Based on Investopedia definition “ A contract for differences (CFD) is an arrangement made in a futures contract whereby differences in settlement are made through cash payments, rather than by the delivery of physical goods or securities.“
A CFD or a Contract for Difference allows you to trade a wide range of popular financial markets including individual stocks, stock indexes, commodities, bonds, precious metals and Forex currencies in both rising and falling markets. This means that you can build a diversified portfolio and have access to much wider trading options.
CFDs are designed to mirror the price of these underlying assets. This way you can take advantage of the price fluctuation without actually owning the underlying instrument. Technically a CFD is a financial contract agreement between the trader and the CFD broker and will allow you to speculate on whether you think the price will go up or down.
How CFD Trading Works?
Each share or asset has buy and sell price known as the bid and the offer price which are derived from the underlying market. If you think the market will rise in value you buy at the ask price, called going long. If you think the market will fall in value you sell at the bid price also called going short. The more the market moves in the direction you predicted the more profits you make. The more the market moves in the opposite direction the more you could lose. It’s up to you how long you keep the trade open.
Advantage and Disadvantages
There are advantages and disadvantages to trading CFDs. Traders who want to start trading CFDs need to completely understand them as a mechanism before trading. CFDs are traded on margin, you only put up a percentage of the trade as collateral based on requirements set by your CFD broker which makes it cost-effective.
Trading on margin as a trader you really wouldn’t have to put the entire cost of a trade as you would with a stock investment. You’re required to maintain a certain amount of margin in your account as defined by your CFD broker, but it’s a fraction of the cost of buying the stocks outright.
As an example, if you wanted to buy 5 shares of a company XYZ that trades at $200 you would have to pay $1000, but if you bought 5 XYZ CFD contracts at $200 and the margin was 5%. The outlay would only be $50. Any increases in the price will, therefore, be at 20 times return on invested capital, but potential losses could be just as dramatic.
It’s important to remember the risk of leverage as your deposit is only a small part of your overall exposure and you can lose substantially more than your deposit if the trade goes against you. However, it is possible to reduce your potential losses by using a stop order. This means that the trade will automatically be closed if it goes against you by an amount you specify.
In addition to your deposit to open or close a CFD trade, you might have to pay a small commission, which can be as low as 0.1%. Other markets such as indices and Forex currencies are commission free. You may also have to calculate interest adjustments that are added or subtracted from your trade if you hold the trade overnight and consider any dividend adjustments.
There are potential disadvantages that you need to be aware of when trading CFDs. CFD instruments are not available in certain parts of the world and you can’t trade them. Higher spreads can be another pitfall to CFD trading as it can ruin any potential profits.
A CFD is a derivative which is always linked to the price of the underlying instrument. CFDs are a flexible and attractive and alternative to other financial vehicles, therefore allows you to explore many alternative options. CFD trading allows you to make money both when the market is rising or falling. You don’t have to put up the full cost of exposure to the market and there is no fixed time period for your trade. With CFDs, you’re able to trade a multiple of your own capital and that’s what we call leverage.