You have probably heard of contracts for difference in your many of few years as an experienced trader. It is a type of trade that professional or experienced investors engage. CFD trading is allowed in many over-the-counter markets across the globe. However, it is prohibited in a few countries like the US. This article will explore why this trade is considered illegal and give you a head start before you decide to join the trade.
What are CFDs?
A CFD is a contract between two people, an investor and a broker, who agree to make money by betting on the increase or decrease of the stock, currency pair, or commodity prices in the global market. The buyer believes that the asset under sale will increase in value from the time the trade is opened to when it closes, while the seller believes that the price will decline: the buyer and the seller profit when they make correct guesses and lose when their guesses are wrong.
One of the key differences between this trade and the traditional financial trade is that actors do not possess the underlying assets. The traders also make a profit whether the commodities are increasing or decreasing in price because the trade is not about the value of the commodity but rather the price difference. Although this trade is very profitable, it is extremely risky for inexperienced traders. It would be best if you were an expert before you could engage in this form of trade.
Why are CFDs illegal in the US?
It’s worth noting that trade in CFDs is only prohibited to American citizens. However, non-American citizens can trade, and hence, there are CFDs on US stock market indices. CFDs are traded over–the–counter and are not listed on any regulated market exchange due to their high level of risk.
The US law prohibits American citizens from engaging in illegal trade both within and outside their territorial borders. For this reason, most CFD brokers do not allow Americans to trade or even open CFD brokerage accounts. However, American citizens with dual citizenship can open CFD accounts outside the country. The trade would, however, not be regulated in its home country, thus exposing the trader to all CFD risks.
The main reason CFDs are illegal in the US is that they are extremely risky and highly unregulated. CFDs are risky because:
It is leveraged– This type of trade requires very little capital to start. Traders can place as little as 2% of the total investment and borrow the rest from brokers. Borrowing money from trading platforms gives the brokers leverage over traders because they sometimes have to pay over 30 times the money they invested or borrowed. Each loan offered is charged a high amount of daily interest that could accumulate large amounts of unpayable debts.
It is unlimited– This trade is also risky because traders can lose more money than they initially invested. So as the trader trade, he gets into a vicious circle of losing money, borrowing more to reinvest until they are left bankrupt.
No collateral is required– In this trade, traders do not need to own the underlying assets. Instead, they own the contract made between them and the CFD provider. Hence, there is no point in time when traders benefit from the capital growth of the asset.
Illiquid: CFDs are not always liquid. A trader may not find a buyer when they want to close a trade position.
The market can be volatile– CFDs are also affected by volatile market conditions like their underlying assets. CFDs can swing back and forth without notice in volatile markets.
So, what alternative trades can you engage in? There are several legal investments that you can profit from. Some of them include options, leveraged EFTs, binary options, forex, and futures contracts. Unlike CFDs, these types of trade are highly regulated, and traders are protected from unfavorable conditions and practices that lead to extreme extortion.
All financial investment involves risks. CFDs are not exempt. However, CFDs operate in a highly unregulated market environment that exposes the traders to extreme risks that could lead to massive loss of money. It would be much beneficial for traders if more measures were put in place to regulate the trade.