposed to a limited threat from hackers and can be copied across all computers running Bitcoin software. Every new block generated must be verified by the ledgers of each user on the market, making it almost impossible to forge transaction histories. Many experts see this blockchain as having important uses in technologies, such as online voting and crowdfunding, and major financial institutions such as JP Morgan Chase see potential in cryptocurrencies to lower transaction costs by making payment processing more efficient.
However, because cryptocurrencies are virtual and do not have a central repository, a digital cryptocurrency balance can be wiped out by a computer crash if a backup copy of the holdings does not exist. Since prices are based on supply and demand, the rate at which a cryptocurrency can be exchanged for another currency can fluctuate widely.
The anonymous nature of cryptocurrency transactions makes them well-suited for a host of nefarious activities, such as money laundering and tax evasion. However, cryptocurrency advocates often value the anonymity highly. Cryptocurrencies are also considered by some economists to be a short-lived fad or speculative bubble - concerned especially that the currency units, such as Bitcoins, are not rooted in any material goods. Bitcoin has indeed experienced some rapid surges and collapses in value.
Cryptocurrencies are not immune to the threat of hacking. In Bitcoin's short history, the company has been subject to over 40 thefts, including a few that exceeded $1 million in value. Still, many observers look at cryptocurrencies as hope that a currency can exist that preserves value, facilitates exchange, is more transportable than hard metals, and is outside the influence of central banks and governments.
An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated once at the end of every day like a mutual fund does.
BREAKING DOWN 'Exchange-Traded Fund (ETF)'
An ETF is a type of fund that owns the underlying assets (shares of stock, bonds, oil futures, gold bars, foreign currency, etc.) and divides ownership of those assets into shares. The actual investment vehicle structure (such as a corporation or investment trust) will vary by country, and within one country there can be multiple structures that co-exist. Shareholders do not directly own or have any direct claim to the underlying investments in the fund; rather they indirectly own these assets.
ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid, and they may get a residual value in case the fund is liquidated. The ownership of the fund can easily be bought, sold or transferred in much the same way as shares of stock, since ETF shares are traded on public stock exchanges.
ETF Creation and Redemption
The supply of ETF shares is regulated through a mechanism known as creation and redemption. The process of creation/redemption involves a few large specialized investors, known as authorized participants (APs). APs are large financial institutions with a high degree of buying power, such as market makers that may be banks or investment companies.
Only APs can create or redeem units of an ETF. When creation takes place, an AP assembles the required portfolio of underlying assets and turns that basket over to the fund in exchange for newly created ETF shares. Similarly, for redemptions, APs return ETF shares to the fund and receive the basket consisting of the underlying portfolio. Each day, the fund’s underlying holdings are disclosed to the public.
ETFs and Traders
Since both the ETF and the basket of underlying assets are tradeable throughout the day, traders take advantage of momentary arbitrage opportunities, which keeps the ETF price close to its fair value. If a trader can buy the ETF for effectively less than the underlying securities, they will buy the ETF shares and sell the underlying portfolio, locking in the differential.
Some ETFs utilize gearing, or leverage, through the use of derivative products to create inverse or leveraged ETFs. Inverse ETFs track the opposite return of that of the underlying assets – for example, the inverse gold ETF would gain 1% for every 1% drop in the price of the metal. Leveraged ETFs seek to gaina multiple return of that of the underlying. A 2x gold ETF would gain 2% for every 1% gain in the price of the metal. There can also be leveraged inverse ETFs such as negative 2x or 3x return profiles.
Advantages of ETFs
By owning an ETF, investors get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share (there are no minimum deposit requirements). Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.
There exists potential for favorable taxation on cash flows generated by the ETF, since capital gains from sales inside the fund are not passed through to shareholders as they commonly are with mutual funds.
Examples of Widely Traded ETFs
One of the most widely known and traded ETFs tracks the S&P 500 Index, and is called the Spider (SPDR), and trades under the ticker SPY. The IWM tracks the Russell 2000 Index. The QQQ tracks the Nasdaq 100, and the DIA tracks the Dow Jones Industrial Average. Sector ETFs exist that track individual industries such as oil companies (OIH), energy companies (XLE), financial companies (XLF), REITs (IYR), the biotech sector (BBH), and so on. Commodity ETFs exist to track commodity prices including crude oil (USO), gold (GLD), silver (SLV), and natural gas (UNG) among others. ETFs that track foreign stock market indices exist for most developed and many emerging markets, as well as other ETFs that track currency movements worldwide.
Options are a type of derivative security. They are a derivative because the price of an option is intrinsically linked to the price of something else. Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option. People somewhat familiar with derivatives may not see an obvious difference between this definition and what a future or forward contract does. The answer is that futures or forwards confer both the right and obligation to buy or sell at some point in the future. For example, somebody short a futures contract for cattle is obliged to deliver physical cows to a buyer unless they close out their positions before expiration. An options contract does not carry the same obligation, which is precisely why it is called an “option.”
What are stocks?:
You have probably heard a popular definition of what a stock is: “A stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater.” Unfortunately, this definition is incorrect in some key ways.
To start with, stock holders do not own corporations; they own shares issued by corporations. But corporations are a special type of organization because the law treats them as legal persons. In other words, corporations file taxes, can borrow, can own property, can be sued, etc. The idea that a corporation is a “person” means that the corporation owns its own assets. A corporate office full of chairs and tables belong to the corporation, and not to the shareholders.
This distinction is important because corporate property is legally separated from the property of shareholders, which limits the liability of both the corporation and the shareholder. If the corporation goes bankrupt, a judge may order all of its assets sold – but your personal assets are not at risk. The court cannot even force you to sell your shares, although the value of your shares will have fallen drastically. Likewise, if a major shareholder goes bankrupt, she cannot sell the company’s assets to pay off her creditors.
What shareholders own are shares issued by the corporation; and the corporation owns the assets. So if you own 33% of the shares of a company, it is incorrect to assert that you own one-third of that company; it is instead correct to state that you own 100% of one-third of the company’s shares. Shareholders cannot do as they please with a corporation or its assets. A shareholder can’t walk out with a chair because the corporation owns that chair, not the shareholder. This is known as the “separation of ownership and control.”
So what good are shares, then, if they aren’t actually the ownership rights we think they are? Owning stock gives you the right to vote in shareholder meetings, receive dividends (which are the company’s profits) if and when they are distributed, and it gives you the right to sell your shares to somebody else.
If you own a majority of shares, your voting power increases so that you can indirectly control the direction of a company by appointing its board of directors. This becomes most apparent when one company buys another: the acquiring company doesn’t go around buying up the building, the chairs, the employees; it buys up all the shares. The board of directors is responsible for increasing the value of the corporation, and often does so by hiring professional managers, or officers, such as the Chief Executive Officer, or CEO.
For ordinary shareholders, not being able to manage the company isn't such a big deal. The importance of being a shareholder is that you are entitled to a portion of the company's profits, which, as we will see, is the foundation of a stock’s value. The more shares you own, the larger the portion of the profits you get. Many stocks, however, do not pay out dividends, and instead reinvest profits back into growing the company. These retained earnings, however, are still reflected in the value of a stock.
Stocks – sometimes referred to as equity or equities – are issued by companies to raise capital in order to grow the business or undertake new projects. There are important distinctions between whether somebody buys shares directly from the company when it issues them (in the primary market) or from another shareholder (on the secondary market). When the corporation issues shares, it does so in return for money.
Companies can instead raise money through borrowing, either directly as a loan from a bank, or by issuing debt, known as bonds. Bonds are fundamentally different from stocks in a number of ways. First, bondholders are creditors to the corporation, and are entitled to interest as wellas repayment of principal. Creditors are given legal priority over other stakeholders in the event of a bankruptcy and will be made whole first if a company is forced to sell assets in order to repay them. Shareholders, on the other hand, are last in line and often receive nothing, or mere pennies on the dollar, in the event of bankruptcy. This implies that stocks are inherently riskier investments that bonds.
The same is true on the upside: bondholders are only entitled to receive the return given by the interest rate agreed upon by the bond, while shareholders can enjoy returns generated by increasing profits, theoretically to infinity. The greater risk attributed to stocks has generally been rewarded by the market. Stocks have historically returned around 8-10% annualized, while bonds return 5-7%.