There are a large number of financial instruments and trading terminologies that can be confusing to both the beginner and intermediate investor. Terms such as Contracts for Difference (CFDs), spread betting, leverage, margin, day trading, stop losses, letting profits run, scalping, and positional trading often confuse traders. There are small differences between the meanings of each of these phrases. Unfortunately, the lack of trading terminology clarity usually ends up in substantial financial losses.
Quotations by financial experts and famous people echo these facts. For example, the quote by Benjamin Franklin: “An investment in knowledge pays the best interest” emphasizes the importance of ensuring that, as a trader, you take the time to understand the subtle differences between the different trading terms and concepts.
Contracts for Difference versus Spread Betting
Let’s take the first two terms mentioned above (CFD trading and spread betting) and look at the differences between the two concepts to determine which is better to use to profit from a financial market asset’s price movements.
What is Spread Betting?
Dan Blystone in his article titled “What is Spread betting” states that “spread betting is a derivative strategy, where participants do not actually own the underlying asset they bet on… [they]… speculate on whether the asset’s price will rise or fall, using the rates offered to them by a broker.”
The most prominent advantage of spread betting is that it is the simplest and most affordable way to begin your online trading career. Spread betting is also classed as gambling. Conversely, spread betting’s most significant disadvantage and most salient point of the trading strategy is that you trade on broker-determined prices, not live financial market asset prices.
Contracts for Difference: A succinct definition
Simply stated, a Contract for Difference (CFD) is a financial contract that is taken out between two legal entities, typically broker (seller) and trader (buyer). Essentially, CFDs are financial derivatives that allow investors to benefit from a linked underlying asset’s price movements without purchasing the underlying asset. CFDs are great for trading on volatile assets like foreign currencies.
For example, if you want to profit from the price volatility of the EUR/USD but you don’t want to buy and sell the fiat currencies, you take out a CFD where you and your broker agree on an opening and closing price as well as the time frame that you want the trade open for.
Additionally, the CFD states that if the difference in opening and closing prices is positive, the broker will pay the trader the difference in these two prices. Conversely, if the stated price variance is unfavorable the trader will pay the broker this amount.
CFDs versus Spread betting
Except for a few details, CFDs are similar to spread betting. They are both leveraged products which trade on margin. A product that trades on margin means that when opening and closing a CFD trading position, you do not have to pay the total cost of the underlying asset. You only pay a percentage of this cost (the margin). The value of the margin percentage differs from asset to asset. The general rule of thumb is between 10% and 30% of the contract’s total value.
Both trading instruments are also best suited to short-term trading strategies like scalping and day-trading. If you take out a long position on a CFD or a spread bet, you will have to pay an additional daily interest rate on the money you have borrowed to keep the trade open. It stands to reason that this extra amount will eat into your profits so, eventually, it won’t be worth keeping the trading position open.
The most critical difference between CFD trading and spread betting is that CFDs are based on the current value of the underlying asset and not a broker-determined price as in spread betting. This is also the most significant disadvantage of spread betting. You are in fact trading against your broker instead of being able to leverage the asset’s exact minute by minute price movements as its traded on the global financial markets.
It is also for this reason that the CFD is a superior product. It might be more difficult to understand the CFD-trading nuances. However, when you open a trading account with a broker like Jones Mutual, a CFD expert will help you learn how to trade successfully with CFDs.
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