I recently attended the Trading and Investing Expo in Sydney and it surprised me at the CFD myths that continue to circulate regarding Contracts For Difference.
Most of these myths centred around the role of market makers and the way they execute orders.
In some part these myths are perpetuated by CFD brokers with an interest in promoting their own products.
I will review a few of these CFD myths in this series of articles.
Proponents of this myth argue that the market maker is trading against the broker.
This implies that the market maker knows what is going to happen on the market better than the individual trader does.
This is however unlikely to be the case.
Individual traders spend far more time analysing the markets than the CFD broker does.
It is not their core business to analyse markets.
The market maker makes money in three ways.
They charge brokerage on each stock transaction, they make money from the spread (the difference between the buy price and the sell price) and they make money from the interest charged on open positions held overnight.
None of these require the market maker to decide whether the market is going up or down.
That is the decision a trader makes and if the trader is correct the CFD broker could lose a lot of money.
To prevent this happening the market maker hedges the position.
If you were to go long 1000 CFDs on AAPL stock then the CFD broker will buy 1000 AAPL stock.
Now if you were right and made money on the CFD transaction the CFD broker made money also on the stock.
If you were wrong and lost money then the CFD broker also lost money.
They hedge their exposure to any CFD position that is entered.
The key difference between the way the CFD brokers act is the way the position is hedged.
Under the Direct Market Access (DMA) model every position that is taken by an individual trader is fully hedged by the CFD broker.
So if one trader was to buy 1000 AAPL CFDs and another trader sold 500 AAPL CFDs the DMA broker would buy 1000 AAPL stock and sell 500 AAPL stock.
With a market maker model the company may hedge the overall exposure.
So if one trader was to buy 1000 AAPL CFDs and another trader sold 500 AAPL CFDs the net effect is to be long 500 AAPL.
To hedge the position the market maker would buy 500 AAPL stocks.
When you look at how a CFD broker makes money, it is in their best interest to execute as many transactions as possible.
To do this the CFD broker takes every transaction that a trader wishes to place and then hedges the position to protect against losing money if the trader is right.
It is not you versus the market maker, it is you versus the market.
The CFD Provider simply provides a mechanism that allows you to execute your orders.
This myth is busted.